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E X T R A

OP T ION

SW hen I was sworn in as Canada’s deputy minister

of finance on September 1, 1985, my colleaguesthrew a bombshell at me as soon as the words of

the oath were out of my mouth. “Deputy,” they told me,“you need to know that this morning we closed two banks.”

I was well aware of the problems that had beset theCanadian Commercial Bank in the fall of 1984 and the win-ter and spring of 1985. As chair of the Private SectorAdvisory Committee for the National EconomicConference, which Prime Minister Mulroney had convenedin Ottawa that spring, I had noticed the absence for pro-longed periods of time of senior Finance officials, and, attimes, the minister himself, culminating in a support pack-age for the institution, which proved to be insufficient.

But I was not prepared for the fact that two Schedule “A”banks (Northland Bank was the second) — which fundedthemselves by raising wholesale deposits, mostly throughbrokers attracted by marginally higher interest paid to depos-itors — had not been able to sustain themselves and hadbeen certified as not being viable by the Inspector General ofBanks. Nor was anyone prepared for the consequences — aRoyal Commission chaired by Mr. Justice Willard Z. Estey,recently retired from the Supreme Court of Canada, into thecauses of the collapse, the payment by the government ofuninsured deposits brought about by the “moral hazard” ofthe inadequate rescue package, the subsequent run ondeposits at other Canadian banks that did not have stable,retail based funding as a “flight to quality” raced through our

FROM A BANG TO AWHIMPER — TWENTYYEARS OF LOST MOMENTUMIN FINANCIAL INSTITUTIONS Stanley H. Hartt

Twenty years ago this month, the failure of two small banks, and the possibility thatsome of Canada’s large ones might need rescuing, began the move towardconsolidation of Canada’s financial services industry. Margaret Thatcher’s “Big Bang”in London in 1986 was followed by Canada’s “Little Bang,” knocking down three ofthe four pillars separating banks, trusts, and brokerage and insurance companies.While banks were allowed to acquire trust companies and securities dealers, afurious lobby by the insurance industry prevented the arrival of one-stop shoppingin Canada. Twenty years later, the question of large-bank mergers and cross-pillarmergers with insurers remains unresolved in Canada, despite persuasive evidencethey should be permitted to enable our financial services industry to remaincompetitive in a global market. Stanley Hartt, who was deputy minister of financeduring the “Little Bang,” suggests it may have ended in a whimper.

Il y a vingt ans ce mois-ci, l’échec de deux petites banques canadiennes et lenaufrage qui menaçait certaines des plus grandes ont provoqué une vague defusions dans le secteur des services financiers. S’inspirant de la politique de chocimposée en 1986 par Margaret Thatcher, le Canada en a appliqué une versionédulcorée qui a tout de même renversé trois des quatre piliers séparant les banques,sociétés de fiducie, maisons de courtage et compagnies d’assurance. Tandis qu’onautorisait les premières à acquérir les deux suivantes, le lobby de l’assurance sedéchaînait en vue d’empêcher l’introduction d’un guichet unique. Deux décenniesplus tard, les grandes fusions bancaires et avec les assureurs restent interdites, mêmesi tout indique qu’elles maintiendraient la compétitivité du secteur des servicesfinanciers dans un marché mondialisé. Selon Stanley Hartt, à l’époque sous-ministredes Finances, la vague n’était pas tout à fait une vague de fond.

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banking system, and far-reachingreforms to our regulatory regime andour financial institutions policy.

Estey essentially found that thebanks in question had compensatedfor having to pay more to attractdeposits by taking on riskier loans inthe expectation of higher returns, andthat the risk-assessment systems at thebanks were ineffective at controllingthe portfolio imbalance that resulted.Sectoral and geographical concentra-tion of loans contributed to the deba-cle, because of inordinate reliance on

clients in the energy business andinordinate exposure to industry cycles.

