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Canada’s Financial Services Sector

Canada's Banks

September 1999

Overview

• Banks play a vital role in Canada's financial system and economic development. There are 11 domestic banks and 42 foreign bank subsidiaries operating in Canada. Most major international banks have a presence here, either through a subsidiary or a representative office.

• Banks account for over 50 per cent of the total domestic assets held by the financial services sector, which also includes insurance companies, trust companies, caisses populaires, credit unions and other financial institutions. Canada's six major domestic banks, with their wide-ranging branch networks, account for about 90 per cent of the bank industry's assets.

• The six major Canadian banks, which are significant international players, are active in the United States and throughout the world. Currently, international operations account for about 40 per cent of their net revenue.

• The Canadian banking system is regarded as highly efficient. Service fees, credit card costs and interest spreads on intermediated credit compare favourably with those of major banks in other countries.

• Canada's banks play an integral role in the national clearing and settlement system, which clears over 3 billion items valued at more than $16 trillion annually. The Canadian payments system is efficient and highly automated, with an increasing proportion of payments being made electronically.

• The six major Canadian banks have over 14,000 automated banking machines (ABMs) in Canada. In 1998, Canadians conducted over 1 billion ABM transactions and almost 1.5 billion debit card transactions.

• Capitalization levels of the Canadian banks exceed the Bank for International Settlements minimum standards.

• Although the Canadian banks have posted very strong financial results in recent years, profits and return on equity were down in 1998, largely due to weaker capital markets. Profits of the six largest banks totalled $7.1 billion in 1998, representing a 15-per-cent return on equity.

• This information sheet describes the regulatory environment that is currently applicable to the Canadian banking sector. It also discusses a major reform of the financial services sector's regulatory framework announced by the Minister of Finance on June 25, l999. The federal government will be introducing legislation to implement this policy framework as soon as feasible. The Minister's statement and the policy paper are available on the Department of Finance Web site (http://www.fin.gc.ca/). Highlights of the policy paper can be found in Annex 1.

Introduction

Canada's financial services system traces its roots to the establishment of a bank in 1817, half a century before Confederation. Since then, the banking industry has been the cornerstone of Canada's financial services system and has become one of the economy's most powerful creators of jobs and wealth.

Today, the banking industry employs 220,000 Canadians. It represents the largest portion of both assets held and capital employed within the financial services sector, which, in addition to domestic and foreign banks, includes trust companies, insurance companies, caisses populaires, credit unions and other financial institutions.

The banking industry has expanded and changed significantly over the past three decades. The financial system has evolved from one where institutions and product lines were identified with each other to one where institutions offer a range of overlapping services. This process was hastened with the Bank Act of 1967, which allowed banks to enter the mortgage and consumer loan markets in significant ways. The process of diversification was further accelerated with changes to financial institutions legislation in 1987 and 1992, which allowed banks to operate securities and trust subsidiaries respectively. All of the large Canadian full-service securities dealers are now bank-owned. The trust and loan industry, which experienced difficulties following the collapse of the real estate market in the early 1990s, has also consolidated with the banking industry. Despite this expansion of the banks' business, they are still recognizable through their core business of accepting deposits and extending credit 
(see Chart 1).

A flexible framework

New information technology, globalization and demographic change are driving innovation and giving rise daily to new opportunities in Canada's financial services sector. The impacts of these changes on consumers, businesses and governments are continually driving the evolution of the sector.

In 1997, the government completed a scheduled five-year review of legislation for federally regulated financial institutions. Amendments to the relevant acts, including the Bank Act, became law in April of that year. The revisions, which are currently in effect, were designed primarily to enhance the efficiency and competitiveness of the financial sector.

However, in response to the dramatic changes in technology and information services continually affecting the banks and other financial institutions in this era of globalization, and as part of its ongoing commitment to review the legislation governing Canada's federally regulated financial institutions every five years, the government established the Task Force on the Future of the Canadian Financial Services Sector in 1996. The Task Force tabled its report in September 1998.

On June 25, 1999, the Minister of Finance released a proposed new policy framework for the financial services sector, which reflects public input provided to both the Task Force and to two parliamentary committees that studied and debated its report.

