Chapter 19: Learning Objectives

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Chapter 19Learning Objectives

• Banking Thought Over Time
• A Brief History of Commercial Banking
• Bank Acts
• Basic Features
• Major Milestones
• Performance of Chartered Banks

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Evolution of Commercial Banking Thought

• The concept of a bank charter a means to protect
  depositors/investors
• The real bills doctrine real assets as a
  means of backing monetary assets
• Free banking a largely unregulated banking
  system. Is this possible?
• Legal restrictions government involvement in the
  financial system and its consequences

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The Development of Commercial Banking in Canada

• The evolution of government note issue from
  Confederation a growing monopoly
• Legal restrictions on banking and the first
  commercial banks in Canada limiting loans to
  commercial concerns but open branch banking
• The key piece of banking legislation the BANK
  ACT? TABLE 19.1 contains a chronology

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Milestones in Canadian Banking

• The First Bank ACT of 1871
• Revision every 10 years
• Establishes narrow federal jusrisdiction over
  the financial sector
• The crisis of 1907
• Recession originating in agriculture reveals the
  need for a lender of last resort (Finance Act
  1914)
• Measures to facilitate loans introduced

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Milestones in Canadian Banking

• The 20th Century
• Creation of a permanent lender of last resort
  The Bank of Canada
• Banks permitted to offer residential mortgages
  since the 1950s
• Deposit Insurance since 1967

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Milestones in Canadian Banking

• The Modern Era and the Bank Act of 1981
• Comprehensive Banking Law
• Chartered Banks can acquire Trusts, securities
  dealers
• Reserve requirements phased out beginning in 1994
• Whats in Store? Merger denials 1998, pressure
  from foreign competition

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An Important Bank Act MilestoneThe BANK ACT of
1991-First Financial Sector Legislation

• Abolishes the restriction of term banking to
  chartered banks alone
• Still requires a revision every 10 years but
  mid-term reviews built-in
• Brings about largest de-regulation in history
• Required reserves abolished
• Still requires chartered banks to be widely-held
• Still places limitations of chartered banks
  financial activities

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Continuing Issues in Canadian Banking

• Financial Innovations (from ATMs to Internet
  banking)
• Market concentration and competition Merger
  Mania
• Regional concerns
• Lending to big and small businesses

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The Bank Act of 2001

• More flexibility to enter new lines of of
  business
• Reduce the regulatory burden
• Creation of a new consumer watchdog agency
• Promotion of lending to small medium-sized
  businesses
• BUT restrictions on mergers, insurance,
  ownership, non-finance activities remain. Foreign
  banks remain second class citizens

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Evaluating Chartered Banks Performance The
Dimensions

• Asset - Liability Composition Tables 19.3 19.4
• Residential mortgages, foreign denominated become
  dominant, commercial loans stable
• Foreign liabilities become dominant while savings
  deposits considerably less important over the
  years
• Asset - Liability Management Table 19.5
• Size Table 19.7
• Top 5 all Schedule I banks
• Bank Profits and Interest rates not what you
  think

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Principal Activities of Financial Institutions
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How We Got from the 1990s to the 21st Century in
theFinancial Services Sector in Canada?

• Key Aspects
• Review
• Continuing Controversies
• and Problems

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The Financial Sector Today Tomorrow

• Despite all the new developments in the financial
  marketplace it is important to remember the the
  functions of banks have not changed. They still
  are
• institutions to clear and settle payments and
  facilitate transactions
• institution to provide a mechanism for pooling
  resources
• provide a means to transfer resources through
  time, industries and borders
• assist in the management of risk
• provide information to facilitate decision-making
• assist in mitigating the asymmetric information
  problem

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What Has Changed?

• The Manner in which services are provided, the
  instruments offered, and the types of entities
  providing financial services
• This has led to
• dis-intermediation and securitization of assets
• divestiture and consolidation
• convergence of business lines facilitated by
  deregulation
• increased complexity of financial services
• increased pressure on bank financial performance

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Key Factors Affecting the Financial Sector Today

• Technology
• backroom efficiencies (EDP)
• new instruments (derivatives, securitization,
  e-money)
• delivery mechanisms (ABMs, PCs, virtual banks)
• software and non-financial entities acting as
  FSPs
• Deregulation and Globalization
• Demographic Factors and the Aging Population
• away from credit provision toward wealth
  management
• increased role of investment advice

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A Refresher on the Evolution of Banking in Canada
The FOUR PILLARS story
BANKS Sec. Dealers trusts insurance
1970s
Banks sec. Dealers trusts insurance asset mgmt
1990s
Universal banking?
Future?
Trust
Wealth Mgmt
INS
Mtge
Brokerage
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What are the Future Challenges?