The deposits in both banks had, ofcourse, been insured by the CanadaDeposit Insurance Corporation, butthat insurance had a limit of $60,000per account. Because Bank of CanadaGovernor Gerald Bouey had declared,at the time of the rescue package, thataccess to his lending window of lastresort was limited by statute to solventinstitutions, depositors concluded thatCCB must be safe. As a result, thebanks’ failures forced the governmentto introduce special legislation reim-bursing depositors for unrecoverablelosses beyond the $60,000 limit.

The damage could not be limitedto two banks. Because of their relianceon wholesale deposits, in short orderthe Bank of British Columbia was con-veyed to the Hong Kong Bank ofCanada (as it was then known, nowHSBC Bank Canada); ContinentalBank was sold to Lloyd’s Bank, whichin turn later left Canada, selling toHKBC; Mercantile Bank (the formersubsidiary of First National City Bankof New York, which still held 25 per-cent at the time) was shored up by aloan package from the Big Six plusCitibank and then sold to NationalBank of Canada; two small Western-

based banks (Bank of Alberta andWestern Pacific Bank) were merged asCanadian Western Bank, andMorguard Bank was sold.

T he policy and regulatory frame-work that had been in place for

these bank failures, the first since the1920s, was subjected to a critical re-thinking. The Office of the InspectorGeneral of Banks was combined withthat of the Superintendent ofInsurance to form the Office of theSuperintendent of Financial

Institutions. CDIC introduced pruden-tial standards of its own so as not to beobliged to rely solely on the superviso-ry expertise of the banking regulator.

A White Paper explored ways inwhich the financial sector might bemodernized, both to replace the lostcompetition brought about by the dis-appearance of so many smaller institu-tions in such a short space of time, andto examine ways to prevent a repeti-tion of the events.

The conventional wisdom aboutwhat happened next is that Canadatried to emulate the 1986 developmentin Margaret Thatcher’s UnitedKingdom that has come to be knownas the “Big Bang.” While there is anelement of truth to this, Canada wasactually driven more by its owndomestic policy needs. The CEOs ofthe Big Six banks asked the minister offinance, Michael Wilson, for an emer-gency meeting, which was held at theChâteau Montebello, Quebec, site ofthe G7 summit in 1981.

There was no one present otherthan the six CEOs, the minister, me ashis deputy, and Don McCutchan, atrusted advisor in the minister’s office.The bankers made a plea to be allowedto enter the securities business, whichhad been denied them for decades so as

to minimize the risk to bank capitalresulting from securities market volatil-ity. Their thesis was that lending hadbecome securitized: the banks’ best cus-tomers could finance themselvesdirectly in the London InterbankMarket, in essence in competition withthe banks themselves, by issuingEurodollar securities, leaving to thebanks the worst credits, on whichspreads could be as little as 3/8 percent.Dick Thomson of the Toronto-Dominion Bank, speaking for thegroup, pointed out that while we were

still dealing with the fright-ening implications of therecent run on virtually all ofthe country’s smaller banks,the government needed toconsider the possibility offailures among the Big Six.

The representationswere persuasive: not only were marketstandards changing so that CEOs ofborrowers were increasingly indiffer-ent to whether a bank funded itself asa principal, added a spread and made aloan to the client, or designed a pieceof paper that the client signed and thebanker then sold to the street; butthere was a policy inclination amongthe minister and his officials to ques-tion the validity of the “four pillars”tradition of financial institutions regu-lation, which saw banks, insurancecompanies, trust and loan companiesand securities dealers all relegated totheir respective regimes of operationand supervision.

T he Glass-Steagall mentality thatproduced the separation of the

pillars was now increasingly subject toserious questioning. One-stop finan-cial supermarket shopping was cominginto vogue as a model for growing andconsolidating financial institutions.The public policy imperative was togenerate new kinds of competition,and the creative juices that would beunleashed by combining commercialand investment banking was seen as ahighly desirable outcome.

It should be remembered that noone expected the single model of

Stanley H. Hartt

Dick Thomson, of the Toronto-Dominion Bank, speaking forthe group, pointed out that while we were still dealing withthe frightening implications of the recent run on virtually allof the country’s smaller banks, the government needed toconsider the possibility of failures among the Big Six.

