1. “ A Characterization of the Canadian Financial System ” Lecturer: Professor Gilles Bernier, Ph.D Industrial-Alliance Insurance Chairholder Department of Finance and Insurance, Laval University Participants: Undergraduate students from Bellarmine U. and Western-Illinois U. Quebec City, May 29, 2003

2. My Biography Professor of finance and insurance at Laval since 1978; Holder of the Industrial-Alliance Insurance Chair since 1999; Education: –Post-doctoral studies in risk and insurance at the Wharton School, U of Pennsylvania, 1987-88 –Ph.D in finance, U of Toronto, 1984 –MBA-Finance, Laval University, 1978 –BBA, Laval University, 1976. Other responsibilities: –Ph.D program director in 1991-92 –Associate dean, Academic Affairs, 1992-96 (AACSB) –Host of different U.S. schools [Lynchburg College (Va) & UNH]

3. Part 1: Introductory Concepts Content 1.Definition and Purposes of a FS 2.Do FI’s Add Value? An Example 3.Governance of FI’s: Comparing Models 4.Forces of Change Impacting FI’s 5.Why Regulate FI’s?

4. 1. Definition and Purposes of a Financial System A combination of institutional structures and regulatory framework that facilitates the following: –Inter-temporal transfer of cash –Inter-temporal transfer of risk Two basic/fundamental economic functions Facilitated by markets & institutions Creates innovative financial instruments

5. Financial System: A Schematic View

6. Financial vs. Market Intermediaries Financial Intermediaries –Commercial banks & other Near-banks –Insurance firms (L&H; P&C) –Mutual funds Market Mediaries –Investment banks –Financial markets (TSX, NYSE, etc)

7. Financial Intermediation Asset transformation / Portfolio Intermediation Raising funds by issuing financial liabilities –Secondary securities Financial claims on financial assets –Bank deposits, Insurance policies and annuities, MF shares/units Investing in financial assets –Primary securities Financial claims on real assets –Bank loans, Corporate bonds & equity

8. 2. Do FI’s Add Value? The Case of L&H Insurers L&H Insurers create value by providing 3 principal services: 1. Risk-pooling and risk-bearing –Risk reduction through a pooling mechanism Actuarial and underwriting activities are a major source of value added –Risks are also borne by shareholders (stock co.) or by previous policyholders (mutual co.) or by other parties holding the debt of the insurer (for both types of firms) This creates value added by increasing economic security 2. “Real” financial services relating to insured losses –Financial planning and counseling for individuals and administration of pension and benefit plans for businesses 3. Intermediation function –Funds raised are invested until withdrawn or needed to pay claims The net interest margin (difference between rate earned on assets and rate credited on products) is the value added here

9. 3. Governance of FI’s: Comparing Models Anglo-American Framework –Shareholder wealth maximization –Separation between banking & insurance –Separation between commercial and investment banking –Separation between the financial & the real sector Euro-Japan Framework –Stakeholder wealth maximization –Japan – Kieretsu network focuses on increasing market share –Bancassurance –Universal banking –Cross-ownership between commercial & financial firms

10. 4. Forces of Change Impacting FI’s Disintermediation Convergence Integration Consolidation Technological revolution Financial innovation Customer sophistication Globalization

11. Product Convergence Very significant within Canada’s FS sector, resulting in large financial groups –Banks in insurance, funds management –L&H Insurers in banking, funds management. Wide array of products being offered by those groups both directly and through subsidiaries. Emerging “monoline” companies focusing on one or a few business lines.

