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Hugh Brown, Ian de Verteuil, John Reucassel and Atul Shah Submission in Response to Finance Canada's 2006 Review of Financial Sector Legislation:
Director, Financial Institutions Division
Financial Sector Policy Branch
Department of Finance
20th Floor, East Tower
140 O'Connor St
25th April 2005
The Bank Act by law expires every five years with the current terminal date being October 2006. This process of automatically reviewing legislation every five years is very progressive and, in our opinion, is a major reason why Canada's financial system remains one of the soundest, and most efficient in the world.
With this timetable in mind, the Federal Government has issued a consultation document (i.e. Annex 6 – 'An Effective and Efficient Legislative Framework for the Canadian Financial Services Sector' attached to the Federal Budget – February 23/05) that details the goals of this review. The consultation document outlines some possible changes to financial sector legislation and asks for interested parties to make submissions by June 1, 2005.
This submission, which is in response to the consultation document, comes from four professional equity security analysts (indicated below) who are employees of BMO Nesbitt Burns, a wholly owned subsidiary of Bank of Montreal. The views expressed are those of these four individuals and may or may not be similar to those of the Bank of Montreal. As equity security analysts covering banks, insurers, asset managers and a variety of other financial services companies, we have a combined experience of over 45 years looking at Canada's financial institutions (FIs). Our perspective tends to be from an owner's viewpoint (i.e., the shareholders of Canada's financial institutions). In this submission, however, our focus is on what is best for all Canadian stakeholders – consumers, employers and owners.
In the Introduction to the Consultation Document in the Budget, three principal goals of the review were mentioned – enhancing interests of consumers, increasing legislative and regulatory efficiency and adapting the framework to new developments. We endorse all three of these items. However, we believe that one significant additional goal should be mentioned - maintaining a globally competitive and efficient financial system. This is paramount to the long-term health of the domestic economy. We must be careful that, as Canadians who have been blessed with a healthy financial system, we do not take this for granted.
Driven by new technologies, globalization, changing consumer demands and demographics, financial systems around the world are experiencing massive change. We believe that, as long as government intervention is limited to an oversight role, Canada's financial institutions can adapt and thrive in this challenging environment.
The purpose of this submission is not to deal with several major financial services policy issues that remain unaddressed. The three most material outstanding issues include bank mergers (we are in favour of allowing banks, who so desire, to attempt the onerous Merger Review Process set forth in the last Bank Act), bank-based distribution of life insurance (we are in favour as the consumer will certainly benefit because of better access) and big bank-big insurer consolidation (again, we are supportive - subject to safety, soundness and competition considerations). We do not intend to cover this ground again. We think people are exhausted and it is well past the time for the Federal Government to make some decisions, one way or another, on these important subjects.
Our submission is structured in two parts. First, we comment on two tenants of regulation of Canada's FIs that have served us well. Second, we suggest six initiatives that could be beneficial to some specific consumers of financial services.
There are several elements of financial services legislation that have been instrumental in insuring the safety and soundness of the system, and allowing sufficient competition for consumers. We comment on two of these elements that are still important today – wide ownership and separation of commercial and financial interests.
1. Wide ownership
Having a widely held financial services system encourages regulation of the industry by market forces (debt and equity market oversight) and ensures that Canada's largest providers of financial services are largely owned and run by Canadians. Canadians can invest in the inherent profitability and stability of financial services in Canada, effectively becoming partners. Currently, we believe that one in every two working Canadians are shareholders in Canada's large financial institutions either directly, or indirectly through mutual and pension funds.
As free-marketers, we believe that allowing close ownership of the major deposit-takers, loan makers and insurance providers and the resulting concentration of power in few hands has the potential for abuses, which outweigh the incremental benefits of flexibility in corporate dealings and structure.
2. Delineation of Commercial and Financial Interests
We are in favour of a broad-based separation of commercial and financial interests. Variations from this stance should be considered on a circumstance-by-circumstance basis and should limit financial institutions to financial services provision and to financing Canada's consumers, entrepreneurs, employers and the public sector.
Canada's larger financial service providers already represent a large part of the Canadian "market" economy. Today, the seven largest public financial institutions (FI) make up 26% of the float capitalization of the Canadian market. Concentration of economic power into too few hands (particularly ones that enjoy quasi-government protection, i.e., too big to fail) should be limited. Therefore, giving financial institutions the power to invest extensively in commercial enterprises (and vice versa) makes no sense.
There are two other important realities that argue for continued separation except in pre-defined circumstances. First, regulators (OSFI principally) would have a much greater need for oversight if FIs were broadly allowed into non-financial businesses. We believe that the status quo has worked well in ensuring a solid financial system. Second, combining the running of and financing for Canada's economy has the potential for numerous conflicts.
