1. Canadian Banking Industry: Historical Evolution, Comparison, and Current State of Government Regulations
(Chapters 10, and 11)

2. Banking Industry: Structure and Competition
Chapter 11
Banking Industry: Structure and Competition
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3. 1.Historical Development of the Canadian Banking System I
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4. From the Free Banking System to Government Regulated Banking System
The process was “unnatual”.
Initially, all banks were allowed to issue their own paper monies until the 1870 Dominion Notes Act.;
BMO helped government bonds to be used for reserves, and government started monopolizing Money Issues.
Bank Act: 1871, (1871), 1891……1913
Finance Act of 1914
Then, B of Canada was set up in 1934;

5. Historical Development of the Canadian Banking System II
The Free Banking Experiment
The Provincial Notes Act, 1866
The Dominion Notes Act, 1870
Seignorage
Gold standard
The (First) Bank Act, 1871
The Bank Act,
The Finance Act, 1914
Lender of last resort
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6. Bank Act over time: “Bank Act Reforms” (refer to textbook pp
Bank Act over time: “Bank Act Reforms” (refer to textbook pp , Table 10-1)
1954
: Banks were allowed to go for household lending and to make mortgage loans insured by NHA
1967
* Canadian Deposit Insurance Corporation was created
: the 6% ceiling on the mortgage loans was removed
1980
: banks were allowed to have mortgage loan companies and venture capital companies.
1981
: Foreign banks were allowed to set up Canadian subsidiaries
banks were allowed to do leasing, factoring and data processing.
Canadian Payment Association was created for nationally “open” clearing system

7. 1987 “Financial Institutions and Deposit Insurance System Amendment Act”
:banks were allowed to own securities houses(investment banks)
: abolishing the Canadian equivalent of “Glass-Steagall Act”
1992
: banks were allowed to own trust companies
: banks were permitted to offer a number of in-house activities, such as portfolio management, and investment counseling.
: required reserves are to be phased out.
1999
:Bill C-67
2001**
New ownership Rules; M & A Review Process; fexbile Bank Holding Company allowed; More Open membership of the Canadian Payment Association to non-deposit taking financial institutions

8. The close-up of the 2001 Bank Act Reform
Bank Holding Companies
Permitted Investment
Ownership Rules
Canadian Payments Act and Access to the Payments and Clearance System
Merger Review Policy
The National Financial Services Ombud Service
Implications for the Canadian Banking Industry
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9. Easier Entry of New Comers
Equity Capital requirement is lowered from $ 10m to $ 5 m.
Some Ownership Concentration allowed for a large bank(equity>$ 5 billions)
a single ownership limit is raised from 10% to 20%

10. Expanded Access to Canadian Payment Association membership
There by access to Large Value Transactions System, and Automatic Clearing Settlement System was given to Insurance, Investment Dealers, Money Market Mutual Funds.
Now these can allow their customers to use Checking Account and Debit Cards
- more competition for Banks

11. 2. Trends of Evolution of the Canadian Financial System
Tradition of
“Four Pillar System” :
Chartered Banks( Credit Unions)
Trust, Mortgage Loan companies
Insurance companies
Investment Intermediaries
Towards
Full Service/Universal Banking

12. Separation of Banking and Other Financial Services Industries Throughout the World
Universal banking
- No separation between banking and
securities industries
2. British-style universal banking
- May engage in security underwriting
Japanese Model
- Some legal separation of banking and other
financial services (the post-war hybrid of U.S. and German banking systems)
U.S. Model
the 1930s Clear Separation; now evolving with legacy
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13. This transformation from the 4 Pillar system to the Universal Banking is the result of the Banks’ Adaptation, their Lobbying and the Legislative changes.
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14. Let’s Examine
Changes in business environment of the financial market (Challenges)
And Financial Innovations by the Canadian Banking Industry (Responses)
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15. Major Challenges Unstable Financial Market:
Interest Rate, FX, Credit Risks have increased.
More Domestic Competition(Domestic Finanical Liberalization):
Banks’ advantages in funding cost and investment profits have been eroded by Other segments of the Financial System or Other Financial Institutions -> Decline of traditional banking and ‘Shadow Banking’
More International Competitions (Global Financial Liberalization)
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16. Changes in Demand Conditions: Challenges of Interest Rate Volatility and Banks’ Responses
Adjustable-rate mortgages
Flexible interest rates keep profits high when rates rise
Lower initial interest rates make them attractive to home buyers
Financial Derivatives
Ability to hedge interest rate risk using futures contracts (financial derivatives)
Payoffs are linked to previously issued securities
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17. Responses to Changes in Supply Conditions: Information Technology
Bank credit and debit cards
Improved computer technology lowers transaction costs
Electronic banking
ATM
Home banking
ABM
Virtual banking
Junk bonds
Commercial paper market
Securitization
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18. Existing Regulations, and Legislation(Bank Act) Lobbying
Reserve requirements act as a tax on deposits
Restrictions on interest paid on deposits led to disintermediation
For example, “Regulation Q” (no interest payment on checking account balances)
Money market mutual funds
Sweep accounts
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19. Financial Innovation and the Decline of Traditional Banking
Decline in Cost advantage of Acquiring Funds (Liabilities)
Disintermediation
Decline in Income Advantage on uses of funds (Assets)
Bank Responses
- Increase in income from off-balance sheet activities
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20. Competition and Technical Innovation
Besides chartered banks, there are over 4000 financial institutions providing services, these include trust, mortgage loan companies, credit unions, caisses populaires, government saving institutions, insurance companies, pension funds, mutual funds and investment dealers
New technology and the internet have led to more competition and innovative banking in Canada
2001 changes in bank ownership laws have encouraged the establishment of new banks
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21. Competition and Legislative Changes
Domestic and International Competition have increased for Banks
For Banks to survive, they should be allowed to be ‘Bigger’, and to cover ‘Business Across the Board’(traditional banking+ securities business + insurance, etc.)
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22. Competition Across All Four Pillars and Convergence
In the past, 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 (a kind of Universal Banking system)
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23. Implications for Financial Consolidation
The way is now open to consolidation in terms not only of the number of banking institutions, but also across financial service activities
Banking institutions will become not only larger, but increasingly complex organizations, engaging in the full gamut of financial service activities taking advantage of economies of scale and economies of scope
Mega-mergers like that of Citicorp and Travelers in the U.S. should become increasingly common
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24. 3. American Banking System for Comparison

