Mini-Review 85-14E
CHANGING REGULATORY ENVIRONMENT FORCANADIAN FINANCIAL INSTITUTIONS:A CONFERENCEREPORT
RandallChanEconomicsDivision
10 September1985
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CHANGINGREGULATORYENVIRONMENTFOR CANADIAN FINANCIAL INSTITUTIONS:
A CONFERENCEREPORT
I NTRODUCTION
In view of the recent federal discussion paper Regulation of
Canadian Financial Institutions, the Conference on the Changing Regulatory
Environment for Canadian Financial Institutions organized jointly by the
Faculty of Law, University of Toronto and the Ontario Economic Council on
May 22 and 23 in Toronto was timely. The panels of speakers were composed
of academics, lawyers from financial institutions and representatives of
industry. The Conference addressed five themes: functions of regulation,
internationalization and integration of markets, federal—provincial
relations, insolvencies and deposit insurance, and consequences of
deregulation. This paper summarizes the main issues raised on each of these
five themes.
FUNCTIONS OF REGULATION
The failure of one financial institution can cause the public
to lose confidence in others and thereby diminish the stability of the
entire system. For this reason, the regulation of financial institutions
differs from that of other industries in that solvency is a major public
policy objective. Other objectives include promoting competition among
different institutions providing similar services, enhancing efficiency in
terms of allocating resources and minimizing cost, and assuring some degree
of Canadian ownership in the financial sector.
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A variety of measures can be used to achieve these goals.
Ownership restrictions similar to those under the Bank Act can ensure
predominantly Canadian ownership. Separation of financial functions
(commercial lending, insurance, fiduciary activity and investment
underwriting) tends to minimize potential conflicts of interest and hence
enhances solvency of the system as would prohibition on self-dealing and
conflict of interest guidelines. In contrast, allowing full integration of
functions within a single financial institution would promote competition
across the entire financial sector for all services. Potential conflicts of
interest can be minimized with the use of “Chinese walls”. These are
essentially codes of conduct for employees within a financial institution
and are designed to prohibit employees of different divisions from passing
client information to each other.
In regulating financial institutions, one ought to distin-
guish between remedial and preventive measures. Remedial measures are
policing procedures whereas preventive measures are intended to preempt
undesired consequences. Because financial institutions are entrusted with
public funds and are highly leveraged, the benefits of preventive regulationare generally considered to be greater than its costs which may entail
higher operational expenses or reduced competition.
INTERNATIONALIZATION AND INTEGRATION OF MARKETS
Developments in the financial services industry in the U.S.
can be characterized by four major trends. The first is integration or
homogenization. For example, the insurance industry is offering more and
more equity based financial instruments and securities firms are providing
money market funds and banking services. The second trend is towards
amalgamation as when insurance companies merge with mutual funds or
with securities firms. Thirdly, we have geographical expansion, such as the
use of bank holding companies to enter into interstate banking. The fourth
trend is international, as shown by the growing presence of foreign banks
and the increasing importance of foreign denominated assets in domestic
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institutions. In sum, these trends represent conglomerization in the
context of expansion.
Many of the underlying causes of deregulation in the U.S.
are not, however, applicable to Canada. Canada has never suffered from the
distortions resulting from U.S. regulations such as Regulation Q and
restriction on inter-state banking.
In the trend towards deregulation, several issues are
considered to be of major importance. How should deposit insurance be
determined so that market discipline can be brought to bear on deposit
institutions? Industrial corporations can now enter into financial services
without restrictions, though not vice versa. How can conflict of interest
and self-dealing be effectively controlled without creating inefficiency and
reducing competition? What is the proper trade-off between solvency and
competiti on?
FEDERAL-PROVINCIAL RELATIONS
With the exception of property and civil rights which fall
under provincial jurisdiction, the Constitution provides the federal
authority with the power to regulate trade, commerce, banking, inter-
provincial trade, peace and order, and bankruptcy and insolvency. Some
observers believe that federal power is sufficiently pervasive for it to
regulate virtually all activities of financial institutions.
