Finance Canada
Reforming Canada's Financial Services Sector -- A Framework for the Future: 2
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2   Promoting Efficiency and Growth


The government is acting to provide greater structural flexibility for financial institutions to compete in the global marketplace. A regime to permit large mutual life insurance companies to demutualize is already in place. The government will introduce:

  • A new definition of widely held ownership that allows strategic alliances and joint ventures with significant share exchanges.
  • A new holding company regime to provide greater structural flexibility.
  • A transparent bank merger review process with a formal mechanism for public input.
  • An examination of capital taxation policy with the provinces.

Financial institutions manage the investment holdings of Canadians, safeguard their wealth and assist consumers and businesses in financing important purchases and investments. Financial institutions must do this while creating value for their shareholders. This, too, serves the broader Canadian interest because the shares of financial sector companies constitute a large part of major stock indexes, pension fund holdings and the savings of individuals.

Financial services are not only important to the everyday lives of Canadians, they are important contributors to economic growth and job creation. The sector:

  • employs more than half a million Canadians;
  • provides a yearly payroll of over $22 billion;
  • exports nearly $50 billion of services annually;
  • represents 5 per cent of Canada's gross domestic product; and
  • yields over $9 billion annually in tax revenue to all levels of government.

Canadian banks and insurance companies have been among the export leaders in our economy. Five of our six largest banks have at least 30 per cent of their assets abroad. Two of our major insurance companies have more activities abroad than here in Canada. This generates foreign exchange revenues and high-paying jobs that benefit all Canadians.

Besides being a major industry and source of employment, the firms in the sector provide services critical to Canadian businesses and consumers, facilitating commerce and allocating credit. Because of the sector's direct and indirect importance, the policy framework must promote its potential for growth, exports and job creation to the benefit of the entire economy. The government is proposing a number of measures to increase that potential.

The demutualization of the large mutual life insurers will permit these companies to access the capital necessary for growth and expansion. A new definition of "widely held" ownership will facilitate strategic alliances and joint ventures. A new holding company regime will provide Canada's financial institutions with greater structural flexibility. The merger review process will be transparent and will provide greater clarity and certainty for the institutions considering this strategy. Finally, the government will undertake an examination with the provinces of the current capital tax regime as applied to the financial sector.

Demutualization of Large Insurance Companies

Earlier this year, Parliament passed legislation to permit large federally regulated mutual life insurance companies to convert into stock companies, a process known as demutualization. Canada's four largest mutual insurance companies (The Mutual Life Assurance Company of Canada, The Manufacturers Life Insurance Company, Sun Life Assurance Company of Canada and The Canada Life Assurance Company) have all announced their intention to demutualize.

Flexibility is a must in today's rapidly changing global financial services marketplace

The new regime gives these companies the ability to structure themselves differently, subject to the approval of their policyholders, in order to improve their efficiency and competitiveness. As stock companies, they will be able to issue common shares, an important source of financing for corporations that want to grow and expand.

Increased ability to raise capital will enable demutualized insurance companies to seize growth opportunities both at home and abroad and make major investments in technology and new products to meet the changing needs of consumers.

Flexibility in this regard is becoming increasingly important given the fierce competition in the global financial services marketplace.

The Widely Held Ownership Rule

The widely held ownership rule should be improved to promote growth and foster competition

The current ownership regime, which requires large banks to be widely held, has served the financial sector well. Canadian financial institutions are generally recognized as meeting high standards of safety and soundness. However, with the passage of time and experience with this regime, the government has come to the view that there are improvements that can be made to the widely held ownership rule to promote growth and foster increased domestic competition, without unduly compromising prudential objectives.

Current Definition of Widely Held Ownership for Banks

The current widely held rule for banks applies to Schedule I banks as set out in the Bank Act. Schedule I banks must be widely held, which is defined to mean that no more than 10 per cent of any class of shares of a bank may be owned by a single shareholder, or by shareholders acting in concert.

Over the last 30 years, this rule has been a key instrument in addressing the prudential concerns relating to banks. Having widely held financial institutions is one way to limit the risk of self-dealing. Widely held rules preclude upstream commercial links, which have traditionally been perceived to increase the risk of inappropriate self-dealing, including distortions in credit allocation. Also, widely held banks are subject to a high degree of market transparency and oversight, something that tends to enhance governance and moderate the riskiness of management decisions.

