1. Copyright  2011 Pearson Canada Inc. 11- 1 Chapter 11 Banking Industry: Structure and Competition Canadian Banks

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

3. Canadian Financial Institutions and Regulators Canadian Banking System Chartered Banks – Schedule 1; Schedule 2; Schedule 3 http://www.ieso.ca/Documents/settlements/se_financialinstitutionslist.pdf *What is the difference between Schedule 1 and Schedule 2? - The 10% rule Big 5 Banks or “Big 3” https://financialpostbusiness.files.wordpress.com/2014/07/bigbanks.jpg Financial System Federally Regulated Financial Institutions Banks (81); Trust Companies (44); Loan Companies (18); Cooperative Credit Associations (6); Cooperative Retail Associations (1); Life Insurance Companies (74); Fraternal Benefit Societies (13) BanksTrust CompaniesLoan CompaniesCooperative Credit AssociationsCooperative Retail AssociationsLife Insurance CompaniesFraternal Benefit Societies Property & Casualty Insurance Companies Property & Casualty Insurance Companies (164) Provincially/nationally Regulated Investment Dealers Investment Industry Regulatory Organization of Canada (IIROC) Provincial Securities Commissions http://iiac.ca/wp- content/themes/IIAC/resources/149/original/The%20security%20in%20the%20securities%20industry%20EN.pdf http://iiac.ca/wp- content/themes/IIAC/resources/149/original/The%20security%20in%20the%20securities%20industry%20EN.pdf Banks schedule 1; schedule 2; schedule 3 11- 3

4. Copyright  2011 Pearson Canada Inc. 11- 4

5. Copyright  2011 Pearson Canada Inc. 11- 5 1.Historical Development of the Canadian Banking System I

6. Initially Canada had Free Banking with no central bank or government regulator The most significant transition from Free Banking and Government Regulated Banking in Canada was the Dominion Note Act of 1870. The government’s IOU or Dominion Notes can be used as bank reserves, on which banks can create loans by a multiple factor. Copyright  2011 Pearson Canada Inc. 11- 6

7. From the Free Banking System to Government Regulated Banking System Bank Act: from 1871 and revised every 10 years Finance Act of 1914 allowed the Department of Finance to act as a pseudo-central bank; Bank of Canada was set up in 1934;

8. Bank Acts over time: “Bank Act Reforms” ( refer to textbook pp.238-239, 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 or CDIC 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 their Canadian subsidiaries (Schedule II Bank=foreign banks’ Canadian subsidiaries) banks were allowed to do leasing, factoring and data processing. Canadian Payment Association was created for nationally “open” clearing system

9. *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 : Foreign banks can now set up Canadian branches: full service branch or lending branch http://www.parl.gc.ca/About/Parliament/LegislativeSummaries/bills_ls.asp?lang=E&ls=C67&Parl=36&Ses=1 2001** New ownership Rules; M & A Review Process; new Holding Company allowed(Bill C-8); More Open membership of the Canadian Payment Association to non-deposit taking financial institutions Holding Company allowed(Bill C-8)

10. Copyright  2011 Pearson Canada Inc. 11- 10 The close-up of the 2001 Bank Act Reform New (Finanical) 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 http://www.bankofcanada.ca/wp-content/uploads/2010/06/daniele.pdf

11. 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 of a large bank is raised from 10% to 20% http://www.bankofcanada.ca/wp-content/uploads/2010/06/daniele.pdf

12. 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

13. 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 Full Service/Universal Banking Towards

14. Copyright  2011 Pearson Canada Inc. 11- 14 Separation of Banking and Other Financial Services Industries Throughout the World 1.Universal banking - No separation between banking and securities industries 2.British-style universal banking - May engage in security underwriting 3.Japanese Model - Some legal separation of banking and other financial services (the post-war hybrid of U.S. and German banking systems) 4.U.S. Model the 1930s Clear Separation; now evolving with legacy

15. This transformation from the 4 Pillar system to the Universal Banking is the result of the Banks’ Adaptation, their Lobbying and the Legislative changes. Copyright  2011 Pearson Canada Inc. 11- 15

16. Let’s Examine Changes in business environment of the financial market (Challenges) And Financial Innovations, Regulatory Adaptation/Lobbying and Globalization by the Canadian Banking Industry (Responses) Copyright  2011 Pearson Canada Inc. 11- 16

17. Major Challenges Unstable Financial Market and Increased Risks: Interest Rate, FX, Credit Risks have increased. More Domestic Competition(Domestic Financial 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) More Regulations: IFRS(Jan. 1, 2011), and Regulatory Changes due to Basel Accords. Low Profits Margin: a small Net Interest Margin Copyright  2011 Pearson Canada Inc. 11- 17

