2 Regulation of the Canadian financial services industry

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2 Regulation of the Canadian financial services industry

Legal Framework

In most countries, financial institutions and financial markets are highly regulated. Canada is not an exception. Financial institutions and financial markets in Canada are regulated at both the federal and the provincial levels. Under the British North America Act of 1867, banking falls within the exclusive jurisdiction of the federal government. The activities of banks are monitored by the federal Office of the Superintendent of Financial Institutions (OSFI), which reports to the Minister of Finance. The OSFI is responsible for administering the Bank Act, the Insurance Act, the Trust and Loan Companies Act, and the Co-operative Credit Associations Act (OSFI 1992).

Both federal and provincial governments regulate trust companies and insurance companies. Traditionally, trust companies have specialized in the provision of residential mortgages while insurance companies have focused on underwriting and selling life insurance policies.

Provincial governments regulate investment dealers, whose principal function, ``market intermediation,'' is critically important to the functioning and liquidity of Canadian financial markets.

Historical perspective

From the 1930s until the 1960s, Canada's financial institutions were regulated according to the ``pillar'' system. Under the pillar system, chartered banks, insurance companies, trust companies, and investment dealers were regulated as separate financial institutions. Each pillar carried out functions that were separate and distinct from that of the other pillars. Virtually no overlap among the pillars was permitted. Concerns about the solvency and stability of the banking system, prompted by a wave of bank failures (particularly in the United States) during the Depression, motivated the move towards this form of regulation, which was designed to guarantee the independent functioning of each sector and to minimize the possibility of negative spillover from one pillar to another (Economic Council of Canada1986).

Ownership restrictions were also an integral part of the pillar system of regulation. Institutions in one pillar were prohibited from owning institutions in other pillars. Financial institutions were also prohibited from owning non-financial institutions. These constraints assured the stability of the system but reduced competition within the financial services industries (ECC 1986).

From the 1960s onwards, the pillar system of regulation began to disintegrate and concerns about competition came to overshadow concerns about solvency. Revisions to the Bank Act in 1967, 1980, and 1992 permitted greater inter-pillar competition so as to encourage the creation of a greater variety of financial services for consumers. Some of the highlights of these Bank Act revisions are listed below.

Key revisions to the Bank Act

1967 revisions

The interest rate ceiling on chartered banks was removed. In addition, chartered banks were permitted to provide conventional mortgages and loans.

The 10/25 rule was introduced so as to reduce foreign ownership of Canadian banks. Under this rule, no single investor could hold more than 10 percent of a bank's voting equity, and non-residents in aggregate were prohibited from owning more than 25 percent.

1980 Revisions

Amendments were introduced to bring foreign-owned banks under federal regulatory control. Previously, foreign owned banks were provincially regulated. It was hoped that putting all banks under the same regulatory regime would ``level the playing field'' among banking institutions.

Under these amendments, subsidiaries of foreign banks were classified as Schedule II banks. Provisions were introduced, however, so as to prevent Schedule II institutions from competing in certain markets.

1992 Legislative Package

Chartered banks and trust companies were given permission to own and establish subsidiaries engaged in securities.

A number of inter-pillar ownership restrictions were eliminated. Banks and insurance companies were allowed to own trust companies; banks and trust companies were permitted to own insurance companies. Financial institutions were granted permission to own corporations that carry out related financial services, such as the purchase and sale of accounts receivable. Further, financial institutions were permitted to own up to 25 percent of shareholders' equity or 10 percent of voting shares of non-financial corporations.

As a result of these revisions to the federal Bank Act and revisions to other federal legislation regulating the financial services industry, there has been a substantial breakdown of the pillar system. Many barriers to entry into the financial services industry have been either eliminated or reduced. As a result, the focus of financial service regulation has shifted from concerns about solvency to a focus on competition.

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Last Modified: Wednesday, October 20, 1999.