New Definition of Widely Held

The widely held rule will apply to all banks and demutualized insurers whose equity is over $5 billion. Banks and demutualized insurers under $5 billion can be closely held. Chapter 3 elaborates on this new size-based ownership regime.

The banking sector has argued that the current definition of widely held, which limits ownership positions to 10 per cent, is too restrictive. It precludes a widely held Canadian bank from entering into a joint venture or alliance that results in any shareholder having more than 10 per cent of any class of the bank's shares. Banks argue that they should be able to enter into joint ventures and strategic alliances that make good business sense and bring about innovation for the consumer. The government agrees. The new rule will address this constraint.

Going forward, the government will allow an investor to hold up to 20 per cent of any class of voting shares, and up to 30 per cent of any class of non-voting shares, of a widely held bank, subject to a "fit and proper" test.
"Fit and Proper"

Generally, "fit and proper" tests are used to assess the suitability of prospective owners. These tests include an examination of the applicant's past record as a business person, the soundness of their business plan and the reasons why they wish to get into the particular line of business. They also seek to assess that applicants have the necessary integrity and fitness of character. These tests help ensure that key shareholders are not a source of weakness to the regulated institutions.

Canada's large banks must be allowed to develop their strategic vision

It is important that Canada's large banks be allowed to develop their strategic vision, free of any unnecessary constraints and based on the best interests of depositors and shareholders. Allowing a single shareholder, or shareholders acting in concert, to control a large bank is inconsistent with this premise and could lead to situations where the bank's policies are slowly steered away from the best interests of the rest of the stakeholders.

The current Bank Act has provisions to prevent any one interest having direct or indirect control of a bank.

The government will review these provisions to ensure they are adequate to preclude control by a shareholder, or shareholders acting in concert, under the new ownership regime.

Widely Held Rule for Demutualized Life Insurers

The new definition of widely held will apply equally to large demutualized life insurers â that is, those with equity over $5 billion.

A Holding Company Structure

A holding company is generally a non-operating company that holds interests in other, generally operating, companies. A holding company structure is currently permitted for financial services providers in the United States, the United Kingdom and many other industrialized countries. In Australia, a recent inquiry into its financial services sector concluded that a non- operating, regulated holding company option should be made available.

In Canada, closely held financial institutions (for example, stock life insurance companies) have always had the option of organizing under an unregulated holding company.

The government will enable widely held financial institutions to organize under a regulated holding company structure.

The holding company option will provide financial institutions with greater flexibility

The holding company option will provide financial services providers with greater choice and flexibility with respect to how they structure their operations. It will also allow them to compete more effectively in the global market by giving them new latitude for raising capital and embarking on strategic alliances.

The holding company regime will enhance domestic competition by providing a structure for institutions to come together under a common ownership structure without having to enter into a parent-subsidiary relationship. This will allow them to maintain their separate identities to an extent not possible under an acquisition or merger. For example, a bank, an insurance company and a mutual fund company might find that there are economies of scale and scope if they were to work together within a corporate group.

Holding Companies for Widely Held Banks

A bank holding company structure will be an incorporated entity under the Bank Act. Under the proposed structure, banks will have the choice of moving certain activities that are currently conducted in-house, or in a subsidiary of the bank, to an affiliate outside of the bank.

Depending on the risk that the affiliate poses for the holding company's bank, the affiliate could be subject to lighter regulation than the bank. However, there will be oversight of the entire group in order to safeguard regulated affiliates.

Chart 2.1
Widely Held Bank Holding Company Structure
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Activities of the Parent Holding Company

The parent holding company will be non-operating. It will be permitted to hold federal financial institutions as subsidiaries, as well as other entities related to financial services or otherwise set out in legislation. The general prohibition on commercial activities that currently applies to banks will apply to holding companies.

Non-Operating Holding Company

A non-operating holding company's activities may include raising capital, subject to prescribed capital rules; investing and managing its cash flow and liquidity; and investing in fixed assets related to its operations. It can also provide certain common services for the other entities in the group. It will not be permitted to undertake any core banking or financial services functions such as credit assessments.