25. Canadian and American banking system share a lot of similarity
Canadian and American banking system share a lot of similarity. Broadly, they used to belong to the same British Specialized Banking System, which has the characteristic separation of commercial banking and securities business, or (confusingly) “ banking and commerce”.

26. The American Story

27. 1) Characteristics of U. S. Banking Industry
Dual Banking System
Some banks are regulated by the state agency and others by the Federal agency
Pre State Banking only
National Banks (Act) emerging
Federal Reserve System
Federal Deposit Insurance Corporation

28. Overlapping and Complex Regulatory Agencies
The Office of the Comptroller of the Currency
gives out “Charter” for national banks
Fed is in charge of national banks, and in sole charge of bank holding companies
FDIC and State Banking Authorities are in charge of state banks with FDIC insurance
State Banking Authorities are in sole charge of state banks without FDIC insurance

29. Fractured Banking Industry
A Large # of Banks: 12,000 until the early 1990.
This number has come down to 7,000 some banks.
Many Lacking “Scales of Economies
-> only 325 banks have assets above $1 billion (’94)
-> until recently, some states had “Unit Banking System”.
-> Consolidation and Simplification: Key Issue of Presidential Reforms

30. * How American Banks Merge?
The number of banks has been decreasing; currently as of 2010, about 7,000 or so.
While mergers between banking groups have slowed, there has been a move towards diversification as the barriers between commercial and investment banking have finally broken down.

31. 2) Historical Background
Federal versus State Struggles for Hegemony
-“The Wizard of Oz as a Monetary Allegory” by H. Rockoff
Background: Depression in the 1890s
Allegories:
Dorothy: an Average conscientious true American
Tornado
Wicked Witch of the East- Eastern Business and Financial Interests
Munchkins -Average Americans
Scarecrow -Western Farmer
Tin Woodman- Unemployed Industrial Workers
Cowardly Lion -“William Jennings Bryan”
Wicked Witch of the West - Grover Cleveland
silver shoes: magic
water that melt the witch: solution – watershed – inflation (through printing money)
A Lesson: So much socio-political problems and regional interests were intertwined with
Monetary policies (and banking practices):
The complexity of the current banking system of the U.S. is a on-goint legacy of the long tradition of these complicated political Struggles between regions, parties and interest groups.

32. 2) Evolution of U. S. Banking Legislation
McFadden Act of 1927: limits and prohibits inter-state banking and branching
Glass-Steagall Act of 1933: Anti-Trust Act separating Banks and Commerce; you can be either a commercial bank(lenders) or an investment bank(securities holders), but not both.

33. * Apparent Rationale Underlying the Separation of Commercial and Investment Banking: Glass-Steagall Act
In favor of Specialized Banking as opposed to Universal Banking
If banks are engaged in securities business, there may occur
Conflicts of Interests;
Unfair Competition;
Risk of Safety and Soundness;
Concentration of Power;
Unfair Stretch of Federal safety net

34. *pros and cons of Glass-Steagall Act
Pros: tried to control monopolistic financial mega companies;
Cons: deprived commercial banks of Monitoring Venues against Moral Hazards; and investment bank of Active Management participation against Principal-Agent Problem .

35. Turn Around - Bank Holding Companies of the 1960s
- Reigle-Neal Act of Interstate Banking and Branching Act (1994)
: Opening up M & A for “Efficiency” in banking sectors
-Gramm-Leach-Bliley Financial Modernization Act (1999)
: Banks are allowed to form Financial Holding Companies across industries and even to carry out “merchant banking” or equity investments in non-financial firms.

36. * Legal Buffer against Abuse of a big financial trust: Legacy of Anti-Trust Act or G-S Act.
The negative effect of the G-L-B Act is “Lack of Competition” which may lead to “Lack of Protection of Small Lenders” beside banks as big lenders.
Legal protection for smaller financial investors is secured by “Lender Liability and Equitable Subordination”
This principle does not exist elsewhere: The U.S. case of allowing merger between banks and commerce may not be equitably applicable elsewhere.

