- Consulting with Canadians -

Power Financial Corporation Submission in Response to Finance Canada's Large Bank Mergers in Canada:

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Concentration and competition in the Canadian Banking industry

Prepared by Bain & Company, Inc. for Power Financial Corporation

December 2003

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Related documents:

• Power Financial Corporation Submission to Minister of Finance Future Structure of The Canadian Financial Services Industry

• Bank/Insurance Mergers Outside Canada: The Lessons For Public Policy

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1.0 Introduction

Bain & Company, Inc., one of the world's leading global business consulting firms, was founded in 1973. We serve clients in six continents, via 31 offices in 19 countries.

Power Financial Corporation engaged Bain & Company to complete a study on the Canadian Banking industry. The information contained in this study was prepared solely for the use of our client. It is not to be relied upon by any 3^rd party without Bain's prior written consent.

Our mandate was to evaluate the trends in banking concentration, to assess the level of competition in the Canadian banking industry and to analyze the impact of consolidation and concentration on Canadian consumers. Additionally, Power asked us to investigate the veracity of the major conclusions reached by the 1998 McKay taskforce on the Future of Financial Services in Canada, and to analyze the prospect of cross pillar mergers in Canada.

We collected many sources of primarily public data, such as Bank financial reports, industry association reports, Bank of Canada data, and data compiled by Statistics Canada. We also referenced data purchased by our client and its subsidiaries from various information providers, such as Investors Economics and Morningstar.

Our report first focuses on the question of concentration in the Canadian banking industry. We then examine various components of prices paid by consumers to determine the impact of Banking industry concentration on Canadian consumers. We also compare the returns of Canadian Banks to other Canadian industries and global banking competitors.

Subsequently, we investigate some of the issues raised by the 1998 McKay taskforce, including the question of consumer access to insurance, and the maintenance of a contestable insurance industry. Lastly, we explore the impact of a potential cross-pillar merger on Canadian consumers.

Most of the data in this report focus on Canada's six largest chartered banks. When we refer to "Banks", we are referring to these six banks collectively.

2.0 Executive Summary

• Data compiled shows that the markets in which the major Canadian Banks participate are highly concentrated, and this concentration is increasing. Banks have over 85% share in three of the four traditional financial pillars and provide, manage or administer nearly 60% of Canadian household assets.
• This leverage appears to lead to higher prices for Canadian consumers

• The major Canadian Banks are very profitable. Canadian banks have some of the highest returns on equity in the Canadian equity market, despite lower risk. Canadian banks also earn almost twice the average return of international banks, despite lower average risk
• In 1998, the McKay taskforce argued that allowing banks to retail insurance in branches would increase Canadian's access to life insurance products. However, Canadian banks' have recently reduced the access to banking services for many Canadians.

• The McKay taskforce stated that even if Banks were to dominate the insurance industry, the low barriers to entry into insurance would discipline their behaviour. But, the Banks large investments in customer information and marketing could create barriers to entry.
• Banks argue that they need to merge to have the increased scale to compete globally. However, when analyzing the decline in the Banks' net interest margin much of it can be attributed to lower international margins and volatility. If a Canadian Bank were to reach "sufficient" international scale, it might lead to lower, more volatile returns.

3.0 Concentration of Financial Assets

The Canadian financial services industry has become more concentrated as a result of successive reforms in recent decades. Regular revisions of the Bank Act, coupled with significant changes in the Trust Companies Act and Insurance Companies Act, have accelerated the trend toward increased concentration.

Canada's financial services sector is currently quite concentrated. Six major Schedule I Banks control 87% of chartered banking assets, and 100% and 87% respectively of the trust and brokerage industry assets under administration. Concentration has grown substantially in each of these three pillars. The only pillar where the Big Six Banks do not have significant share is the insurance industry, where banks represent about 3% of insurance industry premium revenue.

The Big Six Banks provide, manage or administer a significant portion of the average Canadian's assets and liabilities, and this has grown substantially over the last decade. For example, the Big Six Banks share in mortgages has doubled, growing from 31% in 1986 to 67% in 2002. Their share in personal savings, already 66% in 1986, has increased by a further 8 percentage points to 74%. The Big Six Banks now distribute 50% of mutual funds up from only 5% in 1986. Overall, their share of a typical Canadian household's assets has doubled from 27% in 1986 to 54% in 2002. If we look at these numbers excluding insurance and pension assets, the Banks' share has grown from 34% to 67%.