12. Convergence and Integration Strategies Distribution alliances –Agreements w/r to production & distribution Joint ventures –Joint production & distribution Mergers & acquisitions –Integration both within and between industries Greenfield / De novo entry –Entry into a new industry

13. 5. Why Regulate FI’s? Safety & Soundness –Supervision & examination of solvency –Transparency & disclosure Market power, concentration & competition –Level playing field –Fair pricing –Contagion effects Conflict of interest & Tied-selling –Consumer protection

14. Part 2: An Overview of Canada’s Economy Content 1. A Few General Statistics 2. The Relative Importance of the Financial Services Sector in the Economy

15. 1. A Few General Statistics As of 2001 (Swiss Re, Sigma No. 6 / 2002): Population of Canada: 31 million GDP: 705 billion USD Smaller Economy Among G7 Countries With Currently Best Real Growth Inflation Rate: 2,5% (vs 2,8% for the US) Exchange Rate: 1,376 per USD ( 5/22/2003)

16. 2. The Relative Importance of the Financial Services Sector in the Economy As of 2001: Significant contributor to Canada’s economic growth – Number of employees: Over 500 000 people – Yearly Payroll : About $24 Billion CDN Sector represented over 5% of GDP. Sector contributed approximately $9 billion CDN in taxes to all levels of government.

17. Part 3: Tracking the Evolution of Canada’s Financial System Content 1. Canada’s FS Before 1990 2. Canada’s FS After 1990 3. Assessment of Canada’s FS 4. Analysis of the Difference in Solvency Experience of U.S and Canadian L&H Insurers

18. 1. Canada’s FS Before 1990 Four pillars –Banks, trust companies, investment firms, insurance firms Two bank failures in mid-eighties Deregulation in mid-eighties –Banks take over securities firms (1987) –Banks take over trusts companies (1990) –Banks gain limited entry into insurance, and vice-versa (1992) Strong growth of the mutual funds industry during the 90’s

19. 2. Canada’s FS After 1990 3 L&H failures in early 90’s Major demutualization wave (n = 5) in the L&H sector (1999-2000) –Two recent mergers in the L&H sector Sun Life & Clarica in 2002 Great-West & Canada Life in 2003 Two large pillars –Domestic Chartered Banks and L& H Insurers Other smaller players –Property & Casualty Insurers –Credit Unions and Caisses Populaires, Savings & Loans Companies –Foreign Banks

20. 3. Assessment of Canada’s FS In 2000, the IMF undertook « The Financial Sector Stability Assessment » and concluded that Canada’s FS is: –stable and highly advanced and, –among the soundest in the world.

21. 4. Analysis of the Difference in Solvency Experience of U.S and Canadian L&H Insurers Kleffner & Jorgensen (1997) did compare this sector in both countries over the period 1976-91. They conclude that both industries are: –Similar in many ways; –Shifting from protection-type to accumulation-type product; –Intensely regulated and very competitive. On critical area where Canada did perform better over this period: Insolvency (2% vs 12%) –Main reason given: «… federal regulation of insurers in Canada is more consistent than regulation of insurers on a state by state basis in the U.S.. Canadian regulation also appears to have been more timely and proactive than in the U.S., particularly with respect to risk based capital standards… »

22. Part 4: A Quick Glance at Canada’s Banking Sector Content 1.Number of banks 2.The Six Largest Domestic Banks 3.Banking Concentration and Profitability 4.Canadian Banks Abroad 5.Delivery Mechanisms Used by Canadian Banks 6.Is Size Important for Canadian Banks? 7.Should Banks Be Allowed to Merge?

23. 1. Number of Banks (OFSI) Banks (69)  Domestic Banks (16)  Foreign Banks (32)  Foreign Bank Branches- Full Service (17)  Foreign Bank Branches-Lending (4)

24. 2. The Six Largest Domestic Banks (by asset size in decreasing order) Royal Bank of Canada Canadian Imperial Bank of Commerce Bank of Nova Scotia Bank of Montreal National Bank of Canada Laurentian Bank of Canada Note: No Canadian banks appear among the Top 25 Worlwide (Source: The Banker, July 2002)

25. 3. Banking Concentration and Profitability Banks account for over 70 per cent of the total assets of the Canadian Financial Services Sector. The six largest domestic banks account for over 90 per cent of the assets of the banking industry. Typically, the largest banks target ROE’s of about 17%. Realized ROE’s have been lower in 2001 and 2002 (range of 14-16%)

