- Consulting with Canadians -

National Bank of Canada Submission in Response to Finance Canada's Large Bank Mergers in Canada:

National Bank of Canada Brief to the Minister of Finance in Response the June 23, 2003 Government Policy Statement

December 19, 2003

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1. Introduction

National Bank of Canada would first like to thank you for the opportunity to express its views on the rules governing the freedom to merge that was extended to the country's large financial institutions with the passing of Bill C-8. National Bank also takes note of the timeline that was put forward on June 23 of last year in the Response of the Government to the Commons and Senate Committee Reports.

Through its briefs and exchanges during presentations to the Senate and the House of Commons committees, National Bank of Canada participated actively in the proceedings of the committees. The Bank would like to underscore its appreciation for the high level of the discussions held with members of both committees. National Bank is also very satisfied that some of its points of view were taken into account in the committees' reports and in the Government's response.

National Bank of Canada first wants to reaffirm that it shares the industry's views that bank mergers will strengthen the domestic, and especially the international, position of Canadian banking system members.

However, in keeping with the theme of previous submissions, the Bank would like to take this opportunity to express the point of a view of a player that is smaller than the Big 5 banks and–given that it can request "closely held" ownership status–is subject to different ownership rules.

This brief is in two parts. The first part discusses the merger issue through responses to the questions submitted by the government and, subsequently, through additional comments which clarify and expand upon National Bank of Canada's position. The second part of the brief deals with measures to intensify competition that are not directly related to the merger question.

2. Questions related to mergers

a) Responses to the Government's questions

The National Bank supports the Government's openness regarding cross pillar mergers involving the insurance companies. We believe that there is no reason to deprive the Canadian financial services industry of the domestic and international business opportunities that that could arise from these mergers. The benefits of bancassurance as an attractive business model are well established and Canada is alone among industrialized nations in not taking advantage of it.

Furthermore, due to the restrictions on sales of insurance products through bank branches, which form the largest proximity distribution network of financial services in Canada, consumers are deprived of an important source of competition.

Reiterating the position taken in previous briefs to Parliament committees, the Bank does not see any real benefit to submitting merger proposals to a public interest impact assessment. On the other hand, if such reviews are to be conducted for mergers between large banks, they should, to be fair, be conducted for mergers between large institutions in all industries.

National Bank does not believe it is desirable to determine in advance the structure of the Canadian financial system, particularly the minimum acceptable number of large financial institutions.

Formulating public policy along these lines would amount to handcuffing the Canadian financial services industry, depriving it of the ability to adapt to a constantly changing world and setting the "end game" in advance.

Considering the ensemble of the proposals put forth by the Government, the industry would have only a very short window of opportunity from July to November 2004 in which to act¹. For a variety of reasons, many acceptable projects may not even be presented given this time constraint.

We believe that maintaining a dynamic and competitive financial services industry should be the primary objective of economic policy. Meeting this objective depends mainly on how the rules of the Competition Act are applied.

National Bank is of the opinion the Competition Bureau would merely need to modify its guidelines and/or apply them differently to ensure that a significant number of players remain and that competition among them stays strong. We will explore this point further in our proposal.

Concerning the hypothetical question of the definition of a large institution, if the number of such players is to be determined in advance, National Bank sees no reason to change the definition currently used for ownership rules, that is, an institution whose equity exceeds $5 billion.

National Bank believes that equity capital is still the best barometer of institutional size. Equity is verifiable and hard to manipulate. It is the basis of the capital adequacy standards applied by regulatory authorities and credit rating agencies. With the Basel II Accord, this regulatory capital will be increasingly tied to the real risk level supported by the institutions.

Other quantifiable measures that could be used to assess size do not offer the same guarantee of integrity and stability. For example asset levels could easily be increased or reduced through sizeable balance sheet items such as inter-bank deposits, securities and repurchase agreements or by securitization. Defining size through market capitalization as a benchmark for public policy has severe limitations due to its volatile nature.