The Banks share of Canadian financial assets is much lower if we focus only on those items that appear on the balance sheet of a bank. We believe that it is important to also include the assets of Canadian households that the Banks have significant influence over. For example, when a bank owned brokerage sells a mutual fund or stock to a client, those assets do not appear on the bank's balance sheet, but they remain assets that are influenced by Banks. The bank, through its broker, has substantial influence over the asset allocation decision of its customers. The inclusion of these assets more accurately represents the involvement that the Big Six Banks have in the Canadian consumer's wallet.

Banks also have significant influence over the financing activities of Canadian corporations. Despite the entrance of foreign competitors, Banks enjoy substantial and growing share of equity and debt underwriting as well as business loans with 65%, 52% and 92% share respectively. All of these market shares have increased over the past 15 years and the debt and equity underwriting market shares have increased even since 1996.

4.0 Impact of concentration on consumer prices

To determine the impact of concentration on Canadian consumers we examined the prices that consumers pay in the market sectors where the Banks have substantial market share. This examination shows that Canadians are paying more for services now than they have in the past. These increases are consistent whether we look at spreads or fees.

4.1 Spreads

Banks charge consumers interest on loans, and pay interest to consumers for deposits. The difference in the rate charged and paid is known as the "spread."

Canadian Banks net interest margin (or spread) has declined by 3% per year over the last fifteen years. But, the spread on the Banks' domestic business has decreased more slowly at only 1.3% per year, and has been essentially flat since 1997. The net interest margin on international business has driven the decrease in overall bank net interest margin.

Further, if only interest income and expense from core loan and deposit operations is included, the Banks' deposit/loan net interest margin has increased by about 1.5% over the same fifteen-year period.

This increase in deposit/loan net interest margins is surprising if we look at the change in the Big Six Banks' product mix over the last fifteen years. In 1987, residential mortgages and term deposits accounted for 51% of Big Six Banks' balances of assets and liabilities. Today, they account for 59% of balances. This is significant because we estimate that residential mortgages and term deposits have lower spreads than other bank products, such as chequing or savings accounts, personal loans or credit cards.

Consequently, we would expect to see bank deposit/loan net interest margins decline as the Banks' mix changed. The increase in aggregate deposit/loan net interest margin implies that the Big Six Banks have increased average spreads. We estimate this increase to be about 30%.

In examining the data available on bank spreads for individual products such as the posted rates on mortgages, GICs, savings accounts and prime business lending rates, we see that spreads have in fact increased. For example, the spread between a chartered bank 5-year mortgage and 5-year GIC averaged 295 basis points over the 1998-2002 period, more than 100 basis points higher than the spread in the period from 1986 to 1991. Similarly, the spread between the chartered bank prime rate and the rate paid on savings accounts increased by 130 basis points, from 455 bps in 1986-91 to 585bps in 1998-2002.

 

One of the drivers of an increased prime rate spread is the fact that rates paid on savings accounts are no longer in step with the Bank of Canada overnight rate. Prior to the early 1990s, rates paid on savings accounts tended to move with the Bank of Canada rate. More recently, however, Banks have not increased savings rates with increases in the Bank Rate.

4.2 Service fees

In addition to product spreads, consumers are often required to pay deposit fees for services, such as per cheque charges, ABM charges or charges to use branch banking. It appears that Canadians are paying increased deposit fees. On a per capita basis the Banks' business and personal deposit fee revenue has increased by more than 6% per year.

Fee increases have garnered substantial attention from consumers, the press and government. In 2002, after pressure from the government of Canada, the Banks agreed to provide a low-fee account to customers that use only very basic banking services. However, customers with this pattern of minimum usage appear to comprise a very small portion of the banking population: Using data from a survey completed on behalf of a Power Financial subsidiary in 2001, we estimate that fewer than 3% of customers fit this profile. However, Banks have raised fees for other types of customers. For example, Industry Canada's Cost of Banking report estimates that the annual cost of the least expensive account for a "convenience customer" (the largest customer group using the same survey data) increased by over thirty-seven dollars in the period from 1997 to 2001.

