Chapter 18:Learning Objectives

Banking Thought Over Time A Brief History of Commercial Banking Bank Acts:

Basic Features Major Milestones

Performance of Chartered Banks

Evolution of Commercial Banking Thought

The concept of a bank charter: a means to protect depositors/investors

“Free banking”: a largely unregulated banking system. Is this possible?

Legal restrictions: government involvement in the financial system and its consequences

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 18.1 contains a chronology

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

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

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 What’s in Store? Merger denials 1998,

pressure from foreign competition

An Important Bank Act Milestone:The 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

Continuing Issues in Canadian Banking

Financial Innovations (from ATMs to Internet banking)

ATMs in Canada

Principal Activities of Financial Institutions

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

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”

Evaluating Chartered Banks’ Performance: The Dimensions

Asset - Liability Composition: Tables 18.4 & 18.5 Residential mortgages, foreign denominated

become dominant, commercial loans stable Foreign liabilities become dominant while savings

deposits considerably less important over the years

Assets of Chartered Banks

Liabilities of Chartered Banks

Evaluating Chartered Banks’ Performance: The Dimensions

Asset - Liability Composition: Tables 18.4 & 18.5 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 18.5

Balance Sheet of Chartered Banks: NOV 2004

GAP: RBC October 2003

Evaluating Chartered Banks’ Performance: The Dimensions

Asset - Liability Composition: Tables 18.4 & 18.5 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 18.5 Size: Table 18.6

Top 5 all Schedule I banks Bank Profits and Interest rates: not what you

think

Cahrtered Banks’ Size: Top 6

Evaluating Chartered Banks’ Performance: The Dimensions

Asset - Liability Composition: Tables 18.4 & 18.5 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 18.5 Size: Table 18.7

Top 5 all Schedule I banks Bank Profits and Interest rates: not what you

think

How We Got from the 1990s

to the 21st Century in theFinancial Services Sector

in Canada?

Key AspectsReview

Continuing Controversiesand Problems

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

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

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

A Refresher on the Evolution of Banking in Canada

The FOUR PILLARS story

1970s BANKS Sec. Dealers trusts insurance

1990s Banks sec. Dealers trusts insuranceasset mgmt

Future? Universal banking?

INS

Brokerage

WealthMgmt

Trust

Mtge

What are the Future Challenges?

Does Size Matter?

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

NO

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

Challenges (Cont’d)

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

Fees and the Concentration Ratio

0

5

10

15

20

0 20 40 60 80 100

CONCRATIO

FE

E

FEE vs. CONCRATIO

Challenges (cont’d)

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

Challenges (Cont’d)

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?

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

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.”

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”

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

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

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

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