The measures to be implemented are set out in a policy paper entitled Reforming Canada's Financial Services Sector: A Framework for the Future. The Minister's statement and the policy paper are available on the Department of Finance Web site at http://www.fin.gc.ca/ (see Annex 1 for a brief overview of the policy paper). The government will be introducing legislation to implement the proposed new policy framework as soon as feasible.

Regulation and supervision

The regulation of banks is the responsibility of the federal government, with the Bank Act being the principal legislation. However, given the hybrid nature of the banks' activities, some of their subsidiary activities, such as trustee services and securities dealing, are provincially regulated.

The Office of the Superintendent of Financial Institutions (OSFI) is the federal agency principally responsible for supervising all federally regulated financial institutions. OSFI's role is to safeguard depositors from undue loss and to advance and administer a regulatory framework that contributes to public confidence in a competitive financial system.

The Canada Deposit Insurance Corporation (CDIC) also contributes to the safety and soundness of the Canadian financial system by providing deposit insurance. As a general rule, CDIC protects eligible deposits up to a maximum of $60,000 a person, including principal and interest, at each member institution. However, CDIC does insure certain classifications of deposits at the same bank separately, such as joint deposits and deposits held in trust.

Under the current regulatory regime, a distinction is drawn between Schedule I and Schedule II banks (see Annex 2 for a list of these banks). The shares of Schedule I banks are required to be widely held while Schedule II banks may be owned by eligible Canadian financial institutions or eligible foreign institutions. All of the six major Canadian-owned banks are widely held, which means that no shareholder, or shareholders acting in concert, can hold enough shares to exercise control over one of these banks. Under the Bank Act now, no single shareholder, or shareholders acting in concert, can hold more than 10 per cent of any class of shares of this type of bank. However, with the release of the proposed new policy framework, the government has indicated its intention to raise the 10-per-cent limit to 20 per cent of any class of voting shares and 30 per cent of any class of non-voting shares. Any significant changes in share ownership of the banks or other federally regulated financial institutions will continue to require the approval of the Minister of Finance.

Furthermore, under the proposed new policy framework, the regime of Schedule I and Schedule II banks would be replaced by a three-tier system of banks based on their equity.

• Large banks (i.e. banks with equity in excess of $5 billion) would be widely held under the new definition.
• Medium banks (i.e. banks with equity between $1 billion and $5 billion) would be allowed to be closely held. Closely held medium-sized banks would be required to have a public float of 35 per cent of voting shares.
• Small banks (i.e. banks with equity of less than $1 billion) would have no ownership restrictions other than "fit and proper" tests (these tests assess the suitability of prospective owners and help ensure that key shareholders are not a source of weakness to the regulated institutions).

This new size-based ownership regime would allow for the creation of small, local banks with services tailored to the needs of a specific community.

Safety and soundness

There have been very few bank failures in Canada, which is widely acknowledged as having one of the safest and soundest financial sectors in the world. Two small regional banks failed in the mid-1980s, the only such failures since 1923. The soundness of the Canadian banking industry was demonstrated when it absorbed the debt difficulties of the less developed countries in the early 1980s and the decline in real estate values a decade later without experiencing any systemic problems.

Ensuring the safety and soundness of the financial system and the security of deposit holders' assets are the principal purposes of regulation. In 1996, legislative changes to enhance the safety and soundness of the financial system were implemented. The provisions introduced an early intervention system for troubled financial institutions and provided a mechanism for controlling systemic risk in major clearing and settlement systems.

Canada's banks play an integral role in the national clearing and settlement system, which clears over 3 billion items valued at more than $16 trillion annually. The Canadian payments system is efficient and highly automated, with an increasing proportion of payments being made electronically. In February 1999, the Large Value Transfer System (LVTS) started operations. Its purpose is to provide settlement certainty for payments made by financial institutions, governments and large corporations during business hours. The LVTS, which involves a network of linked computers at the major member institutions of the Canadian Payments Association, has built-in safeguards against risk. Each participating institution provides collateral to the system to safeguard its ability to settle. The Bank of Canada, which would provide support in the event of simultaneous failures, backstops the system.

