1. Banking Industry: Structure and Competition
chapter 10
Banking Industry: Structure and Competition

2. The Early History of Commercial Banking in Canada

3. Structure of the Canadian Chartered Banking Industry

4. Canadian Chartered Banks

5. Schedule I, Schedule II, and Schedule III Banks
The Big Six, together with the Laurentian Bank of Canada and the Canadian Western Bank, are Canada’s Schedule I banks
Schedule II banks are some domestic banks (such as Citizens Bank, First Nations Bank, and Manulife Bank) and the Canadian subsidiaries of foreign banks. As of June 2000, there were 39 Schedule II banks in Canada
A Schedule III bank is a foreign bank allowed (under certain restrictions) to branch directly into Canada. As of June 2000, there were 2 Schedule III banks in Canada

6. Permitted Ownership Structure
Schedule I banks and big Schedule II banks (those with over $5 billion in equity capital) must be widely held: no individual can own more than 10% of any class of shares
Small Schedule II banks with equity capital less than $1 billion don’t have to be widely held --- that is, may have a significant shareholder (more than 10%)
Small Schedule II banks with equity capital in excess of $1 billion have to be at least 35% widely held

7. Permitted Ownership Structure (Continued)
Any widely held foreign bank can own 100% of a Canadian bank subsidiary (that is, of a foreign Schedule II bank)
Any widely held and regulated Canadian financial institution, other than a bank, may own 100% of a bank
Schedule II banks can add branches to their initial branch only with ministerial approval
Schedule III banks can branch directly into Canada, following authorization by the Minister of Finance

8. Comparison with the U.S.
As of June 2000, there were 49 banks in Canada and around 8500 in the U.S
The presence of so many banks in the U.S. reflects past regulations that restricted the ability of these financial institutions to open branches
Many small U.S. banks stayed in existence because a large bank capable of driving them out of business was often restricted from opening a branch nearby
It was easier for a bank to open a branch in a foreign country than in another state in the U.S.

9. Response to Branching Restrictions in the U.S.
Branching restrictions were very anticompetitive. The response to these restrictions was:
Bank Holding Companies (BHC)
A. Allowed purchases of banks outside state
B. BHCs allowed wider scope of activities by Fed
C. BHCs dominant form of corporate structure for banks
Nonbank Banks
Not subject to branching regulations, but loophole closed in 1987
Automated Teller Machines
Not considered to be branch of bank, so networks allowed

10. Competition Across All Four Pillars and Convergence
Until recently, Canada’s financial services industry was regulated by institution (banks, securities, insurance, and real estate). This approach to regulation has been known as the four-pillar approach
Recent legislative changes allowed cross-ownership via subsidiaries between financial institutions
As a result, Canada’s traditional four pillars have now converged into a single financial services marketplace

11. Big Six Dominate Canada’s Investment Banking Industry

12. Bank Consolidation Bank Consolidation: Why?
The way is now open to consolidation in terms not only of the number of banking institutions, but also across financial service activities
Mega-mergers are likely on the way, like that of Citicorp and Travelers in the U.S.
Banking institutions will become not only larger, but increasingly complex organizations, engaging in the full gamut of financial service activities

13. Bank Consolidation: Pros and Cons
Bank Consolidation: A Good Thing?
Cons:
Rush to consolidation may increase risk taking
Fear of decline of small banks and small business lending
Pros:
Community banks will survive
Increase competition
Increased diversification of bank portfolios: lessens likelihood of failures

14. Frameworks for the Banking and Securities Industries
Universal banking. Exists in Germany, the Netherlands, and Switzerland and provides no separation at all among the banking, securities, real estate, and insurance industries
British-style universal banking. Exists in U.K., Australia, and now in Canada and the U.S. Separate legal subsidiaries are more common while bank equity holdings of commercial firms and combinations of banking and insurance firms are less common
Japanese banking system. Legal separation of banking and other financial services industries

15. Trust and Mortgage Loan Companies (TMLs)
Regulators
Operate under a charter issued by either the federal government or one of the provinces
Federally incorporated TMLs are regulated and supervised by the OSFI and must also register in all provinces in which they operate and conform to their regulations
The fiduciary component of trust companies is only subject to provincial legislation, even if the company is federally incorporated
CDIC and QDIB (for Québec TMLs)

16. Balance Sheet of All TMLs

17. Credit Unions (Outside Québec)
Regulators
Each each province has a ‘central credit union,’ owned by the member credit unions, providing financial services to member credit unions
All central credit unions are members of the Credit Union Central of Canada (CUCC), also known as Canadian Central, which functions as a central bank (i.e., provides cheque-clearing services for all provincial central credit unions)
Credit unions are covered by a provincial ‘stabilization fund’ (on terms similar to the CDIC’s)

18. (Québec) Caisses populaires
Caisses populaires are organized into 11 regional federations that belong to the Confédération des caisses populaires et d’économie Desjardins du Québec, which has a similar structure to the provincial central credit unions in the rest of Canada
The confederation owns Caisse centrale Desjardins, which functions as a central bank, as the CUCC does for the rest of Canada
The QDIB insures caisses populaires, on terms similar to the CDIC’s

