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

Copyright 2011 Pearson Canada Inc.11- 1

Chapter 11

Banking Industry:Structure and Competition

Canadian Banks

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

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) 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

Banks schedule 1; schedule 2; schedule 3

11- 3

http://www.ieso.ca/Documents/settlements/se_financialinstitutionslist.pdf

https://financialpostbusiness.files.wordpress.com/2014/07/bigbanks.jpg

http://www.osfi-bsif.gc.ca/Eng/wt-ow/Pages/wwr-er.aspx?sc=1&gc=1#WWRLink11







1.Historical Development of the Canadian Banking System I

• 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.


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;

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

*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


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

• 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

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

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


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

• This transformation from the 4 Pillar system to the Universal Banking is the result of the Banks’ Adaptation, their Lobbying and the Legislative changes.


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)


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



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


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)


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


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


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


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

3. American Banking System for Comparison

• 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”.

The American Story

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

Overlapping and Complex Regulatory Agencies• The Office of the Comptroller of the Currency (OCC)charters, regulates, and supervises national banksand federal savings associations (collectively, banks)and licenses and supervises the federal branches andagencies 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

In fact, it is more complicated than it looks: From FR website, we can seehttp://www.federalreserve.gov/pf/pdf/pf_5.pdf :


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

* 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.

0

2000

4000

6000

8000

10000

12000

14000

16000

'75 '80 '85 '90 '95 '00

# of Banks

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

32

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 AmericanTornadoWicked Witch of the East- Eastern Business and Financial InterestsMunchkins -Average Americans Scarecrow -Western FarmerTin Woodman- Unemployed Industrial WorkersCowardly Lion -“William Jennings Bryan” Wicked Witch of the West - Grover Clevelandsilver shoes: magicwater that melt the witch: solution – watershed – inflation (through printing money)

• A Lesson: So much socio-political problems and regional interests were intertwined withMonetary 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.

Ten Largest U.S. Banks

Updated one can be found:for HC http://www.ffiec.gov/nicpubweb/nicweb/top50form.aspx

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/

1) Updated one is at https://www.snl.com/InteractiveX/Article.aspx?cdid=A-26316576-11566

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.

* Apparent Rationale Underlying the Separation of Commercial and Investment Banking: Glass-Steagall Act

In favor of Specialized Banking as opposed to Universal BankingIf 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

•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.

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


* 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.

• 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


• 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- 1 Chapter 11 Banking Industry: Structure and Competition...

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