26. 4. Canadian Banks Abroad The six major domestic banks also have a significant presence outside Canada, in areas such as the United States, Latin America, the Caribbean and Asia. International operations accounted for approximately 33% of their gross revenues in 2001. BMO, Scotia & CIBC were (in 2000) among the Top 30 worldwide w/r to the relative importance of their international activities (The Banker, 2001)

27. 5. Delivery Mechanisms Used by Canadian Banks Banks with significant branch networks rely on the « Bricks and Clicks » strategy : –Increasing use of technology to handle low-margin acounts; –Focus on advisory services and sale of high-value products. Use of branches and e-networks to sell products of 3rd-party producers (best price/service) –Use of excess capacity in distribution channels; –Realized savings from not developing and market own products (e.g., mutual funds, & term deposits).

28. 5. Delivery Mechanisms (cont’) Banks are also developing Web sites to facilitate access by their customers to a wide variety of products and services. For example: –Web auction facilities for small-business financing; –B2B Web sites to facilitate purchase of supplies Credit scoring techniques more widespread which make standard loans less costly.

29. 6. Is Size Important for Canadian Banks? Recent banking literature seems to suggest that SE in a number of business lines extend further than previous empirical work had indicated. The prevalent view here is that even the largest Canadian banks need to be North Amerian entities in order to operate at an efficient scale in certain lines of business (See Freedman & Goodlet pp.12-13 for examples)

30. 7. Should Banks Be Allowed to Merge? Major deals were announced back in 1998: –Royal Bank and Bank of Montreal –CIBC and TD Bank As Professor L. Booth of U of T said at the time: –«What the government has to decide is whether allowing the banks to merge will generate gains in highly competitive markets, like international and coporate lending and investment banking, that more than outweigh the losses caused by less competition in the areas that matter most to Canadians, namely retail and commercial lending ». Both deals were rejected by the Federal Government in 1999. Recently, Manulife announced a plan to acquire CIBC. The Federal government has put the question to a Senate Committee which will review such an option in the Fall.

31. Part 5: A Quick Glance at Canada’s Insurance Sector Content 1.A Few Macro Comparative Statistics 2.The Canadian L&H Market 3.The Canadian P&C Market 4.Current Issues in the Canadian Insurance Industry

32. 1. A Few Macro Comparative Statistics As of 2001 (Source: Swiss Re, Sigma No. 6 / 2002): Total premium volume: (in USD) – Canada $ 45.3 billion USA $ 904.021 billion Overall weighted share of world insurance market : – Canada 1.88% (8 th ) USA 37.54% (1st) Insurance density (total business per capita in USD): – Canada $1460 (17 th ) USA $ 3266 (4th) Insurance penetration (% of GDP for total business) : – Canada 6.42% (9 th ) USA 8.97% (10th)

33. 1.46% of the world market (9 th ) Currently, 110 companies are monitored for financial soundness by OSFI (49 Canadian, 61 Foreign). Increasing concentration due to consolidation (MS of Top 5: 68% in 2002 vs. 47% in 1994). The market is dominated by 5 large stock groups: – [Great-West / London / Canada Life], [Sun Life/Clarica], Manulife, Desjardins Financial Security and the Industrial-Alliance Group Market is shifting away from exclusive sales forces (45%) towards independent producers (55%). 2. The Canadian L/H Market

34. Major wave in 1999-2000 (largest wealth transfer in Canadian history): Insurer IPO Date – Clarica: July 21, 1999 – Manulife: Sept. 30, 1999 – Canada Life: Nov. 5, 1999 – Industrial-Alliance Feb. 10, 2000 – Sun Life: March 23, 2000 Demutualization in the Canadian L/H Insurance Industry