Ownership of the Parent Holding Company

Where a widely held bank chooses to organize under a holding company, the widely held requirement will be applied at the level of the parent holding company.

Permitted Investments for Holding Companies and Parent-Subsidiaries

At the present time, there are restrictions on what banks can invest in or hold as a subsidiary. Certain financial services â such as credit cards and consumer lending â are restricted to taking place within the bank itself.

The government intends to expand the permitted types of subsidiaries so that both a holding company and a parent-subsidiary structure will be permitted a broader range of investments than is currently the case for banks.

This expansion of permitted investment activities will give banks choice and flexibility regarding how they structure themselves, as they will be able to carry out their activities in-house, under a holding company or through a parent-subsidiary structure, without facing significantly different permitted investment constraints. Permitted investments for trust companies and insurance companies will be similarly expanded.

Investment rules will be eased to allow more activities to be conducted outside the bank

The ability to have additional subsidiaries will also permit the creation of new special-purpose entities and facilitate alliances and joint ventures through these entities. This will enhance the flexibility of banks to meet the increasing technological and competitive challenges from sources such as unregulated and "monoline" firms specializing in a single line of business. The new rules will be based on defined categories of eligible investments and a number of key parameters. There will be five broad categories of permitted investments:

  1. Regulated financial institutions (e.g. banks, trusts);
  2. Firms primarily engaged in providing financial services (e.g. credit cards, small business loans, consumer loans);
  3. Entities acting in the capacity of a financial agent, advisor or administrator (e.g. investment counselling, payroll administration);
  4. Entities undertaking ancillary, complementary or incidental activities (e.g. Interac service corporation activities, armoured car transportation); and
  5. Certain other activities not primarily related to financial services, but specifically enumerated (e.g. certain information services, real property brokerage corporations).

Control requirements, approvals and other rules will be based on the category of investment.

Ownership of Subsidiaries of Holding Companies

Banks held as subsidiaries of the holding company must be de jure controlled by the parent holding company. That is, the parent must own a majority of the bank's shares. The remaining shares of a bank subsidiary will be required to meet the widely held criteria.

The government will apply the 20-per-cent limit on voting share ownership and the 30-per-cent limit on non-voting share ownership to the total direct and indirect cumulative ownership of the bank.

This means that no single investor will be able to use the holding company structure to exceed these bank ownership restrictions.

Other regulated financial institutions' subsidiaries would be subject to "control in fact" (where a minority of shares can be held, but control can nevertheless be exercised) by the holding company.

The holding company parent will also be required to "control in fact" subsidiaries that are primarily engaged in providing certain financial services (e.g. credits cards, small business loans, consumer loans). However, less than controlling interest in such firms may be permitted subject to the minority investment rules or such other tests as may be elaborated in consultation with stakeholders.

There will be no control requirement for subsidiaries undertaking advisory or agency activities, those considered ancillary or incidental to financial services, or permitted subsidiaries that are not directly related to financial services.

Regulation of Holding Companies

The government will continue to ensure that appropriate regulatory safeguards are in place. Consolidated supervision at the holding company level will ensure that the Office of the Superintendent of Financial Institutions (OSFI) has an overview of the group's activities. Such consolidated supervision is in line with Canada's commitments under the Core Principles for Effective Banking Supervision established by an international committee of bank regulators (the Basle Committee on Banking Supervision). This includes the ability to review both banking and non-banking activities conducted under the holding company, and having adequate supervisory powers to bring about corrective action.

The holding company group will be subject to consolidated capital adequacy requirements.

These requirements will be consistent with international standards and best practices. Taken as a whole, these capital rules will be applied in a way that permits our banks to remain competitive with regulated institutions in leading countries.

The holding company parent and its downstream holdings will be subject to consolidated supervision with a risk-based focus. This means that supervision will focus on those activities of the group that may pose material risks to the bank and other federally regulated financial institutions which form part of it. This will allow for tailored and flexible supervision based on the particular activities of the group.