National Bank also believes that the Competition Bureau is the appropriate body to deal with the other criteria listed in the Government's question, notably geographic range and product offerings.

The National Bank does not think that it is essential to consider merger proposals together. It believes that an adequate application of the competition laws would render unnecessary the need to arbitrarily determine the minimum number of "large institutions" and thus eliminate the advantage that would otherwise be given to "first out of the blocks" merger candidates.

This kind of "beauty contest" only makes sense if the acceptable number of mergers–the reciprocal of a minimum acceptable number of large institutions–is determined in advance, an approach that National Bank rejects.

National Bank is glad to find this question among the subjects the Government has submitted to the public.

The Bank believes that there are two possible approaches to divestitures. One is to view them as a process that would enable merger candidates to slip under the competition market-share benchmark criteria. If we look at divestitures this way, then the competitive situation that would result following divestitures becomes a secondary issue.

The assets sold in any divestiture could be disparate in nature and could originate from both merger candidates. In this case, the divested branches would be of interest mainly to big players who would use the acquired branches to participate in the consolidation process in that market.

Conversely, the regulatory authorities could use a divestiture opportunity to strengthen an existing competitor, or, even better, attract a new entrant to serve as a counterweight to the newly merged institution. For this to happen, the branches put up for sale would have to be a viable franchise in and of themselves.

One example of this kind of franchise would include numerous branches covering a fairly large, contiguous territory, with the branches all coming from one of the merged institutions. In fact this is the approach that was used in a number of cases in the United States, notably in the divestitures following the merger of Fleet Bank and BankBoston.

We submit to the Government that this second approach should also be used in Canada, and that the Competition Bureau guidelines and operational methods should be structured to reflect this policy stance.

b) National Bank of Canada's proposal

National Bank of Canada would like to take this opportunity to reiterate its position concerning possible mergers between large Canadian banks.

We believe that the legitimate ambitions of Canadian banks that wish to merge can coexist within a very competitive Canadian financial system. For this to happen, we need to ensure that the Competition Bureau's rules regarding the examination of the competition aspects of a proposed merger are structured in such a way that they systematically lead to this result.

By February 2, 2004, National Bank will submit a separate brief to the Competition Bureau in which it will further detail its proposals. For the purposes of our response to the Government, we would like to put forward the following principal points.

At the risk of simplification, according to the current rules, merger proposals fall into three possible categories.

On the basis of recent Competition Bureau decisions and analyses made public during the examination of the two failed bank merger projects of 1998, it appears that the effective upper limit set by the regulators is 45%, not 35%. In other words it would seem that mergers within the 35% to 45% range (the orange light range) are viewed more as "green light," as opposed to "red light" proposals.

This should not be taken as a criticism of the Competition Bureau's work, but rather as an observation that the fact that the Bureau is taking into account many attenuating factors in the merger proposals has given rise to a de facto "large degree of permissiveness."

In a given market, one player with a 45% market share can leave room for an acceptable level of competition, as long as there are two or three additional players with a certain critical mass who are also operating in the same market.

However, in such a scenario, if there were to be a second merger in which the newly-merged player also had a market share of close to 45%, we would be faced with two dominant institutions with a combined market share of nearly 90%, with only a small market share divided among the remaining players. In such a case, a second merger could easily become unacceptable.

That means there is a significant advantage to the potential merger partners who submit the first proposal. This would appear to be against basic fairness principles, which dictate that all proposals should be treated equally on their own merits.

If we look at the single market example above and apply it to the Canadian market as a whole, it's easy to understand the government's concern with the minimum acceptable number of financial institutions, and its desire to simultaneously examine all projects so as not to confer on any proposal a "first come" advantage.

If we take again the example above, this time applying an effective ceiling of 35%, we obtain a completely different result. The advantage of the "first come," proposal is largely attenuated, since a second or even a third merger could still leave a highly acceptable level of competition.

Furthermore, for the Canadian financial system as a whole, mergers that could theoretically create a dominant player would necessitate such considerable divestitures that for all intents and purposes it would render them dead on arrival.