18. Copyright  2011 Pearson Canada Inc. 11- 18 Financial Innovation and the Decline of Traditional Banking Decline in Cost advantage of Acquiring Funds (Liabilities) – unregulated ‘shadow banking’ raises funds cheaper than the heavily regulated banks –Disintermediation Decline in Income Advantage on uses of funds (Assets) – low loan rate; smaller NIM Bank Responses - Increase in income from off-balance sheet activities

19. Copyright  2011 Pearson Canada Inc. 11- 19 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)

20. Copyright  2011 Pearson Canada Inc. 11- 20 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 and Off-Balance Sheet Business –Ability to hedge interest rate risk using futures contracts (financial derivatives) –Payoffs are linked to previously issued securities

21. Copyright  2011 Pearson Canada Inc. 11- 21 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

22. Copyright  2011 Pearson Canada Inc. 11- 22 Legal Challenges and Responses: Regulations, and Lobbying Reserve requirements act as a tax on deposits Recently, the Insured Mortgage Purchase Plan (IMPP) boosted profits of the major Canadian banks Less Restrictions in Canada than in U.S. eg) Restrictions on interest paid on deposits led to disintermediation in U.S., but not so much in Canada U.S. has “Regulation Q” (no interest payment on checking account balances Tn circumvent regulation, U.S. banks have developed Money market mutual funds; Sweep accounts Canadian Government has Domestic Bank Friendly Regulations eg1) Principle-based regulations in Canada vs. Rule-based regulations in U.S. -> protects the Canadian banks eg2)Recently, the Insured Mortgage Purchase Plan (IMPP) boosted profits of the major Canadian banks

23. Copyright  2011 Pearson Canada Inc. 11- 23 Implications for Financial Consolidation 1.The way is now open to consolidation in terms not only of the number of banking institutions, but also across financial service activities 2.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 3.Mega-mergers like that of Citicorp and Travelers in the U.S. should become increasingly common

24. 3. American Banking System for Comparison

25. 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-1863 State Banking only 1863 National Banks (Act) emerging 1913 Federal Reserve System 1934 Federal Deposit Insurance Corporation

28. Overlapping and Complex Regulatory Agencies The Office of the Comptroller of the Currency (OCC) charters, regulates, and supervises national banks and federal savings associations (collectively, banks) and licenses and supervises the federal branches and agencies of foreign 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 Office of Thrift Supervision

29. In fact, it is more complicated than it looks: From FR website, we can see http://www.federalreserve.gov/pf/pdf/pf_5.pdf : http://www.federalreserve.gov/pf/pdf/pf_5.pdf Copyright  2011 Pearson Canada Inc. 11- 29

30. Fractured Banking Industry A Large # of Banks: 12,000 until the early 1990. This number has come down to 6,000 some banks. https://www2.fdic.gov/sod/pdf/dstc_2014.pdf 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

31. * How American Banks Merge? The number of banks has been decreasing; currently as of 2014, about 6,000 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.

32. More recent changes in the number of U.S. Commercial Banks 32

33. 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.

34. Ten Largest U.S. Banks Updated one can be found: for HC http://www.ffiec.gov/nicpubweb/nicweb/top50form.aspxhttp://www.ffiec.gov/nicpubweb/nicweb/top50form.aspx

35. Ten Largest Banks in the World 2) Why are the U.S. banks ranking surprisingly low in this list? http://www.forbes.com/sites/halahtouryalai/2014/02/12/worlds-100-biggest-banks-chinas-icbc-1- no-u-s-banks-in-top-5/ http://www.forbes.com/sites/halahtouryalai/2014/02/12/worlds-100-biggest-banks-chinas-icbc-1- no-u-s-banks-in-top-5/ 1) Updated one is at https://www.snl.com/InteractiveX/Article.aspx?cdid=A-26316576-11566https://www.snl.com/InteractiveX/Article.aspx?cdid=A-26316576-11566

36. 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.

37. * 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

38. 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.

39. Pros and Cons of the G-L-B Act Cons: -Mega-size Financial Supermarket is too monopolistic; -It becomes ‘too big to fail’: in trouble, it has to be rescued with public funds Pros: -Diversification across banking, securities and insurance -Banks gets more venues to reduce Information Asymmetry and to fight Moral Hazards of borrowers/investee Copyright  2011 Pearson Canada Inc. 11- 39

40. * 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.

41. 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 limits proprietary trading of securites -Funeral Plan required of a large financial Company Copyright  2011 Pearson Canada Inc. 11- 41

42. 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. We will look into the details of Regulation/Financial Supervision in Chapters 10 and 13. Copyright  2011 Pearson Canada Inc. 11- 42