37. Frank-Dodd Act of 2008 for the Wall Street Reform
-more disclosure of financial institutions and particularly Hedge Funds: As a result, some hedge funds are turning to be ‘family funds’.
-Volker Rule
-Funeral Plan required of a large financial Company
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38. Financial Consolidation
Larger and more complex banking organizations challenge regulation
Increased “too big to fail” problem
Extends safety net to new activities, increasing incentives for risk taking in these areas
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39. How does the Canadian Government/OSFI Regulate the banking industry?
In Canada it is the principle-based regulation as opposed to the rule-based regulation in the U.S.
General emphasis is on:
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40. 1) Restrictions on Asset Holding
Even without government intervention banks have incentive to take more risk as risky assets provide higher returns.
Full information to creditors/depositors on banks risk-taking activities might mitigate problem.
Government regulation directly attempts to restrict banks from too much risk taking
Restrict holdings of common stock
Promote diversification
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41. 2) Capital Requirements
Government can impose set capital requirements
Minimum leverage ratio (amount of capital divided by the bank’s total assets)
Increase in off balance sheet activities a concern
Basel Accord: risk-based capital requirements
Regulatory arbitrage
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42. Capital Requirements (Continued)
International Standards for Capital Requirements
Basel (Accord) 1 by the Bank for International Settlement;
requires the bank to hold as capital at least 8% of their risk-weighted asset
Basel (Accord) 2 tries to eliminate Regulatory Arbitrage (to reduce off-balance risks)
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43. 3)Financial Supervision: Chartering and Examination
Chartering (screening of proposals to open new banks) to prevent adverse selection
Examinations (scheduled and unscheduled) to monitor capital requirements and restrictions on asset holding to prevent moral hazard
Capital adequacy
Asset quality
Management
Earnings
Liquidity
Sensitivity to market risk
Filing periodic ‘call reports’
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44. 4) Assessment of Risk Management
Greater emphasis on evaluating soundness of management processes for controlling risk
Focus is four elements of risk management
Quality of oversight
Adequacy of policies and limits
Quality of risk measurement and monitoring systems
Adequacy of internal controls
Interest-rate risk limits
Internal policies and procedures
Internal management and monitoring
Implementation of stress testing and Value-at risk (VAR)
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45. 4) Disclosure Requirements
Requirements to adhere to standard accounting principles and to disclose wide range of information
Eurocurrency Standing Committee of the G-10 Central Banks also recommends estimates of financial risk generated by the firm’s internal monitoring system be adapted for public disclosure
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46. Disclosures (Continued)
Canadian Reform: Bill 198
corresponds to the U.S. Sarbanes-Oxley Act;
enhances disclosure of information with a better audit, and limits conflicts of interests
International Reform
International Accounting Standard Board adopts International Financial Reporting Standards (IFRS) : eg) fair-value accounting
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47. 5) Consumer Protection
Requires lenders to provide information to consumers on the costs of borrowing (including a standardized interest rate)
Requires provision of information on the method of assessing finance charges
Requires that billing complaints be handled quickly
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48. 6) Restrictions on Competition
Justified by moral hazard incentives to take on more risk as competition decreases profitability
Disadvantages
Higher consumer charges
Decreased efficiency
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49. CIDC Insurable deposits include Savings and chequing accounts
Term deposits with a maturity date < 5 years
Money orders and drafts, certified drafts and cheques, and traveller’s cheques
The CDIC does not insure
Foreign currency deposits or term deposits with maturity date > 5 years
T-bills, bonds and debentures issued by governments and corporations (including the chartered banks)
Investments in stocks, mutual funds, and mortgages.
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50. *The Ultimate Protection of Consumers
(Federal) Canadian Deposit Insurance Corporation
for banks
Provincial Deposit Insurance Corporation for CUCP and TMLC.
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51. Differential Premiums
Differential premiums means investments with differing risk profiles are subject to different insurance premiums
Premium categories range from 1 (best) for a well capitalized bank, to 4 (worst) for a significantly under capitalized bank
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52. Is No Insurance Good for the Society?: Opting-Out I
Permits Schedule III banks, that accept primarily wholesale deposits (defined as $ or more), to opt out of CDIC membership and therefore to operate without deposit insurance
It requires, however, an opted-out bank to inform all depositors, by posting notices in its branches, that their deposits will not be protected by the CDIC, and not to charge any early withdrawal penalties for depositors who choose to withdraw
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53. Opting-Out II Implications:
Minimizes CDIC exposure to uninsured deposits
By compensating only the insured depositors rather than all depositors, this legislation increases the incentives of uninsured depositors to monitor the risk-taking activities of banks, thereby reducing moral hazard risk
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54. Financial Regulation after Subprime Financial Crisis
-Increased Regulation of Mortgage Brokers
-Fewer Subprime Mortgage Products
-Regulation Compensation
-Higher Capital Requirements
-Additional Regulation of Privately Owned Government-Sponsored Enterprises
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