19. Balance Sheet of Credit Unions and Caisses Populaires

20. Government Savings Institutions
Province of Ontario Savings Office
Established in 1921
Today only lends to the Treasurer of Ontario for provincial government purposes
Alberta Treasury Branches
Established in 1938
Today there are 278 branches in 109 communities across Alberta, operating in three target markets: individual financial services, agricultural operations, and independent business

21. International Activity

22. International Focus of the Big Six

23. Largest Banks in the World

24. Foreign Banks in Canada
As already noted, a foreign bank may enter the Canadian banking industry as either a Schedule II or a Schedule III bank
The difference between Schedule II and Schedule III banks is that a Schedule II bank is a Canadian subsidiary of a foreign bank, whereas a Schedule III bank is a foreign bank allowed to branch directly into Canada, under certain restrictions
Schedule III banks cannot take retail deposits (i.e., deposits < $150,000) and, as a result, are not subject to requirements for CDIC insurance

25. Schedule II Banks in Canada

26. Financial Innovation and Decline in Traditional Banking
Innovations Increasing Competition
1. Money market mutual funds
Avoids deposit rate ceilings and reserve requirements
2. Junk bonds
Result of better information in credit markets
3. Commercial paper market
Result of better information in credit markets and rise in money market mutual funds
4. Securitization
Result of better information in credit markets and computer technology

27. Personal Deposits versus Mutual Funds (in Canada)

28. Bank Profitability

29. Share of Noninterest Income

30. Decline in Traditional Banking
Loss of Cost Advantages in Acquiring Funds (Liabilities)
  i  then disintermediation because
1. Money Market Mutual Funds
2. Foreign banks have cheaper source of funds: Japanese banks can tap large savings pool
Loss of Income Advantages on Uses of Funds (Assets)
1. Easier to use securities markets to raise funds: commercial paper, junk bonds, securitization
2. Finance companies more important because easier for them to raise funds

31. Banks’ Response
Loss of cost advantages in raising funds and income advantages in making loans causes reduction in profitability in traditional banking
1. Expand lending into riskier areas: e.g., real estate
2. Expand into off-balance sheet activities
3. Creates problems for regulatory system
Similar problems for banking industry in other countries

32. Financial Services Reform for the 21st Century
Bank Holding Companies
The Permitted Investment Regime
New Ownership Rules
Access to the Payments and Clearance System
Merger Review Policy

33. Advantages of the Holding Company Form of Ownership
Allows banks to engage in other activities related to banking (i.e., provision of investment advice, data processing and transmission services, leasing, and credit card services)
Allows for lighter regulation throughout the bank financial group because certain activities (those not involving deposit-taking and insurance) can be undertaken by less-regulated, non-bank affiliates
Provides increased flexibility to achieve economies of scale and scope through strategic partnerships, alliances, and joint ventures

34. The Permitted Investment Regime
The new legislation provides greater flexibility for bank involvement in the information technology area --- i.e., the Internet and wireless technology
Implications:
Although bank involvement in the information technology area is subject to regulation, the new permitted investment regime will enhance the ability of bank financial groups to:
pursue strategic alliances and joint ventures, and
further accelerate the technological advances that are already taking place

35. New Ownership Rules
The proposed legislation lowers the capital needed to create a bank from $10 million to $5 million and allows domestic and foreign commercial firms to establish small and medium-sized banks
Increases the limit a single shareholder can own of a widely held financial institution (either a BHC or a bank subsidiary under the BHC) from 10% of any class of shares to 20% of voting shares and 30% of non-voting shares
However, it does not permit a single shareholder to own more than 10% of both a BHC and a bank subsidiary under the BHC at the same time

36. New Ownership Rules (Continued)
Small banks don’t have to be widely held and can be wholly owned (have one particular investor own 100% of their shares)
Medium sized banks and BHC with shareholders’ equity between $1 billion and $5 billion can be closely held provided that there is a 35% public float (that is, they could have a single shareholder own up to 65% of their shares).
Large banks and BHC, those with shareholders’ equity in excess of $5 billion, are required to be widely held.

37. Access to the Payments and Clearance System
The new legislation allows non-deposit taking financial institutions (life insurance companies, securities dealers, and money market mutual funds) access to the payments and clearance system
Implications:
This will increase competition by allowing non-deposit taking financial institutions to provide bank-like services (i.e., chequing accounts and debit cards) without being banks, thereby directly competing with banks, TMLs, and CUCPs

38. Merger Review Policy
The new legislation acknowledges that mergers are a legitimate business option that should be available to Canadian bank financial groups
Does not allow mergers between large banks and large demutualized life insurance companies
Note that such mergers are not prohibited in countries such as Australia, Germany, the Netherlands, Switzerland, the U.K., and the U.S.

39. Implications for the Canadian Banking Industry
A BHC structure, new ownership rules, expanded permitted investments, expanded access to the payments and clearance system, and a transparent merger review policy will:
further speed up the financial consolidation process, because the way is now open to both mergers and acquisitions, and strategic alliances, partnerships, and joint ventures
together with new information technologies, make possible new financial products and services and a more vibrant and dynamic market for financial services