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bank-owned investment dealers,which eventually emerged to be thesole and solitary solution. At first, itseemed as if the hoped-for diversity ofbank/dealer combinations wouldcome to fruition. Wood Gundy made adeal with First Chicago (a deal thatfoundered after the stock market melt-down of October 19, 1987, when theDow lost 23 percent of its value in asingle session: Wood Gundy was near-ly itself a fatal victim because of a hugebet the firm had made on the privati-zation of BP, following which WoodGundy was “rescued” by CIBC withthe help of Jack Cockwell’s Brascan).

Burns Fry sold a minority interestto Security Pacific, before undoing thatarrangement and merging with NesbittThomson in 1994. Bank of Montrealhad acquired Nesbitt in 1987, just asBank of Nova Scotia had purchasedMcLeod Young Weir, and Royal Bankof Canada had acquired DominionSecurities. National Bank of Canadabought the venerable Quebec-basedhouse of Lévesque Beaubien. OnlyToronto Dominion Bank opted tobuild instead of buying their securitiesdealer arm, although even they even-tually went on to purchase several topquality boutiques in subsequent yearsto round out their offering.

So Canada’s “Little Bang” (or, morepejoratively, “whimper”) was born of aphilosophical view favouring cross-pillar pollination through competitionin each other’s previously watertightcompartments. As we will see, thisapproach has become mired in a newbut equally stultifying batch of regula-tory restrictions since the events thatoriginally produced this policy shift,which has led to an unfortunate loss ofmomentum and opportunity.

T he advent of bank-owned securi-ties dealers raised the inevitable

constitutional issue: which level ofgovernment would regulate what?Banking is a federal matter under sec-tion 91 of the Constitution Act, whereassecurities regulation has been charac-terized as a matter of property and civilrights in the various provinces. This

being Canada, the most vigorousdebate was reserved not for the under-lying policy, but for the dispute overpowers and jurisdiction. While the dis-cussions involved the ministersresponsible from every province, theyultimately resulted in the so-calledHockin-Kwinter Accord, between thenminister of state for financial institu-tions in the federal government, TomHockin, and Monte Kwinter, hisOntario counterpart.

The accord listed which securitiesactivities could be carried on in banks,while all other securities-related func-tions were reserved for the provinciallylicensed securities dealers. This was the

first of the sclerotic limitations placed oncross-pillar competition by governments,which never quite permitted financialmarkets to capitalize on the original rea-son for breaking down the pillars.

I ronically, within the newly integrat-ed institutions resulting from the

“Little Bang,” the bright line betweenfunctions has been steadily and inex-orably erased. This corresponds withreality: financing with the optimal mixand the lowest cost of capital ofteninvolves a combination of bank debt,capital markets debt and equity, and it isfinding the right mix, not the right pil-lar, that the corporate world cares about.

From a bang to a whimper — twenty years of lost momentum in financial institutions

The bank towers of Bay Street reflect the wealth and power of Canada’s big banks.Canada’s “Little Bang” of the late 1980s allowed banks to own security dealers and trusts,

but not insurance companies. The question of large-bank mergers, and cross-pillarmergers with insurers, is again on the table. Will it end with a bang or another whimper?

CP Photo

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But while Canada was still in theprocess of unleashing the competitiveforces that would spur variety in prod-uct offerings and multiply the sourcesof capital, the negotiations for the FreeTrade Agreement with the UnitedStates became a major preoccupationfor the government. Simon Reisman,our forceful and effective chief nego-tiator, and Gordon Ritchie, his deputy,developed a sectoral approach to thebargaining, which was essential toensure the necessary domestic consul-tation and the expertise to negotiatethe best arrangements possible. Thevery able Bill Hood, one of my prede-cessors as deputy of finance, headedthe financial sector working group.

Unfortunately for us, the US hadnot yet come around to the deregulationthat both the UK and Canada hadalready completed, and so, in offering us“national treatment,” as we were offer-ing them, there was precious little ofinterest they could concede. We had tocontent ourselves with a promise that, ifthe Glass-Steagall restrictions ever wentaway and the lines between banking andsecurities were erased, Canadian institu-tions could benefit from that liberaliza-tion regardless of what the institutionsfrom any other country could do. Thesame was true for a contemplated futureremoval of the restrictions on inter-statebank branching. We also obtained someeasing of the ability of our bank-owneddealers to participate in governmentdebt offerings, which would not other-wise have then been available to anydealer with bank ownership.