Consumers and small business

The government takes an active interest in enhancing consumer protection in the area of financial services. The Bank Act contains various provisions aimed at protecting consumer interests, including requirements regarding the disclosure of borrowing costs. In 1997, these provisions were updated and measures were introduced to prohibit coercive tied selling. The tied selling provisions were brought into force in September 1998.

Under the proposed new policy framework announced in June 1999, the government would broaden the scope of the coercive tied selling provisions by prohibiting a bank from coercing or imposing undue pressure on a customer to purchase a financial product from it as a condition of obtaining any other product, rather than just loans.

As part of the proposed new policy framework, the government has also made a commitment to establish a new Financial Consumer Agency, which would be responsible for monitoring federal consumer protection legislation, promoting industry best practices and providing consumer education and information in the area of financial services.

Complementing this agency would be a new independent Canadian Financial Services Ombudsman (CFSO), which would replace the Canadian Banking Ombudsman established by the banking industry in 1996. The CFSO would ensure fair and impartial resolution of individual and small business complaints involving financial institutions, and would accept all financial institutions as members. The government would require banks to join the CFSO, and other financial institutions would be eligible to join if they wish to do so.

In addition, the government will build on its efforts to encourage the banks to take steps to facilitate access to financing for the small business sector. The six major Canadian banks have developed codes of conduct, which outline their responsibilities towards their small business customers and make the borrowing process more transparent. The government has announced plans for a comprehensive program to ensure that more and better statistics on, and analysis of, small and medium-sized business financing are made available in order to provide a better understanding of their needs.

The changing industry structure

As of June 1999, there were 11 domestic banks and 42 foreign-owned banks operating in Canada (see Annex 2). The six major domestic banks account for about 90 per cent of the assets of the Canadian banking industry (Annex 3 lists these banks according to assets). The six major banks also account for about 13 per cent of Canada's equity market capitalization. Bank shares constitute the most liquid sector of Canadian equity markets, with an average trading volume of $1 billion per week.

The six major domestic banks have nationwide branch networks, with over 8,000 branches and more than 14,000 automated banking machines (ABMs) in Canada. They hold about half of the Canadian financial sector's total assets and play a major role in several key markets. For example, they account for about 79 per cent of business loans (including a significant percentage of small and medium-sized business debt financing), about 67 per cent of financial institution deposits, some 60 per cent of residential mortgage loans outstanding, and about 62 per cent of consumer credit.

In addition to the six large domestic Schedule I banks, there are five smaller domestic banks,¹ which account for about 2 per cent of banking industry assets. Among these is the Citizens Bank of Canada, which opened for business in 1997 and is one of Canada's newest banks. It is known as a "virtual" bank because it relies on telecommunications technology, rather than a "bricks and mortar" branch structure, to transact business with its customers. Another smaller bank is the First Nations Bank of Canada, a joint venture of The Toronto-Dominion Bank and the Saskatchewan Indian Equity Foundation, which is scheduled to be wholly owned by the Aboriginal community by 2006.

Most of the prominent international banks have a presence in Canada, either through a subsidiary or a representative office. Until recently, under the Bank Act, foreign banks booking deposits in Canada had to set up a separately incorporated Canadian subsidiary and maintain at least $10 million in capital to support its activities in Canada.

However, on June 17, 1999, the government passed legislation allowing foreign banks to open branches in Canada. Foreign bank branches are now permitted to draw on the capital base of the foreign parent to support their lending activities in Canada. Foreign banks can now establish either a lending branch or a full-service branch. Both types of branches have powers similar to those of domestic banks. However, full service branches are not allowed to accept deposits of less than $150,000. Lending branches are not permitted to take any deposits and are restricted to borrowing from other financial institutions. For this reason, lending branches face fewer regulatory requirements than full-service branches. At present, foreign banks account for almost 10 per cent of banking industry assets in Canada.

The international dimension

Canadian banks have a long history of involvement in international finance. On average, foreign business accounts for about 40 per cent of their earnings and in some cases it is considerably higher. The majority of this business is with the United States. However, for more than a century, Canadian banks have also had an important presence in the Caribbean. Today, they are among the most important financial institutions in some of the Caribbean Commonwealth countries. Recently, Canadian banks have also expanded their activities in Latin America and Asia.