In fact, however, the federal government has acquiesced for
about 100 years in the granting of licences by provincial governments to
bank-like institutions and provincial government regulation of banking—type
activities. The courts have also tended to rule in favour of provincial
governments over the years.It can be argued that the proposal of the federal discussion
paper to relate commercial lending power exclusively to institutions
chartered under the Bank Act is an attempt to consolidate federal juris-
diction over most deposit institutions. There are three possible outcomes
of this latent federal-provincial jurisdictional dispute: no coordination
between the two levels of governments, constitutional amendment for the
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division of power, or judicial determination of the scope of federal
jurisdiction over financial institutions.
INSOLVENCIES AND DEPOSIT INSURANCE
The recent rash of insolvencies in financial institutions and
their attendant claims have raised some fundamental questions about thefunction of deposit insurance and the impact of the existing system on
competition, efficiency and market discipline.
Under the present system of a flat rate premium structure,deposit insurance can only succeed only if the probability of insolvency is
low and the chances of loss are small. Proponents of this system point tothe ease with which it can be administered, particularly if separation of
function is enforced. Risk-related premium is not considered practical
because of the disparity in size of existing deposit institutions. To
improve prudential supervision and enhance the solvency objective, these
observers prefer to render existing regulations more stringent to include
more information disclosure, greater capital requirement and stricter
eligibility conditions for chartering. They also suggest that the
introduction of some form of co-insurance would instill an element of
discipline on depositors as well as management.
Critics of the present system contend that deposit insurance
as it is now operated does not constitute an insurance contract against
defined hazards. Owing to the authorities’ concern for public confidence,
deposit insurance has become in effect a financial guarantee for the deposit
institution’s liability. This results in an unequal sharing of risks and
rewards because earnings are retained by the institution but losses are
borne by the guarantor. The flat-rate premium structure also means that
prudently managed institutions subsidize those which accept unreasonable
risks. If reform is not carried out, delays in short-run adjustment will
ultimately undermine the system. Proposed reforms include market value
accounting, increased capital requirement, greater information disclosure,
greater enforcement power for supervisory authority, recalibrated insurance
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coverage, risk- related premiums, reinsurance for larger risks and statutory
limitation on bailouts. It was pointed out that the U.S. experience with
failures and market adjustments has been one of consolidation and
conglomeration; yet the federal discussion paper seems to halt the growth of
Canada’s large banks.
CONSEQUENCES OF DEREGULATION
The pursuit of several public policy objectives inevitably
results in trade-offs. Such is the case with the promotion of competition
and efficiency on the one hand and the preservation of stability, confidence
and solvency on the other. Public policy must therefore seek to bring about
the regulation of markets and functions so as to restrict as little as
possible the efficient operations of the institutions, while ensuring their
solvency. Guidelines on conflict of interest and the ban on self-dealing as
outlined in the federal discussion paper are considered by many observers as
a reflection of the federal government’s overriding concern with solvency.
Most argue that for these cases the costs of regulation would far exceed the
potential benefits. After all, regulation cannot guarantee honesty and
integrity. Perhaps some degree of self-regulation may be appropriate.
Some industry representatives claim that the proposed
creation of ‘C’ banks would not meet the needs of small trust companies
seeking greater commercial lending power because most such companies are not
in a position to establish a financial holding company in order to
incorporate a ‘C’ bank. For them, greater commercial lending power under
appropriate provincial legislation would be more realistic.
Other representatives criticized the federal government for
paying only “lip service” to competition because foreign competition would
still be restricted in the future. Domestically, the future scope of
operations of those institutions that can most likely unleash competitive
forces in a deregulated environment has been frozen by the discussion paper.
Conglomerations are not in themselves bad. The role of competition is to
promote countervailing powers. If the market is sufficiently open,
contestability of markets and market discipline will impose themselves upon
financial institutions.
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