New Initiatives to Deal with Small Business and Sub-Prime Financing Business:
We believe these are very important growing, borrowing populations that are underserved by the existing structure. We believe the Federal Government could execute a number of initiatives that would increase the supply and lower the cost of funds and other financial services to these sectors. In all cases the private sector and market forces would be relied upon.
We present the following six recommendations:
1. Removal from Federal financial institutions legislation of the prohibition on providing residential mortgages exceeding 75 per cent of the value of the property unless the loan is insured. This change would encourage mainstream intermediaries (i.e., large banks, credit unions, trust companies, etc.) to enter this riskier space.
While the residential mortgage market in Canada is highly competitive, the self-employed and small business owners often, because of their own specific financial limitations, need high-ratio mortgages and often must insure with either CMHC or Genworth (GE Capital). We believe with the removal of the legislated requirement to insure high-ratio mortgages, additional competitors could more effectively compete and the resulting market forces could lead to material savings to these consumers.
2. Consider additional measures that will increase the financing available to Canada's small business community. We believe that many of Canada's large FIs have been reluctant to provide credit to higher risk, small businesses, because of concerns of reputational risks of pricing appropriately for the risk and the incremental cost of operating in this segment. This has probably resulted in a narrower range of funding alternatives for Canada's small business, and has encouraged the entry of foreign financial institutions that are less concerned with public backlash from high-priced lending.
It is difficult to deal with this issue – because the reality is that large FIs need to be encouraged to enter segments where they will necessarily charge more than they currently do. Possible initiatives could include the following: public acknowledgement by government officials of the need for a fair risk adjusted rate of return for lenders, broader investment powers for the Credit Union movement and additional flexibility in the development of subsidiaries (wholly or partially owned) that are dedicated to small business financing (Roynat model).
Despite the above proposal (and as we detailed earlier in this submission), we are very strong proponents of maintaining separation of banking and commercial activities for concentration of power and conflict of interest reasons. We do not believe a broadly diversified portfolio of small business equity investments with a cap on aggregate exposure, would violate this objective. Expansion into mainline commercial activities without a financial sector flavour should, however, remain totally off limits.
3. Allow electronic cheque imaging in place of Canada's current cheque clearing process where paper cheques are physically transported. This change would lead to various efficiencies including greatly reducing cheque hold times. Reducing the cheque hold period should benefit many individuals, especially those from lower income levels, who currently are turning to higher cost lenders for short term liquidity needs.
4. Greater Foreign Bank Entry should be encouraged. Foreign Banks such as HSBC, Wells Fargo, ING, MBNA Bank, etc., are having a material positive impact on the competitive balance in Canada's financial markets (i.e. retail banking, mortgage lending, sub-prime lending, credit cards, retail deposits, etc.) Their continued expansion should be encouraged. Subject to OSFI approval, the prohibition on foreign bank branches taking retail deposits of less than $150,000 should be ended. When (and if) large Canadian banks merge and divest large clusters of branches, foreign banks should get a 'fair' chance at the auction, alongside domestic buyers.
5. Measures to facilitate the demutualization of Canada's credit unions should be incorporated into related legislation. Canada's credit union movement is in the process of consolidating with the objective of better serving its customer base. For a multitude of reasons many building societies in the United Kingdom, saving banks in the United States and life insurance companies in Canada, have elected to convert to stock form as a means of surviving, prospering and growing. Individual credit unions should be given this option. We believe the success of the demutualizated life insurers is a tremendous case study of the benefits to consumers, investors and Canada of such an initiative.
6. Standardize the regulatory framework for Canada's large Federal Institutions. As such, we think that integration of the Bank Act with the Trust and Loan Company Act makes sense. One issue we continue to champion is the need for consolidated financial disclosure for banks, trusts and insurers, though this may be an issue that is best handled through regulation. It is difficult to understand how we can be confident of public market oversight of a Financial Institution, when that institution does not disclose consolidated financial statements and capital adequacy ratios in its home jurisdiction.
In summary, while we are supportive of the mandated periodic review of the Bank Act, we are not broadly in favor of wholesale changes at this time. This is evidenced by the relatively benign nature of our suggestions. Overall, we hold to the view that Canada's financial institutions can compete and grow in a global sense. However in an environment where technology, consumer demands and other financial systems are changing (often rapidly), Canadian regulators and law-makers need to ensure that the industry has clear, supportive and reasonable guidelines that allow Canada's Financial Institution to adapt and evolve. Such an environment, we believe, will benefit all Canadians.
Ian de Verteuil