4.3 Mutual fund fees

There are two broad types of mutual funds: those sold with the advice of a salesperson and those sold "without advice". The Banks generally offer mutual funds without advice, and hence charge lower fees than do mutual fund companies that use advice sales forces. In the US, the fees on funds sold without advice through banks and direct channels are discounted between 40% and 50% when compared with the fees on funds sold with advice through a salesforce. In Canada this discount is lower, between 20 and 35%. Further, the Canadian discount has been decreasing by about 2% per year, while US Banks and direct sellers have kept their discount relatively constant.

4.4 Other fees

Traditionally, consumers have purchased securities via commission-based accounts. With these types of accounts, commissions, typically in the order of 2%, are paid at the time of a trade. However, securities held over a long period of time only generate commissions at the time of purchase or sale. Banks, through their brokerages, have begun to offer so-called "wrap" products, which bundle a variety of different investment instruments where an annual fee is charged as a percentage of total assets in the wrap. Fees on these wrap products tend to be in the order of 3.5% annually, much higher than if the consumer purchased these products separately through commission-based accounts. Bank owned brokerages have been successful at promoting these wrap products, as assets in wrap products have been growing at 20% annually, 2.5 times faster than assets in traditional securities accounts have grown.

5.0 Bank returns

We also examined the returns generated by the Canadian Banks. Returns should be competitive with profits generated by other sectors of the economy, adjusted for risk, and with profits generated by international firms in similar industries.

Domestically, Canadian banks average return on equity over the last 5 years has been 14.2%. This represents the third largest ROE across all sectors of the Canadian economy. However, Canadian banks are significantly less risky than most other sub-sectors of the Toronto Stock Exchange. Given their lower risk we would have expected the Banks to earn lower returns than other industry sectors.

When we look abroad, we see that the five largest banks have above average market capitalization given their asset size compared to other international banks. We hypothesize that this is because the Canadian Banks earn returns more than 1.5 times the international bank average of 8.6%.The Banks have generated these returns with earnings volatility (or risk) that has been below the international average.

6.0 Issues raised by the McKay taskforce

In 1998 the McKay taskforce recommended that regulation be amended to allow Canadian banks to sell insurance through their branch networks. The Taskforce's argument was founded on three premises:

1. Canadians would have better access to insurance

2. Canadians would not be hurt by bank entry because the insurance market would remain contestable

3. Bancassurance had worked well in Europe

We will discuss each premise in turn.

6.1 Access

The McKay taskforce posited that low income Canadians were under-served by the insurance industry, and that permitting banks to sell insurance to consumers through their branch banking system would increase the Canadian consumer's access to insurance products.

The McKay taskforce did not identify the Banks' recent closures of branches as an impediment to this increased access. The Big Six Banks have closed over 2,000 bank branches since 1990 (excluding the Trust Company branches that were purchased and integrated this figure is still 1,000 bank branches). In the last five years alone, Banks have closed over 1,000 branches. Banks have closed branches despite the fact that Canadians are heavy users of the branch banking system. In a survey conducted in 2001 by a Power Financial subsidiary, it was found that 83% of Canadians conduct at least one transaction monthly at a branch.

While bank branches are in decline, the number of life agents is increasing. CLHIA estimates that there are currently 73,500 exclusive or independent life licensees in Canada, up from 53,400 in 1993.

In a sample of 30 small towns with a population below 2,000, we found that 7 towns were served by a bank branch, while in 16 of the towns there were one or more licensed life insurance agents.

Branch closures appear to disproportionately affect the most vulnerable Canadians. It has been estimated that the Banks have exited 45% of the bank branches in rural Canada (Public Interest Advocacy Centre, Financial Post, September 2000). Banks in low-income areas have also been particularly impacted. In the lowest income area of Winnipeg a total of 9 bank branches have been closed since 1995 (Winnipeg Free Press, February 2003).

Subsequently, cheque-cashing firms and white label ABMs have emerged. For example, Money Mart, a cheque-cashing service targeting low-income Canadians, has added 85 units in the last four years. The following quotes demonstrate the concern that bank branch closures are generating:

Canadian Press News Service, April 2003

Edmonton Journal, October 2002

6.1.1 Customer information

Banks have substantial data on Canadians' personal finances. As illustrated by the following quotes, banks have mined this information to target the most profitable potential customers. If allowed to use this information in their insurance operations, it is possible that banks would use this information to target only the best customers of traditional insurers. This would not improve Canadians' access to insurance.