To summarize, National Bank of Canada believes that a tightening of the Competition Bureau evaluation criteria could preserve the highly competitive nature of the Canadian banking sector, without the need to arbitrarily decide in advance the industry's structure and the number of large financial players that will emerge.

It also goes without saying that such a tightening should be structured to induce further divestitures, which would lead to the appearance of new players or the growth of medium-sized firms, which, in turn, would act as counterweights to the merged institutions.

The acceptable level of concentration is the key element in determining the number and nature of the divestitures required. Taking into account the current structure of the banking industry in Canada, in which the market is more or less divided between five banks of relatively similar size, the difference between a 35% and a 45% market share level is enormous.

Our opinion is that the yellow light zone–between 35% and 45%–should be considered to be closer to a red light than a green light scenario. The same market share criteria should apply to an existing competitor that would like to take advantage of divestitures to extend its network.

It is important to note that tightening the competition criteria would have three important systemic effects:

• First, it would act as a natural break to the number of mergers and would be a major obstacle to two large institutions that wanted to merge, if the final effect would be an excessively dominant institution.
• Second, it would considerably decrease the advantage that would otherwise accrue to the first merger proposal submitted. This would in turn greatly reduce the need to examine all merger projects as a group in a "now or never" context, which would hamstring Canadian financial institutions' ability to take steps later on to react to a changing marketplace.
• Third, the application of corrective measures would lead to larger divestitures. These divestitures should be veritable franchises, in and of themselves, of the kind that are susceptible to attract new competitors in those markets.

National Bank recognizes that there will always be a certain amount of ministerial judgment useful and necessary in the application of the guiding principals such as those that are used to evaluate the impact of mergers on competition. The philosophical basis of these guiding principles will be as important as their wording.

3. Other measures to intensify competition

National Bank of Canada strongly opposes the Government imposing full functionality on the Canadian banking industry and giving access to this unified network to whoever demands it.

This would amount to a tax on the Canadian banking industry, in order to give a massive subsidy to competitors–both foreign and Canadian–who have not invested in establishing costly branch and ATM proximity networks.

The ATM network comprises an infrastructure that is very costly to implement and service. Canadian consumers insist that the principal financial institution that services their day-to-day transaction account offers ATM services so they can make most of their basic transactions. Banking services to businesses and consumers remain very much proximity services in Canada and ATM networks are an important component in maintaining that proximity.

In Canada and elsewhere, the networking of ATM systems is based primarily on an exchange of services, the main purpose of which is to increase the number of services offered to clients.

National Bank has been a leader in this area, dating back to 1985, when it formed the Ideal network in partnership with Bank of Nova Scotia. The Ideal network pre-dated the cross-country deployment of Interac by five years. This network provided not just deposits services but also account verification and account-to-account transfers.

National Bank is also part of The Exchange Network, which has 1,300 terminals across Canada. This network offers partial functionality given that it enables clients to make deposits but not pay bills. However, clients have the advantage of being exempt from the fees that financial institutions now charge to non-clients when they make withdrawals at their ATM. National Bank's involvement in The Exchange Network is part of the Bank's partnership strategy.

However, like Interac, The Exchange Network is primarily an exchange of services among participants. To access the network, financial institutions must offer the other participants at least one terminal for each 5,000 of their own clients/cardholders. The Exchange Network is a fine example of a market solution to the challenge of the limited territorial coverage of each of its participating institutions.

National Bank believes that adding full functionality to the ATM network would not have a significant impact on the supply of credit to SMEs. Proximity is an even greater factor in SME financing than it is to services to individuals.

For one, a good knowledge of the local market and of the individuals involved is crucial when dealing with SMEs. They cannot be financed from a distance in the same way that you can provide a mortgage loan based on an individual's credit history.

More fundamentally, SMEs are heavy users of branch level services. At National Bank of Canada, commercial customers conduct 262 transactions at the counter for every 100 transactions at an automatic teller. For individuals, the ratio is 40 counter transactions for every 100 ATM transactions.

