Chapter 10

Banking Industry:
Structure and
Competition

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 Historical Development of the Banking Industry

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 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
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 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
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 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
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 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

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 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
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 Canadian Chartered Banks

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 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
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 (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
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 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.

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 Structure of the Commercial Banking
Industry in the United States

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 Ten Largest U.S. Banks

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 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
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 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

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 Bank Consolidation

Bank Consolidation: Why?

1. The way is now open to consolidation in terms
not only of the number of banking institutions,
but also across financial service activities
2. Mega-mergers are likely on the way, like that of
Citicorp and Travelers in the U.S.
3. Banking institutions will become not only larger,
but increasingly complex organizations,
engaging in the full gamut of financial service
activities
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 Bank Consolidation:
Pros and Cons
Bank Consolidation: A Good Thing?
Cons:
1. Rush to consolidation may increase risk taking
2. Fear of decline of small banks and small
business lending
Pros:
1. Community banks will survive
2. Increase competition
3. Increased diversification of bank portfolios:
lessens likelihood of failures
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 Trust and Mortgage Loan
Companies (TMLs)
Regulators
1. Operate under a charter issued by either the
federal government or one of the provinces
2. 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
3. The fiduciary component of trust companies is
only subject to provincial legislation, even if the
company is federally incorporated
4. CDIC and QDIB (for Québec TMLs)
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 Credit Unions (Outside Québec)

Regulators
1. Each each province has a ‘central credit union,’
owned by the member credit unions, providing
financial services to member credit unions
2. 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)
3. Credit unions are covered by a provincial
‘stabilization fund’ (on terms similar to the CDIC’s)
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 (Québec) Caisses populaires

1. 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
2. The confederation owns Caisse centrale
Desjardins, which functions as a central bank, as
the CUCC does for the rest of Canada
3. The QDIB insures caisses populaires, on terms
similar to the CDIC’s
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 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
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 International Activity of the Big Six

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 Largest Banks in the World

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 Financial Services Reform
for the 21st Century

• Bank Holding Companies

• The Permitted Investment Regime
• New Ownership Rules
• Access to the Payments and Clearance System
• Merger Review Policy

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 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
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 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
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 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
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 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.
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 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
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 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.

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 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
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