July 2001
Financial Services Reform is Politicized and Dated
by Jason Clemens with Shahrokh Shahabi-Azad
Bill C-8, one of the largest bills ever considered by parliament, was supposed to re-shape and modernize the regulatory environment for financial services in Canada. Unfortunately, the growing consensus among observers is that the legislation is far too political and doesn't contain nearly enough sound economic and regulatory content.
Some good things...
Before being disparaging of the legislation, it's worthwhile to note several positive reforms, including:
- greater scope of allowable investments by financial service companies
- increased organizational flexibility through the use of holding companies
- increased ownership limits
- tiered ownership rules which promote the creation and development of small- and medium-sized financial service providers
- expanded access for non-deposit financial service companies (e.g. life insurance companies, securities firms, and mutual fund providers) to the Canada Payments Association
- increased allowances for foreign bank entry and domestic competition
Pitfalls in the legislation
Unfortunately for financial services companies, particularly banks, the legislation was drafted and considered with an antiquated view of the financial services industry. The legislation fails to recognize the rapidly changing nature of financial services, particularly with respect to new technology and ongoing innovation. An abbreviated summary of Bill C-8's major failures includes:
- continued politicization of the merger approval process
- only limited and marginal increases to foreign participation in domestic markets
- statutory preclusion of mergers/ acquisitions of large Canadian banks and demutualized life insurance companies (i.e., those that have moved from policy ownership to share ownership)
- continued prohibition of auto lease financing by foreign and domestic banks
- asymmetric regulation of banks relative to other financial institutions (for example, Bill C-8 prohibits tied selling of all financial products sold by banks, reduces the level of permissible due diligence for account openings and transaction completions, and requires the provision of low-cost accounts, but applies the changes to banks only)
- creation of the Financial Consumer Agency of Canada (FCAC) and the Canadian Financial Services Ombudsman
- onerous branch closure regulations including 4 to 6 months notice and the ability of the FCAC to hold "consultations"
- annual publication of a public accountability statement describing how the institution contributes to the Canadian economy and society
- increased unilateral power to the Superintendent of Financial Institutions including the ability to remove directors and senior officers, and impose financial penalties
When politics gets in the way of sound economics
An underlying theme of this legislation is that government regulation of the financial service sector—especially banking—is essential to public welfare. Rather than implement a coherent, sound, and competitive system of regulations, the federal government has chosen to rely on highly-politicized mechanisms to regulate and monitor the financial services industry. For instance, although some investments are specifically permitted by the legislation, banks must still seek pre-approval from the Minister of Finance to make such investments. The Minister of Finance also has the power to unilaterally approve or disapprove of proposals for shareholders to increase their holdings beyond the 10 percent previously-set limit.
The legislation also fails to sufficiently streamline the regulatory process. For example, banks must not only receive pre-approval from the Minister of Finance for permitted investments, but in many cases, such as the purchase of provincial financial institutions and factoring firms, the banks must also receive the approval of the Superintendent of Financial Institutions. Given changes to US legislation (specifically, the Gramm-Leach-Bliley Act), which significantly streamlines the regulatory process for financial firms, the reforms enacted under the legislation simply do not make the Canadian regulatory regime internationally competitive.
Fundamental problems
More fundamentally, the new legislation reveals the absence of an understanding of the rapidly changing landscape and foundation of the financial services industry. The burdensome regulations placed on institutions engaged in both financial service consolidation and bank-branch closures indicate a blatant misunderstanding of technology and its effects in this industry.
As Wendy Dobson, former federal Assitant Deputy Minister of Finance, succinctly pointed out, the new legislation makes Canadian banks prisoners of the past in a fast-forward world (1999). Our own 1998 analysis concluded that the Canadian government simply failed to appreciate the rapidly changing nature of financial services and that the 1999 decision to preclude bank mergers doomed Canada to a second-best process of branch rationalization.
Technology means less bricks and mortar, more fibre optics
The rate of change over the last decade in the means by which financial
service companies have delivered their products has been breathtaking in
pace and scope. In 1990, the Big 5 banks (the Royal Bank of Canada, the
Canadian Imperial Bank of Commerce (CIBC), the Toronto-Dominion Bank
(TD Bank),1 the Bank of Montreal, and Scotiabank) offered services through
6,310 branches and 8,083 automated teller machines (ATMs) (figure 1). None
of the major financial institutions offered either phone or Internet-based
banking in 1990.
By 2000, a mere decade later, the number of Big 5 branches had shrunk by 18.3 percent to 5,155, while the number of ATMs increased an amazing 100.3 percent to 16,192 (figure 1). More indicative of the pronounced technological changes in the industry is that the Big 5 serviced 9.7 million customers through telephone banking and another 5.8 million customers through Internet banking in 2000 (figure 2). In fact, the number of telephone and Internet customers that the Big 5 served increased 65.8 percent and 262.0 percent, respectively, between 19972 and 2000. In other words, while the number of bricks-and- mortar branches have declined, the use of electronic-based delivery methods (i.e. ATMs, telephone banking, and Internet-banking) has exploded.
Unfortunately, much of this technological revolution has been ignored or misunderstood in the drafting of the new legislation. Rather than promote, or at least not impede this type of creative destruction, the new legislation actually obstructs the replacement of buildings with new technologies. It does this by establishing an onerous branch closure process, codifies a highly politicized merger approval process, and maintains a number of punitive taxes aimed solely at the financial services industry.
