Chapter 10

1. Chapter 10 Banking Industry: Structure and Competition © 2005 Pearson Education Canada Inc.

2. Historical Development of the Banking Industry © 2005 Pearson Education Canada Inc.

3. Financial Innovation Innovation is result of search for profits Response to Changes in Demand Major change is huge increase in interest-rate risk starting in 1960s Example: Adjustable-rate mortgages Financial Derivatives Response to Change in Supply Major change is improvement in computer technology 1. Increases ability to collect information 2. Lowers transaction costs Examples: 1. Bank credit and debit cards 2. Electronic banking facilities 3. Junk bonds 4. Commercial paper market 5. Securitization © 2005 Pearson Education Canada Inc.

4. Avoidance of Existing Regulations Regulations Behind Financial Innovation 1. Reserve requirements Tax on deposits = i r 2. Deposit-rate ceilings As i, loophole mine to escape reserve requirement tax and deposit-rate ceilings Examples 1. Money market mutual funds 2. Sweep accounts © 2005 Pearson Education Canada Inc.

5. Decline in Traditional Banking Loss of Cost Advantages in Acquiring Funds (Liabilities)  i then disintermediation because 1. Deposit rate ceilings 2. Money market mutual funds 3. 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 © 2005 Pearson Education Canada Inc.

6. 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 © 2005 Pearson Education Canada Inc.

7. Schedule I, Schedule II, and Schedule III Banks • The Big Six, together with the Laurentian Bank of Canada, the Canadian Western Bank, and another 8 domestic banks are Canada’s Schedule I banks • Schedule II banks are some domestic banks and the Canadian subsidiaries of foreign banks. As of October 2002, there were 31 Schedule II banks in Canada • A Schedule III bank is a foreign bank allowed (under certain restrictions) to branch directly into Canada. As of October 2002, there were 21 Schedule III banks in Canada © 2005 Pearson Education Canada Inc.

8. Canadian Chartered Banks © 2005 Pearson Education Canada Inc.

9. Permitted Ownership Structure • 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 © 2005 Pearson Education Canada Inc.

10. (Continued) • 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 © 2005 Pearson Education Canada Inc.

11. Comparison with the U.S. • As of October 2002, there were 68 chartered banks in Canada and around 8000 in the United States • 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. © 2005 Pearson Education Canada Inc.

12. Structure of the Commercial Banking Industry in the United States © 2005 Pearson Education Canada Inc.

13. Ten Largest U.S. Banks © 2005 Pearson Education Canada Inc.

14. Branching Regulations in the U.S. Branching Restrictions: McFadden Act and Douglas Amendment Very anticompetitive Response to Branching Restrictions 1. Bank Holding Companies A. Allowed purchases of banks outside state B. BHCs allowed wider scope of activities by Fed C. BHCs dominant form of corporate structure for banks 2. Automated Teller Machines Not considered to be branch of bank, so networks allowed © 2005 Pearson Education Canada Inc.

15. 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 © 2005 Pearson Education Canada Inc.

16. Bank Consolidation • Bank Consolidation: Why? • The way is now open to consolidation in terms not only of the number of banking institutions, but also across financial service activities • Mega-mergers are likely on the way, like that of Citicorp and Travelers in the U.S. • Banking institutions will become not only larger, but increasingly complex organizations, engaging in the full gamut of financial service activities © 2005 Pearson Education Canada Inc.

17. Bank Consolidation:Pros and Cons • Bank Consolidation: A Good Thing? • Cons: • Rush to consolidation may increase risk taking • Fear of decline of small banks and small business lending • Pros: • Community banks will survive • Increase competition • Increased diversification of bank portfolios: lessens likelihood of failures © 2005 Pearson Education Canada Inc.

18. Trust and Mortgage Loan Companies (TMLs) • Regulators • Operate under a charter issued by either the federal government or one of the provinces • 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 • The fiduciary component of trust companies is only subject to provincial legislation, even if the company is federally incorporated • CDIC and QDIB (for Québec TMLs) © 2005 Pearson Education Canada Inc.

19. Credit Unions (Outside Québec) • Regulators • Each each province has a ‘central credit union,’ owned by the member credit unions, providing financial services to member credit unions • 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) • Credit unions are covered by a provincial ‘stabilization fund’ (on terms similar to the CDIC’s) © 2005 Pearson Education Canada Inc.

20. (Québec) Caisses populaires • 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 • The confederation owns Caisse centrale Desjardins, which functions as a central bank, as the CUCC does for the rest of Canada • The QDIB insures caisses populaires, on terms similar to the CDIC’s © 2005 Pearson Education Canada Inc.

21. 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 275 branches in 240 communities across Alberta, operating in three target markets: individual financial services, agricultural operations, and independent business © 2005 Pearson Education Canada Inc.

22. International Activity of the Big Six © 2005 Pearson Education Canada Inc.

23. Largest Banks in the World © 2005 Pearson Education Canada Inc.

24. 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 © 2005 Pearson Education Canada Inc.

25. 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 © 2005 Pearson Education Canada Inc.

26. 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 © 2005 Pearson Education Canada Inc.

27. 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 © 2005 Pearson Education Canada Inc.

28. 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. © 2005 Pearson Education Canada Inc.

29. 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 © 2005 Pearson Education Canada Inc.

30. 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. © 2005 Pearson Education Canada Inc.

31. 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 © 2005 Pearson Education Canada Inc.