OSFI will use its supervisory authorities over the holding company and its subsidiaries on a discretionary basis and as events warrant. Where, for example, a holding company places certain activities such as credit cards in affiliates outside of the bank itself, regulation of such affiliates will be generally lighter than that applied overall to a fully regulated bank. The bank within the holding company, however, will continue to be subject to the full supervisory regime.

Where feasible, in the supervision of non-regulated subsidiaries of the holding company, greater reliance may be placed on transparency and market discipline to ensure that entities in the group remain well managed and well capitalized. However, OSFI will have the authority to issue compliance orders, require special audits and require the holding company to increase its capital where circumstances warrant. If warranted, OSFI could require the holding company to divest a subsidiary or other investments.

Holding Companies for Widely Held Insurance Companies

Canada's four largest life insurance companies (The Manufacturers Life Insurance Company, Sun Life Assurance Company of Canada, The Canada Life Assurance Company and The Mutual Life Assurance Company of Canada) are mutually owned and therefore widely held. They must remain widely held during their transition to stock companies.

A regulated holding company regime, broadly similar to that being established for the widely held banks, will be made available to demutualizing insurance companies.

Holding Companies for Closely Held Financial Institutions

Generally, where a corporate group acquires or sets up a closely held bank, the group will be required to consolidate its financial services related activities, either under the bank or under a regulated bank holding company. This recognizes Canada's commitment to international accords requiring that groups that contain a bank be regulated on a consolidated basis.

Under the new regime, closely held banks will also be allowed to organize under a regulated holding company model.

As is now the case, closely held insurance and trust companies will be able to organize under an unregulated holding company regime. The exception to this will be demutualizing companies that can become closely held after their transition period. They will be subject to a regulated holding company regime under the Insurance Companies Act.

A Transparent Merger Review Process

In this era of rapid economic change, technological revolution and globalization, mergers and acquisitions are legitimate business strategies for growth and success. However, given the key importance of the financial services industry, and the largest banks in particular, to the entire Canadian economy, it is essential to ensure that proposed mergers are in the best interests not only of their proponents, but of Canadians and the Canadian economy overall.

To this end, the government will establish a formal and transparent Merger Review Process among banks with equity in excess of $5 billion.

The application of this process would take into account changing circumstances in the condition of the banks. In addition, the process would apply equally to bank holding companies under the new regime. The three criteria on which the government based its rejection of the 1998 bank merger proposals will continue to apply:

"â¦(Merger) proposals will first have to demonstrate, in the light of the circumstances of the day, that they do not unduly concentrate economic power, significantly reduce competition or restrict our flexibility to address prudential concerns." The Hon. Paul Martin, December 14, 1998.
The process will begin when the banks indicate their intention to merge.

Large banks will be required to prepare Public Interest Impact Assessments as part of any merger proposal

The banks will be required to prepare a Public Interest Impact Assessment (PIIA) as recommended by the Task Force on the Future of the Canadian Financial Services Sector.

The PIIA will provide helpful information for all stakeholders in a merger and serve as an important input to the Minister of Finance's decision.

The PIIA must cover the costs and benefits of the proposed transaction. For example, it must include the impacts on sources of financing for individual consumers and small and medium-sized enterprises. It must also cover regional impacts including branch closures and changes to service delivery, as well as the impact of the merger on international competitiveness, employment and technology.

As well, the PIIA must explain what impact the merger would have on the structure of the financial sector overall; provide an outline of any steps the merging parties intend to take to mitigate adverse effects of the transaction; and cover any other considerations the Minister of Finance may specify. The government will release guidelines setting out in more detail the required contents of the PIIA. The banks will make public their PIIA.

The House of Commons Standing Committee on Finance (Finance Committee) will be asked to consider the PIIA and to conduct public hearings into the broad public interest issues that are raised by the merger as proposed.
Task Force Finding

The Task Force stated, "We believe that public participation in the review of proposed mergers involving very large institutions is essential in light of their public importance."

Task Force on the Future of the Canadian Financial Services Sector, Change, Challenge, Opportunity: Report of the Task Force, September 1998, p. 117 (Adobe Acrobat format).

Concurrent with the Finance Committee hearings, the Competition Bureau and Office of the Superintendent of Financial Institutions (OSFI) will conduct their respective reviews of the merger as proposed from the perspective of market competition and the safety and soundness of the merged bank and the financial system.