In other words, relatively speaking, businesses use counter services 6.63 times as much as individuals. This is to be expected, when you consider the variety and complexity of transactions made by businesses and their ongoing need to deposit and withdraw cash and small change, etc. In order to better meet these unique needs, you'll find a commercial counter in all bank National Bank branches of a significant size.

In conclusion, National Bank believes that the integration of the services offered by ATM networks should continue to be voluntary, based on the principle of an exchange of services, with the goal of better serving the clients of network members.

The cooperative movement is very strong, not just in Quebec where it holds a 45%² market share, but right across Canada. As a matter of fact, the market share of cooperatives is about 35% in Manitoba and Saskatchewan and between 20 and 25% in Prince Edward Island, New Brunswick and British Columbia. If we exclude Ontario, where cooperatives have yet to make as significant inroads, the market share of cooperatives in Canada is approximately 30%.

This market share means that for every dollar of loans or deposits for individuals held by the banks, we find 40 cents in the cooperative movement. In other words, it is hard to describe the cooperative movement as a marginal competitor that needs massive public support to stay alive.

Nonetheless, cooperatives continue to benefit from advantageous fiscal and regulatory treatment. For example, a large integrated cooperative like Desjardins benefits from lower effective income and capital tax rates by splitting earnings among numerous local entities.

Cooperatives also benefit from significant regulatory advantages not available to banks, particularly the ability to sell insurance at the branch level, where allowed by provincial regulation. This is a highly popular service among coop clients which bank clients should also be able to access.

Savings and credit cooperatives would likely be interested buyers in the case of divestitures resulting from bank mergers. In fact, they are already active in branch "secondary market."

Cooperatives have already acquired some 50 branches that Bank of Montreal put on the market in the West several years ago. National Bank also sold four Ontario branches to credit unions in 2001. These transactions were undertaken by paying a market premium, without the need for any public support.

National Bank believes that the Government should adopt an attitude of neutrality towards the cooperative movement, with the exception of the slight adjustments that are needed to accommodate their special legal and corporate structures.

More specifically, the Bank opposes any fiscal relaxation that would favor the cooperatives themselves, their members or holders of certain securities that would confer an advantage to the cooperative sector. Moreover, National Bank believes that large integrated cooperative organizations should be considered as such for taxation purposes in order to establish fiscal equity with private enterprise.

We believe that this restriction is totally justified and does not constitute an obstacle to competition.

If we look closely at the experience of foreign banks since 1981, we find that the large majority have set up in urban areas, where a wide range of financial services are already available.

These banks have focused primarily on wealthy clients and on multi-national businesses from their countries of origin. In a nutshell, Canadian consumers would derive only minimal benefits if foreign banks were given unrestricted access to the Canadian market.

4. Conclusion

Canadians have every right to be proud of their solid, efficient and competitive banking sector, which offers one of the best quality/price suites of financial services among industrialized nations. It is our obligation to preserve that asset.

But preservation does not mean freezing the existing structure. On the contrary, it is by enabling banks to develop their ambitions, supporting their international visions and allowing them to be more efficient that we can preserve this dynamism.

National Bank believes that maintaining a high level of competition is the most important criteria when evaluating merger proposals. For this reason, the Bank believes that the preservation of the public interest is best served through the prudential examination of merger proposals by OSFI, and oversight of the competitive aspects by the Competition Bureau.

For its part, National Bank believes that the best way to preserve competition is to ensure that the process of analyzing competition and the corrective measures needed to ensure it, are orchestrated in a systematic manner.

The goal must be to guarantee that there are a significant number of large players operating in each of the markets, without dictating in advance the possible combinations and the number of financial institutions that would emerge.

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¹ Assuming that the merger regulations are deposited on June 30, 2004, and the first proposal is submitted September 30^th, 2004, following the 60-day period that was foreseen. [Return]

² Market share is defined as the combined volume of loans and deposits of individuals of domestic banks and cooperatives. [Return]