Craigg Balance, technology manager RBC, quoted in Canadian Banker, 1997

Bank Technology News, 1998

SVP Scotiabank, quoted in Canadian Banker, 2000

6.2 Contestable insurance market

The McKay taskforce stated that the concern that the Banks would use their sheer size and resources to oust Canadian insurance companies, and to then raise prices once insurance companies retreated, was unfounded. The rationale of the taskforce was that the insurance market is contestable: the barriers to entry are low, and hence any excessively high pricing by the Banks would be disciplined by the threat of entry by potential competitors.

The insurance industry is contestable today, but the Banks could erect barriers to entry, thereby reducing the contestability of the insurance market.

The investment that banks have made in gathering and analyzing customer information highlights this issue. If banks were able to use their accumulation of customer information to target market insurance to specific customers, it would represent a significant barrier to any potential insurance entrant.

Another potential barrier to entry is demonstrated by comparing the marketing and advertising spending of the Banks versus the spending of Canadian insurance companies. As the following graph illustrates, it is estimated that the Big Six Banks spend about seven times as much on marketing and advertising as the insurance industry.

6.3 European bancassurance

The McKay taskforce took the European bancassurance market as an example for Canada. However, it is difficult to adequately compare these two markets. The structure of European competition and the European regulatory framework is different from Canada. Significantly, since 1998, when the findings of the taskforce were presented, there have been examples of poor performance among European bancassurance ventures. The jury is still out on the success or failure of the European bancassurance model.

7.0 Impact of cross pillar mergers

The Banks want to develop international capabilities to better service an increasingly mobile pool of capital and their increasingly international clients. Their argument for mergers is that the mergers may give them the balance sheet size and market capitalization that will allow them to make acquisitions of sufficient size and scope to expand their global banking.

Canadian banks are relatively small by international standards. The largest Canadian bank is ranked 44^th by assets out of all world banks. Even a merger between the largest Canadian bank and insurer results in a company that ranks only 23^rd (on a market capitalization ranking) among the world's financial institutions.

 

Even if a Canadian bank were able to reach sufficient international scale, it is not clear that this would lead to positive results. Firstly, the Big Six Banks' international margins are substantially lower than their domestic margins. Secondly, the retail and investment banks that have expanded globally have much more volatile earnings than Canadian Banks. Finally, the Big Six Banks have experienced strong, steady earnings growth with the exception of a few significant international events (such as the 1992 foreign real estate investment write-offs, the 1997-1998 Asian and ruble crises and the write-offs of US telecom, high tech and energy trading company debt in 2002). The potential result of attaining significant international scale is deterioration in margin and increased earnings volatility. If we look at the historic ROE of both UBS and Credit Suisse we see an illustration of this increased volatility subsequent to international and cross pillar expansion. Both UBS and Credit Suisse experienced increased volatility after international expansion. Lower and more erratic returns in international business could have an impact on the spreads that the Banks will charge to Canadian consumers.

 

 

 

 

8.0 Conclusions

The banks currently provide, manage or administer over 85% of three of the four traditional financial services pillars, and almost 60% of Canadian household assets. Spreads on many banking products have increased and service fee revenue is increasing. Banks have high returns given their level of risk when compared both to other Canadian industry sub-sectors and to international banking peers.

In 1998, the McKay taskforce argued that if banks were to enter the life insurance industry, they would increase access to life insurance products. However, Canadian Banks' have closed 2,000 branches since 1990, with a disproportionate number in rural and low-income urban areas. In addition, the banks have extensive customer information systems, allowing them to target customers based on value. This could allow the banks to cream only the most profitable insurance business and not increase overall access.

The McKay taskforce stated that even if banks were to dominate the insurance industry, low barriers to entry into insurance would discipline their behaviour. However, with the Banks investments in customer information, marketing and advertising, they could erect barriers to entry.

Banks argue that mergers would allow them to gain international scale. However, banks have experienced lower margins and increased volatility as their international exposure has expanded.