Chapter 10

chapter 10

Banking Industry: Structure and Competition

Copyright © 2002 Pearson Education Canada Inc. 10- 2

The Early History of Commercial Banking in Canada


Structure of the Canadian Chartered Banking Industry


Canadian Chartered Banks


• The Big Six, together with the Laurentian Bank of Canada and the Canadian Western Bank, are Canada’s Schedule I banks

• Schedule II banks are some domestic banks (such as Citizens Bank, First Nations Bank, and Manulife Bank) and the Canadian subsidiaries of foreign banks. As of June 2000, there were 39 Schedule II banks in Canada

• A Schedule III bank is a foreign bank allowed (under certain restrictions) to branch directly into Canada. As of June 2000, there were 2 Schedule III banks in Canada

Schedule I, Schedule II, and Schedule III Banks


• Schedule I banks and big Schedule II banks (those with over $5 billion in equity capital) must be widely held: no individual can own more than 10% of any class of shares

• Small Schedule II banks with equity capital less than $1 billion don’t have to be widely held --- that is, may have a significant shareholder (more than 10%)

• Small Schedule II banks with equity capital in excess of $1 billion have to be at least 35% widely held

Permitted Ownership Structure


• Any widely held foreign bank can own 100% of a Canadian bank subsidiary (that is, of a foreign Schedule II bank)

• Any widely held and regulated Canadian financial institution, other than a bank, may own 100% of a bank

• Schedule II banks can add branches to their initial branch only with ministerial approval

• Schedule III banks can branch directly into Canada, following authorization by the Minister of Finance

Permitted Ownership Structure (Continued)


• As of June 2000, there were 49 banks in Canada and around 8500 in the U.S

• The presence of so many banks in the U.S. reflects past regulations that restricted the ability of these financial institutions to open branches

• Many small U.S. banks stayed in existence because a large bank capable of driving them out of business was often restricted from opening a branch nearby

• It was easier for a bank to open a branch in a foreign country than in another state in the U.S.

Comparison with the U.S.


Response to Branching Restrictions in the U.S.

Branching restrictions were very anticompetitive. The response to these restrictions was:

1. Bank Holding Companies (BHC)A. Allowed purchases of banks outside stateB. BHCs allowed wider scope of activities by FedC. BHCs dominant form of corporate structure for banks

2. Nonbank BanksNot subject to branching regulations, but loophole closed

in 19873. Automated Teller Machines

Not considered to be branch of bank, so networks allowed


Competition Across All Four Pillars and Convergence

• Until recently, 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


Big Six Dominate Canada’s Investment Banking Industry


Bank Consolidation

Bank Consolidation: Why?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. Mega-mergers are likely on the way, like that of Citicorp and Travelers in the U.S.

3. Banking institutions will become not only larger, but increasingly complex organizations, engaging in the full gamut of financial service activities


Bank Consolidation:Pros and Cons

Bank Consolidation: A Good Thing?Cons:1. Rush to consolidation may increase risk taking2. Fear of decline of small banks and small

business lendingPros:1. Community banks will survive2. Increase competition3. Increased diversification of bank portfolios:

lessens likelihood of failures


Frameworks for the Banking and Securities Industries

1. Universal banking. Exists in Germany, the Netherlands, and Switzerland and provides no separation at all among the banking, securities, real estate, and insurance industries

2. British-style universal banking. Exists in U.K., Australia, and now in Canada and the U.S. Separate legal subsidiaries are more common while bank equity holdings of commercial firms and combinations of banking and insurance firms are less common

3. Japanese banking system. Legal separation of banking and other financial services industries


Trust and Mortgage Loan Companies (TMLs)

Regulators1. Operate under a charter issued by either the

federal government or one of the provinces2. Federally incorporated TMLs are regulated and

supervised by the OSFI and must also register in all provinces in which they operate and conform to their regulations

3. The fiduciary component of trust companies is only subject to provincial legislation, even if the company is federally incorporated

4. CDIC and QDIB (for Québec TMLs)


Balance Sheet of All TMLs


Credit Unions (Outside Québec)

Regulators1. Each each province has a ‘central credit union,’

owned by the member credit unions, providing financial services to member credit unions

2. All central credit unions are members of the Credit Union Central of Canada (CUCC), also known as Canadian Central, which functions as a central bank (i.e., provides cheque-clearing services for all provincial central credit unions)

3. Credit unions are covered by a provincial ‘stabilization fund’ (on terms similar to the CDIC’s)


(Québec) Caisses populaires

1. Caisses populaires are organized into 11 regional federations that belong to the Confédération des caisses populaires et d’économie Desjardins du Québec, which has a similar structure to the provincial central credit unions in the rest of Canada

2. The confederation owns Caisse centrale Desjardins, which functions as a central bank, as the CUCC does for the rest of Canada