W hen the legislation governingbanks, insurance companies and

trust and loan companies was revised byParliament in 1992, it was disappointingto see that, while banks were allowed toown insurance companies, they couldnot offer their own products over thecounter in their branches (other thancreditor life insurance on such productsas mortgages and car loans, which hadlong been legal). This was the result of afierce lobby from the insurance industry.The owners of insurance companiesfeared that their franchises would be

stolen by the banks (staying just clear ofprohibitions in the Competition Actagainst tied selling) by making the bor-rower believe that the bank would be suf-ficiently gratified if the house insurerwere used that the loan might be morelikely to be forthcoming. The prohibitionagainst in-branch insurance sales was ini-tially intended to be temporary, untilinsurance shareholders had an opportu-nity to monetize their investments.

Then there were the agents andbrokers. Mostly self-employed, or atleast masters of their own hours ofwork, and representing an element ofsociety that was well-educated, finan-cially comfortable and politicallyinvolved, it would be fair to say thatevery candidate for the two leadingnational parties had and has a cadre ofinsurance industry personnel on his orher campaign team. These agents andbrokers feared the commoditization oftheir product if sold by bank personnelover the counter in bank branches andmade their opposition known.

T his was another lost opportunityto open our financial markets to

challenge from competitive forces. Thetruth is that plain vanilla insurancewould be appropriate to sell in bankbranches, while the more complex andrewarding cases involving estate plan-ning, business succession and buy-sellarrangements will always be sold inliving rooms or offices after multiplemeetings. The bifurcation of the mar-ket between commodity products andhighly individualized ones might actu-ally help the most skilled professionalagents and brokers

Having given away the “10/25”rule, (by virtue of which individual for-eign owners were restricted to 10 per-cent of a financial institution, andforeign ownership collectively was limit-ed to 25 percent) in the FTA negotia-tions, Canada attempted to precludeforeign banks seeking to buy our previ-ously protected institutions, as well as toprevent further domestic consolidation.“National treatment” meant no share-holder, Canadian or foreign, could holdmore than 10 percent of a large financial

institution (now moving to 20 percent),and the government declared that “bigshall not buy big.” This and other policyenunciations were also aimed at cross-pillar combinations between banks andinsurance companies.

T he government has permitted fourlarge insurance companies to

demutualize, and, based on size, thetwo smaller ones to be purchased bytwo larger companies. The banks haveabsorbed the trust companies; most,though not all, were bought in cir-cumstances that qualified as acquisi-tions of “failing firms.” In the latestversion of the Bank Act, smaller banksqualify as targets to the extent of 100percent or 65 percent, based on size.

The United States has now caughtup in the modernization of financialinstitutions regulation. Not only hasthe separation between commercialand investment banking been repealed,but laws now accommodate the “ban-cassurance” model, where banks andinsurance companies co-exist in thesame corporate structure. Canada’sgovernment, on the other hand, hasunfortunately, lost sight of the prom-ise, and the purpose, of dismantlingthe four pillars, and progress is stalledin liberalizing our financial system.

We are still waiting for the finalword on whether the current govern-ment will permit bank mergers and/orcross-pillar mergers. It would be the ulti-mate reversal of the thrust toward open-ness, begun in harsh circumstances in1985, if the MacKay Committee report,the ensuing White Paper, the Bank Actamendments permitting bank mergers,the Kolber Report of the Senate BankingCommittee, the regulations, and thelong-awaited public interest guidelinesamounted to a Potemkin village, offer-ing the illusion of policy development,but masking the reality of a reluctance topermit the changes that would allow usto reap the benefits of really mattering inthe world.

Stanley H. Hartt, deputy minister offinance from 1985 to 1988, is chairmanof Citigroup Canada.

Stanley H. Hartt