A better way to rationalize branch banking
There are a number of ways to rationalize a branch network. The Institute's 1998 analysis concluded that merging banks and other financial institutions was the most efficient way to rationalize the branch banking system in Canada (Clemens, Law, and Mihlar). Consolidations, or mergers, would allow for the orderly closure of redundant branches by merged partners while still serving communities with surviving branches. Such rationalization would also enable the consolidated firms to gain economies of scale in researching, developing, and launching new technologies.
Unfortunately, the 1999 decision to preclude mergers, which has resulted in the burdensome process through which banks must wade to consolidate effectively, ensures a much less efficient rationalization process—one that relies on population growth. Figure 3 shows the number of Canadians per Big 5 branch and per ATM between 1990 and 2000. In 1990, there were 4,404 Canadians per Big 5 branch, and 3,438 Canadians per Big 5 ATM. By 2000, the number of people per branch increased 35.5 percent to 5,965, while the number of people per ATM declined by 44.8 percent to 1,899. In other words, the Big 5, like most other financial institutions, weren't investing in bricks and mortar, but rather in electronically-based delivery systems. This second-best process of rationalization through population growth will continue, thanks to government policy.
The cost of second-best
Some observers may argue that such a second-best option is actually a positive
balance for society. It permits rationalization, albeit much more slowly,
while still supporting communities. What this rather simplistic analysis
fails to take into account is the foregone savings associated with branch
rationalization. By reducing the number of branches they maintain and by
using less costly alternative delivery systems, financial institutions
can provide the same or even higher service levels while saving money.
The cost savings for the Canadian economy are potentially very large. Based
on the work of Professors Frank Mathewson and Neil Quigley, estimates of
the total annual savings garnered from rationalization just within the
Big 5 banks is between $3.3 and $9.9 billion (see table 1).3 This translates
into annual savings of between $108 and $323 per Canadian. Over a ten-year
period, this means savings in the range of $1,512 to $4,537 per Canadian.
Savings would be even greater if smaller banks, credit unions, and other financial institutions were included. For example, the annual savings increase by at least an additional $617 million to $1.85 billion when de-mutualized life insurance companies are included. There are significant savings available within the financial services industry that the federal legislation wilfully precludes through onerous regulations and politicized oversight.
Removing barriers to entry is key
Some people may worry about the distribution of those savings. A number of researchers, including Frank Mathewson, Neil Quigley, Jack Mintz, and a number of Fraser Institute analysts, have concluded that the best way to ensure that consumers realize those savings is to encourage greater competition by removing legislative barriers to entry for both domestic and foreign competitors. The current legislation takes some small steps in that direction, but more is clearly needed, particularly with respect to foreign competitors. Any barriers that prevent the full participation of foreign financial institutions should be removed.4
Conclusion
It's time to stop revelling in our punishment and persecution of financial institutions—particularly the banks— and begin to appreciate the strength they provide to our economy. The financial services legislation makes some progress in modernizing Canada's regulatory regime, albeit limited to a small number of areas. Unfortunately, effective and competitive reforms have been impeded by politics. It is important that this legislation be seen as a starting point for further reform, rather than an end point. New initiatives should begin immediately with a view towards promoting the sector rather than limiting its potential.
Notes
1 TD Bank is now TD Trust.
2 The earliest year for which compiled data were available.
3 Savings estimates are based on a 10% to 30% reduction in non-interest costs.
4 For an excellent discussion of how foreign competition could be facilitated and how it benefits Canadians, please see J. Chant (2001).
References
Canadian Bankers Association (2001). Financial Services Reform 2001: The CBA's Response to Bill C-8. March. Toronto, ON: Canadian Bankers Association. Available on the Internet at www.cba.org.
Chant, John F. (2001). Main Street or Bay Street: The Only Choices? Toronto, ON: CD Howe Institute. Available on the Internet at www.cdhowe.org.
Clemens, Jason, Marc T. Law, and Fazil Mihlar (1998). Bank Mergers: The Rational Consolidation of Banking in Canada. Critical Issues Bulletin. Vancouver, BC: The Fraser Institute. Available on the Internet at www.fraserinstitute.ca.
Clemens, Jason and Fazil Mihlar (1998). Response Submission to the MacKay Task Force on the Future of the Canadian Financial Services Sector. Submitted to the House of Commons, October 6. Unpublished.
Dobson, Wendy (1999). Prisoners of the Past in a Fast-Forward World: Canada's Policy Framework for the Financial Services Sector. Toronto, ON: CD Howe Institute. Available on the Internet at www.cdhowe.org.
Mathewson, G. Frank and Neil C. Quigley (1998). Canadian Bank Mergers: Efficiency and Consumer Gain versus Market Power. Toronto, ON: CD Howe Institute. Available on the Internet at www.cdhowe.org.
Ministry of Finance. Summary of Key Legislative Measures and Statements of Government Policy. Digital documents available on the Internet at www.fin.gc.ca.
Mintz, Jack M. and James E. Pesando (1996). Putting Consumers First: Reforming the Canadian Financial Services Industry. Toronto, ON: CD Howe Institute. Available on the Internet at www.cdhowe.org.
Jason Clemens (jasonc@fraserinstitute.ca) is the Director of Fiscal Studies at The Fraser Institute. He has a Masters degree in Business Administration from the University of Windsor.
Shahrokh Shahabi-Azad is a Research Analyst at The Fraser Institute. He has a Masters degree in Economics from Simon Fraser University.
info@fraserinstitute.ca
4th Floor, 1770 Burrard Street, Vancouver, BC, Canada, V6J 3G7
Tel: (604) 688-0221 Fax: (604) 688-8539 Book Orders: 1-800-665-3558 ext. 580
You can contact us at the above email address for any comments or information requests. Please report any dead links or technical problems.