35. Evidence of significant underpricing of L/H IPOs: – Offer-to-close: 9% on average. – Most short-run returns achieved during first day of trading. Evidence of strong returns even if first day excluded. Evidence that a secondary market investor holding those shares would have outperformed the market*: Wealth Relative Index [Ritter (1991)] Day 1 to 6 months1.31 Day 1 to 1 year1.33 Day 1 to 2 years1.55 * Here, the market is proxied by the TSE Financial Services Sub-Index. Source: Babin & Bernier, 2001, Assurances IPO PERFORMANCE ANALYSIS

36. 2.51% of the world market (7 th ) Currently, 198 companies are monitored for financial soundness by OSFI (93 Canadian, 105 Foreign). P/C is a less concentrated market than L/H: – Specific regional markets or specific product lines. Top 5 MS in 2002: 36% (CGU Group Canada, ING Canada, Co-operators Group, Royal & Sun Alliance, Economical Ins.Group) Broker Co’s still have a dominant MS of 67% (24% for Direct Writers and 9% for Reinsurers only) 3. The Canadian P/C Market

37. 4. Current Issues in the Canadian Insurance Industry In the L/H market: – Aging of population and increase in life expectancy Shift from life insurance products to savings products (e.g. Segregated funds) and health products (e.g. Dread disease insurance). LTC and LTC / DI hybrids are also starting to appear in the Canadian L/H market. – A.M.Best expects that the major Canadian life stock insurers will seek to expand in the USA. Sources: Journal de l’assurance and A.M.Best Report, 7/17/2002

38. In the Canadian P/C market: (Similarities with USA) – All time low industry profits in 2001 (Avg. ROE < 3%) High Auto bodily injury claims mostly in Ontario & Atlantic Provinces Low investment returns and excessive capital Lack of support by provincial governments for auto insurance reform. Québec wants to review its No-fault System. – Slightly improving operating results since 2002-Q1 and also in 2003 Increased prices and tighter underwriting terms – Significant Shortage of Management Talent Great opportunities for business university graduates. Source: IBC, Canadian Underwriter and Canadian Insurance 4. Current Issues (cont’d)

39. Part 6: A Quick Glance at Canada’s Securities Industry Content 1.Our Stock Markets 2.Our Mutual Funds Industry 3.The Regulation of our Securities Markets 4.Governance of Publicly- Traded Companies in Canada

40. 1. Our Stock Markets Since 2000, Canada has 3 « specialized » exchanges: –The Toronto Stock Exhange (TSX) where securitities issued by more « senior » companies (n~1,500) are being traded (e.g. large cap stocks); –The TSX Venture Exchange where securities of more « junior » firms are being traded. Born after the 1999 merger of the Alberta & Vancouver Stock exhanges, it is owned by the TSX but operates out of Vancouver. –The Montreal Exchange trades mostly Options & Futures contracts, and stocks of small Quebec-based public companies.

41. 2. Our Mutual Funds Industry Palltrack (a MF tracking service) lists about 6,000 funds for Canada compared to 15,000 in the US: –Crowded out market; –Choosing among competing funds is an increasingly challenging exercice for consumers. The Investments Funds Institute of Canada (IFIC) is the self-regulatory body overlooking the practices of the MF industry (www.ific.ca)

42. 3. The Regulation of our Securities Markets In Canada, the regulation of the securities industry is under 10 provincial securities commissions (versus only one in the US, the SEC). The 2 most important commissions in Canada are the OSC and QSC. The provincial commissions also collaborate with self-regulatory bodies such as IFIC and the Investors Dealer Association (IDA).

43. 4. Governance of Publicly- Traded Companies in Canada Currently, the TSX has the power to set corporate governance standards for public companies: –Voluntary guidelines but no mandatory rules. Strong lobby by the new « Canadian Coalition for Good Governance » to sort things out in this area. –« Enforcement should be expressed in legislation, and carried out by securities regulators » C. Lamoureux, CEO, Ontario Teachers’ Pension Plan, May 22, 2003. –Mr Lamoureux feels that Canada is no different from the US. We need to adopt the same standards that were included in the U.S. Sarbanes-Oxley Act following the major financial scandals (Enron, WorldCom. etc.,).