• Does Size Matter?

• Technology is expensive/economies of scale
• Globalization may also be a function of size
• Providing all services requires a certain size

YES

• Services can be provided by different entities
• Agency costs become larger
• There is no correlation between size efficiency
• Dangers of monopoly power

NO
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Challenges (Contd)

• Economies of scale can be quickly exhausted
• not everyone wants to shop from the same
  store
• size can also mean diseconomies of scale if focus
  is lost (leads to divestiture) and conflict of
  interest
• what matters to shareholders is profitability not
  size

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Fees and the Concentration Ratio
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Challenges (contd)

• Does Regulation Matter?
• Institutional Regulation
• regulatory solvency implies a moral hazard
  problem
• market discipline must be tempered by disclosure
  rules
• Functional Regulation
• Regulate lines of business? But solvency is an
  institutional not a functional problem
• Different regulators for different regulatory
  functions?
• Potential for overlap
• are functions sufficiently distinct?
• Coordination problems among regulators

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Challenges (Contd)

• International Considerations
• harmonizing international laws (EU, BIS, WTO)
• the problem of cross-border transactions
• Traditional vs non-traditional Financial Service
  Providers (FSPs)
• some regulated, some not making supervision
  difficult
• the Holding Co. model can regulators erect the
  right firewalls between the regulated and
  non-regulated parts?

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The Current State of Regulatory Functions in
Canada

• Competition Bureau
• looks at local level competition
• OSFI
• conducts a prudential review
• Ministry of Finance
• conducts the final policy review and makes
  decision

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What Does OSFI do?

• Supervise and ensures that financial institutions
  comply with law and are financial sound
• Advise management and require remedial action if
  unsound
• Promote policies to manage and control risk
• Monitor events that can negatively impact
  financial conditions
• Overlaps with CDIC whose mandate is
  instrumental in the promotion of sound business
  and financial practices for member institutions.

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Costs and Benefits of Regulation

• COSTS
• 1. Compliance
• 2. Operating costs of multiple regulatory regimes

• BENEFITS
• 1. Seal of approval
• 2. Lower costs as a result of 1. May lead to
  lower prices

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Factors Motivating the 1991 Amendments to the
Bank Act

• Need to modernize legislation
• Desire to break-down barriers between the
  pillars
• Need to define range of business appropriate to a
  FSP
• Need to deal with increased potential for
  conflict of interest arising out of financial
  consolidation
• Need to address issues surrounding deposit
  insurance and supervision
• Provincial legislation and the need to harmonize
  legislation across the country
• recognition of globalization phenomenon

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The Task Force on the Future of the Canadian
Financial Services Sector

• The ISSUES
• role of the financial sector in economic activity
• the state of competition in the financial sector
• the state of international competitiveness of
  Canadian banks
• the role of technology and its impact on the
  financial sector
• the quality of financial services provided to
  consumers

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Recommendations of the Report (Sept 1998) leading
to 2001 Bank Act Reforms

• 1. Allow life insurance Cos., Mutual Funds and
  Investment Dealers to access payments system
• 2. Making ABMs more functional (e.g., accept all
  deposits)
• 3. Coop banks should be allowed to form banks
• 4. Demutualize major insurance Cos.
• 5. Change deposit insurance to allow other FSPs
  to compete or stop giving banks an edge in this
  area
• 6. Relax closely-held vs. widely-held rules
• 7. Banks should be allowed to offer insurance and
  auto leasing services
• 8. Encourage new domestic entrants into the
  financial industry

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Summary

• The history of Canadian commercial banking is a
  fascinating one reflecting changes in views over
  time about the role of commercial banks in the
  financial system and the role of government as a
  regulator
• The centerpiece of financial legislation is the
  BANK ACT
• Understanding chartered banks performance is
  complex and must be accomplished along several
  dimensions, including size, profitability,
  asset-liability composition and management