OSFI will report to the Minister of Finance on prudential issues. The Competition Bureau will provide to the parties and to the Minister of Finance a report setting out the Bureau's views on the competitive aspects of the proposed merger. The Minister will make these reports public. The reports of the Competition Bureau and OSFI would be available for scrutiny by the Finance Committee.

Taking into account these reports, the Minister of Finance will then render a decision on whether the proposal will be allowed to proceed in light of any prudential, competition and other public interest concerns. If the Minister considers that these concerns are too great to be remedied, the transaction will be denied. If the proposal raises concerns which can be met by imposing conditions, the merger will proceed only if those conditions are met.

Under the new process, the Competition Bureau and OSFI will respectively negotiate the competition and prudential remedies with the merger applicants. The two agencies will work with the Department of Finance in the co-ordination of an overall set of prudential, competition and other public interest remedies. It will then be up to the merging banks to decide whether to implement those remedies. If so, the merger would proceed to final approval by the Minister of Finance.

Chart 2.2
Merger Review Process for Large Banks

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Legally Enforceable Undertakings

In addition to a new, more transparent merger review process for the largest banks, legislative changes will be needed with respect to the Minister of Finance's authority to impose legally enforceable undertakings in cases of mergers and acquisitions.

A mechanism will be created to bring together a full set of remedies to address competition, prudential and other public interest concerns.

Legislative changes will be introduced to ensure that a financial institution complies with the terms and conditions attached to the approval of mergers and acquisitions and to provide the Minister of Finance with appropriate powers of sanction.

Accounting for Business Combinations

The number and value of mergers and acquisitions have increased significantly over the past several years in North America as companies seek to increase their market share, reduce costs, acquire new technologies and expand their global presence. The financial services sector is one of the leaders in this consolidation trend.

In this environment, the accounting treatment of these business combinations is an important factor. It is generally acknowledged that the Canadian accounting standards in this area can result in lower reported income than the rules that apply in the United States, which can put Canadian firms at a competitive disadvantage relative to their U.S. counterparts in making strategic acquisitions.

The government supports harmonized accounting standards

Accounting standards bodies in Canada and the United States are working towards new, harmonized standards for business combinations by the end of 2000. The government supports this initiative and encourages these bodies to make the necessary changes as soon as possible, and to consider bringing forward an interim solution in Canada to level the playing field. These changes will be beneficial to all Canadian companies, including those in the financial services sector.

If sufficient progress is not made, OSFI will consider what actions could be appropriate to facilitate mergers and acquisitions for Canadian financial institutions.


Capital Taxes

The government recognizes that taxes on capital are an important element in determining the competitiveness of our banks. However, in this field, the federal government shares responsibility with the provincial governments.

Capital taxes are an important component of taxes paid by financial institutions, and they have expressed concern that the existing capital tax burden has placed them at a competitive disadvantage vis-Ã-vis their non-regulated and foreign competitors. Historically, capital taxes have served two policy goals. The first is that they can act as minimum taxes such that financial institutions pay the greater of their income tax and capital tax. The second is that capital taxes provide more stability in government revenue, as the base for capital taxes is more stable than that for corporate income taxes.

This role of capital taxes needs to be reviewed given recent developments and the balance to be struck between these two roles of capital taxes.

The federal government will raise with the provinces the effects of capital taxation on the financial services sector. As part of these discussions, the federal government is committing to a review of its own capital taxes.

Withholding Taxes

Withholding taxes are levied on certain financial transactions between Canadian residents and non-residents. As an example of this, taxes are levied on interest payments to non-resident lenders. In certain circumstances, the withholding tax liability is exempted. For instance, an exemption exists in respect of interest payments on eligible long-term borrowings from unrelated non-residents. This exemption is meant to reduce the costs of Canadian businesses accessing capital from abroad.

Both the Task Force on the Future of the Canadian Financial Services Sector and the Technical Committee on Business Taxation have argued that an extension of the current withholding tax exemption to all interest payments to non-resident arm's length lenders would increase choice and lower prices for Canadian borrowers.

The government is reviewing this issue in the context of its treaty negotiations with other countries, as withholding tax rates are generally established by treaty.

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