Banking Structure and competition

1. Banking Structure and competition Marc Prud’Homme University of Ottawa Last update: 14/09/12

2. History of Banking in Canada

3. History of Banking in Canada • In 1867 there were 34 chartered banks in Canada with 127 branches. • The Provincial Notes Act of 1866. Government in an attempt to protect the public against bank failure wanted to issue Government notes. • The banks were against this since it was an important source of profits. • The Dominion Notes Act of 1870: BNAA of 1867 grants the federal government the jurisdiction over currency and banking. • Government monopoly over small denominations (< $5). • The issuance of banknotes ended in 1935 with the creation of the Bank of Canada.

4. First Bank Act: 1971 • Decennial revision • Issuance of charters with 10 year revision and renewal. • $100 000 paid up capital before opening for business against a total of $500 000. • Note issues limited to denominations smaller than $5 and limited to paid up capital plus reserves. • No reserve requirements but 1/3 of notes issued had to be in the form of Dominion notes. • No mortgage lending and real estate loans but encourages commercial loans. • Double (as opposed to limited) liability for shareholders. • Monthly reports to government.

5. Finance Act: 1914 • With the advent of WWI, the immediate preoccupation was to preserve the stability and liquidity of the banking system. • The public was in a panic and started to convert money into gold. • The government and the banks were concerned about its ability to convert money into gold on demand since gold reserves were a small fraction of the money liabilities. • In light of this, the government suspended the convertibility of banknotes and government notes on demand. • It’s the end of the gold standard.

6. Finance Act: 1914 • As a result of the suspension of the gold standard, the Finance Act was legislated. • The Act permitted the Department of Finance to act as a lender of last resort, that is, lending Dominion notes to banks in exchange for securities, thus avoiding panics.

7. Financial Innovation • Financial innovation is driven by the desire to earn profits • A change in the financial environment will stimulate a search by financial institutions for innovations that are likely to be profitable • Responses to change in demand conditions • Responses to changes in supply conditions • Avoidance of regulations

8. Financial Innovation • Responses to Changes in Demand Conditions: • Adjustable-rate mortgages • Flexible interest rates keep profits high when rates rise • Lower initial interest rates make them attractive to home buyers • Financial Derivatives • Ability to hedge interest rate risk

9. Financial Innovation • Responses to Changes in Supply Conditions: • 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 (more on this in a moment)

10. Financial Innovation • Avoidance of Regulations: • Reserve requirements act as a tax on deposits • Restrictions on interest paid on deposits led to disintermediation • Money market mutual funds

11. Financial Innovation

12. A word about securitization • Securitization is the financial practice of pooling various types of contractual debt such as residential mortgages, commercial mortgages, auto loans or credit card debt obligations and selling said consolidated debt as bonds, pass-through securities, or Collateralized mortgage obligation (CMOs), to various investors. • The principal and interest on the debt, underlying the security, is paid back to the various investors regularly. • Securities backed by mortgage receivables are called mortgage-backed securities (MBS), while those backed by other types of receivables are asset-backed securities (ABS).

13. A word about securitization • Critics have suggested that the complexity inherent in securitization can limit investors' ability to monitor risk, and that competitive securitization markets with multiple securitizers may be particularly prone to sharp declines in underwriting standards. • Private, competitive mortgage securitization is believed to have played an important role in the U.S. subprime mortgage crisis.

14. A word about securitization • In addition, off-balance sheet treatment for securitizations coupled with guarantees from the issuer can hide the extent of leverage of the securitizing firm, thereby facilitating risky capital structures and leading to an under-pricing of credit risk. • Off-balance sheet securitizations are believed to have played a large role in the high leverage level of U.S. financial institutions before the financial crisis, and the need for bailouts

15. Competition Across All 4 Pillars • Until recently in Canada: Separation of banking and other financial services industries. • Banking, Brokerage, Trusts, and Insurance. • Regulation was therefore by institution: the 4 pillar approach which limited competition. • In the past 50 years the 4 pillars have been crumbling. • Since 1967, banks are allowed to make conventional mortgage loans thus encroaching on mortgage loans companies. • Brokerage firms engaged in banking activities by offering money market mutual funds. • In the 1980s, banks were allowed to own brokerage firms. • Today the aim of legislation is to promote a single financial services marketplace. • See next page.

16. The Near Banks: Regulation & Structure • Trust and Mortgage Loan Companies • In the beginning, various Banks Acts prevented banks from engaging in fiduciary services. FS: Administer Estates, Trusts, and Agencies. (i.e., assets that belong to someone else.) • In the early 1900s, Trust companies were allowed to act as financial intermediaries. • Now banks are allowed to own Trust companies.

17. The Near Banks: Regulation & Structure • Trust and Mortgage Loan Companies • The development of Mortgage Loan Companies paralleled that of Trust companies. Banks were prohibited from making mortgage loans. • TMLs are regulated either at the federal or provincial level. Those regulated at the federal level come under the Trust and Loans Company Act and are regulated and supervised by OSFI. They must also register in the province they operate. • The fiduciary component of trust companies is only subject to provincial legislation, even if the company is federally incorporated

18. The Near Banks: Regulation & Structure • Cooperative Banks • Cooperative banks are small financial institutions organized around individuals with a common bond (union members or employees of a particular firm.) • There are two cooperative financial systems in Canada: CaissesPopulaires and the credit union system. • There are 2 200 credit unions and CPs in Canada with 10 million members and 61 000 employees. • Most CPs and CUs are the size of a bank branch with on average $10 million in assets. The largest is VanCity with $6 billion of assets.

19. The Near Banks: Regulation & Structure • Cooperative Banks • They are established under provincial jurisdiction and are non-profit organization. • Unlike banks, CUs and CPs accept deposits and lend only to members. • All CUs outside Quebec are members of the Credit Union Central of Canada, who coordinates certain functions and cheque clearing services. • Members have voting rights, elect board of directors, which determine lending and investment policies • Have their own set of institutions, including central banking and deposit insurance • The main source of funds is deposits (85% of liabilities) followed by members equity (7%) • Asset portfolio made up largely of mortgages (55%)

20. Financial Services Reform: 21st Century • The rapid change in the financial services industry has led to the Task Force on the Future of the Canadian Financial Services Sector: The MacKay Report. • Objective: • Accelerate changes in the financial industry • Introduce new opportunities for strategic alliances in order to increase competition and providing more innovative products to Canadians. • Key elements • Bank holding companies; An organization that owns several different companies. • Allows them to engage in other activities related to banking. • Lighter regulation for non-deposit type activities conducted by affiliates. • Leverages economies of scale and scope.

21. Financial Services Reform: 21st Century • Key elements (cont’d) • New ownership rules • A single investor can now hold 20% of voting shares and 30% of non voting shares. However, over 10% requires the approval of the Minister of Finance. • Three-tiered ownership regime. Small banks (equity < $1 billion) do not have to be widely held. Medium banks ($1 billion < equity < $5 billion) can be closely held as long as there is a 35% public float. Large banks (equity > $5 billion) must be widely held. • Merger review policy • Access to the Payments and Clearance System

22. Implications for Canadian Banking Industry • The financial consolidation process will increase with the 2001 legislation as the way is open to new mergers and acquisitions, strategic alliances, partnership and joint ventures • Financial groups will become larger and increasingly complex, engaging in a full gamut of financial activities

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