3. The QDIB insures caisses populaires, on terms similar to the CDIC’s


Balance Sheet of Credit Unions and Caisses Populaires


Government Savings Institutions

Province of Ontario Savings Office• Established in 1921• Today only lends to the Treasurer of Ontario for

provincial government purposes Alberta Treasury Branches• Established in 1938• Today there are 278 branches in 109 communities

across Alberta, operating in three target markets: individual financial services, agricultural operations, and independent business


International Activity


International Focus of the Big Six


Largest Banks in the World


Foreign Banks in Canada

• As already noted, a foreign bank may enter the Canadian banking industry as either a Schedule II or a Schedule III bank

• The difference between Schedule II and Schedule III banks is that a Schedule II bank is a Canadian subsidiary of a foreign bank, whereas a Schedule III bank is a foreign bank allowed to branch directly into Canada, under certain restrictions

• Schedule III banks cannot take retail deposits (i.e., deposits < $150,000) and, as a result, are not subject to requirements for CDIC insurance


Schedule II Banks in Canada


Financial Innovation and Declinein Traditional Banking

Innovations Increasing Competition

1. Money market mutual funds

Avoids deposit rate ceilings and reserve requirements

2. Junk bonds

Result of better information in credit markets

3. Commercial paper market

Result of better information in credit markets and rise in money market mutual funds

4. Securitization

Result of better information in credit markets and computer technology


Personal Deposits versus Mutual Funds (in Canada)


Bank Profitability


Share of Noninterest Income


Decline in Traditional Banking

Loss of Cost Advantages in Acquiring Funds (Liabilities) i then disintermediation because

1. Money Market Mutual Funds

2. Foreign banks have cheaper source of funds: Japanese banks can tap large savings pool

Loss of Income Advantages on Uses of Funds (Assets)1. Easier to use securities markets to raise funds: commercial paper,

junk bonds, securitization

2. Finance companies more important because easier for them to raise funds


Banks’ Response

Loss of cost advantages in raising funds and income advantages in making loans causes reduction in profitability in traditional banking

1. Expand lending into riskier areas: e.g., real estate

2. Expand into off-balance sheet activities

3. Creates problems for regulatory system

Similar problems for banking industry in other countries


Financial Services Reformfor the 21st Century

• Bank Holding Companies• The Permitted Investment Regime• New Ownership Rules• Access to the Payments and Clearance System• Merger Review Policy


Advantages of the Holding Company Form of Ownership

• Allows banks to engage in other activities related to banking (i.e., provision of investment advice, data processing and transmission services, leasing, and credit card services)

• Allows for lighter regulation throughout the bank financial group because certain activities (those not involving deposit-taking and insurance) can be undertaken by less-regulated, non-bank affiliates

• Provides increased flexibility to achieve economies of scale and scope through strategic partnerships, alliances, and joint ventures


The Permitted Investment Regime

The new legislation provides greater flexibility for bank involvement in the information technology area --- i.e., the Internet and wireless technology

Implications:Although bank involvement in the information

technology area is subject to regulation, the new permitted investment regime will enhance the ability of bank financial groups to:

• pursue strategic alliances and joint ventures, and • further accelerate the technological advances that

are already taking place


New Ownership Rules

• The proposed legislation lowers the capital needed to create a bank from $10 million to $5 million and allows domestic and foreign commercial firms to establish small and medium-sized banks

• Increases the limit a single shareholder can own of a widely held financial institution (either a BHC or a bank subsidiary under the BHC) from 10% of any class of shares to 20% of voting shares and 30% of non-voting shares

• However, it does not permit a single shareholder to own more than 10% of both a BHC and a bank subsidiary under the BHC at the same time


New Ownership Rules (Continued)

• Small banks don’t have to be widely held and can be wholly owned (have one particular investor own 100% of their shares)

• Medium sized banks and BHC with shareholders’ equity between $1 billion and $5 billion can be closely held provided that there is a 35% public float (that is, they could have a single shareholder own up to 65% of their shares).

• Large banks and BHC, those with shareholders’ equity in excess of $5 billion, are required to be widely held.


Access to the Payments and Clearance System

The new legislation allows non-deposit taking financial institutions (life insurance companies, securities dealers, and money market mutual funds) access to the payments and clearance system

Implications:This will increase competition by allowing non-

deposit taking financial institutions to provide bank-like services (i.e., chequing accounts and debit cards) without being banks, thereby directly competing with banks, TMLs, and CUCPs


Merger Review Policy

• The new legislation acknowledges that mergers are a legitimate business option that should be available to Canadian bank financial groups

• Does not allow mergers between large banks and large demutualized life insurance companies

• Note that such mergers are not prohibited in countries such as Australia, Germany, the Netherlands, Switzerland, the U.K., and the U.S.


Implications for the Canadian Banking Industry

A BHC structure, new ownership rules, expanded permitted investments, expanded access to the payments and clearance system, and a transparent merger review policy will:

• further speed up the financial consolidation process, because the way is now open to both mergers and acquisitions, and strategic alliances, partnerships, and joint ventures

• together with new information technologies, make possible new financial products and services and a more vibrant and dynamic market for financial services

Chapter 10

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