During the past two decades Canada has been encouraging the liberalization of the regulatory framework governing international financial institutions, including the right to establish new entrants. Consistent with this, Canadian regulatory barriers to entry for foreign financial institutions have been largely eliminated. Foreign banks have been permitted to establish subsidiaries in Canada since 1980 and, as mentioned above, they are now eligible to open branches here. In addition, other important restrictions were eliminated under the Canada-U.S. Free Trade Agreement, the North American Free Trade Agreement and the World Trade Organization agreement on financial services.

Most of the foreign banks in Canada are involved in wholesale banking or niche financing, and their physical presence often consists of a head office and one branch. An exception is the Hongkong Bank of Canada, which has an extensive branch network and accounts for close to one-third of foreign bank assets in Canada.

Recent performance

Canadian financial sector profitability rose significantly in the early and mid-1990s, with the banking industry experiencing strong earnings from 1995 to 1997 (see Chart 2). However, profits fell somewhat in 1998, largely due to weaker capital markets. The six major domestic banks earned $7.1 billion in 1998, down 5 per cent from the 1997 record levels. Rates of return on assets and equity remain close to those of major banks in the United States, although they are below those of major banks in the United Kingdom. For the major Canadian banks, the rate of return on equity was 15 per cent in 1998.

Net interest income remains the major source of revenue for the banks, although non-interest income has been gradually assuming more importance (see Chart 3).

Non-interest income includes fees for processing cheques, servicing credit card transactions, exchanging and trading foreign currencies, managing mutual funds, underwriting securities and trading derivatives. Increased income from these sources has tended to be related to increases in the overall volume of business and the introduction of new products. Service fees on established products, which compare favourably with those at similar-sized U.S. institutions, have generally shown little change during the 1990s.

The average interest spread between the Canadian banks' borrowing (principally deposits) and lending rates has been on a downward track over the past five years (see Chart 4).

The capital levels of the major Canadian banks are above the Bank for International Settlements (BIS) minimum standards. The BIS minimum ratios are 4 per cent of risk-weighted assets for Tier 1 capital and 8 per cent for total capital. The Canadian ratios appear in Chart 5.

Looking ahead

Canadian demographics, technology and globalization are major underlying forces that will shape the banking industry for years to come.

With the aging of the baby boom generation, the banks are focusing more on personal wealth management. This is expected to be a growth area, as is the provision of savings vehicles such as mutual funds. On the other hand, demographic developments are limiting the growth potential of several of the banks' traditional markets, such as personal deposits, consumer credit and mortgage lending. A major challenge for the banks will be to maintain their core retail deposit base at a reasonable cost.

The six major domestic banks have been investing heavily in technology in order to boost productivity and contain the cost of delivering financial services. Technology has increased the optimal scale of some operations, which has encouraged agreements on the co-sourcing and outsourcing of document processing and back-office operations.

Canadians have been extremely receptive to new technologies introduced by the banking industry. ABM transactions are currently running at a rate of more than 1 billion transactions a year. Debit cards have rapidly gained wide acceptance, with almost 1.5 billion transactions conducted in 1998. ABMs are projected to deliver a greater range of services in the future, such as providing traveller's cheques, taking loan applications and perhaps providing mutual funds.

At the same time, technological developments such as telephone and virtual banking have lowered the barriers to competing in various lines of business. The banks face intensified competition from new players, including firms that have not been active in financial services. However, they are actively delivering services through the Internet and the telephone, and are beginning to experiment with new ways of delivering retail banking services by locating branches in retail stores or forming alliances with retail chains.

Annex 1

Reforming Canada's Financial Services Sector: A Framework for the Future

On June 25, 1999, the Minister of Finance announced a new policy framework for Canada's financial services sector. The new framework is outlined in Reforming Canada's Financial Services Sector: A Framework for the Future, a policy paper that sets out a comprehensive, balanced package of four interrelated components. They are:

Promoting efficiency and growth with:

• 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.

Fostering domestic competition by:

• Encouraging new entrants with liberalized ownership rules and lower minimum capital requirements.
• Facilitating the ability of the credit unions to compete by allowing a restructuring of their system.
• Expanding access to the payments system to provide additional competition in deposit-like services.
• Allowing foreign banks to offer services to businesses and individual consumers via branches, in addition to subsidiaries.

Empowering and protecting consumers of financial services with:

• Measures to improve access to financial services regardless of income or place of residence, including a standard low-cost account and a process to govern branch closures.
• A Financial Consumer Agency to strengthen oversight of consumer protection measures and expand consumer education activities.
• An independent Canadian Financial Services Ombudsman.
• Measures to prevent coercive tied selling and improve the information consumers receive when purchasing services or making investments.
• Public Accountability Statements for financial institutions to report on their contributions to the Canadian economy and society.
• More and better statistics on and analysis of small and medium-sized business financing to provide a better understanding of their needs.

Improving the regulatory environment by:

• Improving the governance of the payments system.
• Reducing the reporting burden relating to Canada Deposit Insurance Corporation standards.
• Providing the Superintendent of Financial Institutions with new powers to deal with the potential risks arising from increased competition.
• Streamlining the Office of the Superintendent of Financial Institutions' regulatory approvals process.

Annex 2

Banks Registered to Do Business in Canada (June 18, 1999)

Schedule I banks

1. Bank of Montreal
2. The Bank of Nova Scotia
3. Canadian Imperial Bank of Commerce
4. Canadian Western Bank
5. Laurentian Bank of Canada
6. National Bank of Canada
7. Royal Bank of Canada
8. The Toronto-Dominion Bank

Schedule II banks

1. ABN AMRO Bank Canada
2. Amex Bank of Canada
3. BT Bank of Canada
4. Banca Commerciale Italiana of Canada
5. Bank of America Canada
6. Bank of China (Canada)
7. Bank of East Asia (Canada)
8. Bank of Tokyo-Mitsubishi (Canada)
9. Banque Nationale de Paris (Canada)
10. The Chase Manhattan Bank of Canada
11. Cho Hung Bank of Canada¹
12. Citibank Canada
13. Citizens Bank of Canada ^(d)
14. Comerica Bank – Canada
15. Crédit Lyonnais Canada
16. Credit Suisse First Boston Canada
17. CTC Bank of Canada
18. Dai-Ichi Kangyo Bank (Canada)
19. Deutsche Bank Canada
20. Dresdner Bank Canada
21. First Chicago NBD Bank, Canada
22. First Nations Bank of Canada ^(d)
23. Fuji Bank Canada
24. Hanvit Bank Canada
25. Hongkong Bank of Canada
26. ING Bank of Canada
27. J.P. Morgan Canada
28. MBNA Canada Bank
29. Mellon Bank Canada
30. Paribas Bank of Canada
31. Republic National Bank of New York (Canada)
32. Sanwa Bank Canada
33. State Bank of India (Canada)
34. Tokai Bank Canada
35. UBS Bank (Canada)
36. The Industrial Bank of Japan (Canada)
37. International Commercial Bank of  Cathay (Canada)
38. Korea Exchange Bank of Canada
39. Manulife Bank of Canada ^(d)
40. National Bank of Greece (Canada)
41. Rabobank Canada
42. Sakura Bank (Canada)
43. Société Générale (Canada)
44. The Sumitomo Bank of Canada
45. Totta & Sottomayor Bank Canada
46. United Overseas Bank (Canada)

¹ In process of liquidation.

^(d) Domestic Schedule II banks.

Note: The 11 domestic banks include the Schedule I banks and those Schedule II banks marked with a ^(d).

Annex 3

The Six Largest Banks by Assets (October 31, 1998)

¹ These are: Laurentian Bank of Canada, Manulife Bank of Canada, Canadian Western Bank, Citizens Bank of Canada and First Nations Bank of Canada. All except for Canadian Western Bank and Laurentian Bank of Canada are Schedule II banks. These are: Laurentian Bank of Canada, Manulife Bank of Canada, Canadian Western Bank, Citizens Bank of Canada and First Nations Bank of Canada. All except for Canadian Western Bank and Laurentian Bank of Canada are Schedule II banks.

This is part of a series of short monographs by the Department of Finance describing the Canadian financial system. Copies are available from: The Department of Finance, 140 O'Connor Street, Ottawa, Ontario K1A 0G5.