Foreign Bank Entry Policy - Consultation Paper: 1
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I. Introduction

Overview

Foreign banks play an important role in the Canadian financial sector. There are currently 42 foreign bank subsidiaries operating in Canada. Their assets account for about 10% of domestic assets in the Canadian banking sector. Several foreign banks also operate in Canada through non-bank financial institutions, such as insurance and securities companies. Moreover, there are many foreign banks that provide financial services in Canada through other financial entities, such as consumer lending and leasing companies.

Foreign banks that wish to operate in Canada must first seek entry approval. Once established here, they are subject to various regulatory requirements depending on the kind of entities they operate in Canada.

The last comprehensive review of the regulatory framework for foreign banks dates back to 1980. The competitive landscape has changed dramatically since then, and a number of trends have emerged. Globalization has become a major force. Businesses in all spheres and all countries continually seek greater access to foreign markets. Moreover, new technologies and delivery channels have revolutionalized the financial services offered to consumers and how they are provided.

Numerous changes have been made to foreign bank entry policy in recent years to reflect these trends. For example, during the recent review of financial institutions legislation, the government made several modifications to reduce the regulatory burden on many foreign banks while ensuring consistent treatment with domestic institutions. These include allowing foreign banks with a foreign bank subsidiary in Canada to own other regulated financial institutions directly rather than through the subsidiary.

The result of incremental changes in recent years is an entry regime that provides relatively open access to the Canadian market for foreign banks. Nevertheless, during the recent legislative review it was clear from consultations with various groups and reports by parliamentary committees that more fundamental changes were appropriate. Foreign banks were seeking greater clarity in the entry rules and more options to operate in Canada.

Therefore, on February 14, 1997 the government announced that it would review its current policy for foreign banks and develop a new framework for entry, including the development of a regime to allow foreign banks to branch directly into Canada. The government committed to consult interested parties on an appropriate new framework.

A related matter under consideration involves the rules for foreign banks that do not wish to establish a Canadian entity, but would like to provide services in Canada from outside the country. With the introduction of new delivery channels like the Internet, it is now feasible for banks to service customers worldwide, sometimes even without establishing any operations outside their home jurisdiction. Such cross-border activities are of interest given their implications for Canadian consumers and financial institutions.

Scope of the Review

The review has three main components, namely:

1. developing a regime to allow foreign banks to branch directly into Canada;
2. establishing a clear entry policy, including how the Minister of Finance will make use of the discretion under section 521 of the Bank Act to permit foreign banks to establish entities in Canada; and
3. reviewing the rules for foreign banks operating cross border into Canada.

The focus of the review is on the role of foreign banks within the existing financial institutions framework. It is not intended to fundamentally alter the policy for domestic institutions through this process. Rather, the Task Force on the Future of the Canadian Financial Services Sector will examine the need for broader, structural changes to the financial system and make recommendations to the government.

In addition to the areas above, the paper discusses two technical amendments related to foreign bank entry.

Considerations

The Department has identified a number of considerations or factors to keep in mind in developing a new foreign bank entry framework. These will be familiar to many readers, as similar concepts underpin domestic financial sector policy. They are as follows:

1.  Enhancing Competition/Services.

A primary consideration in developing financial sector policy is to ensure that Canadian consumers and businesses, both large corporations and small enterprises, have a broad range of choices in the financial services market at the lowest possible cost. This means promoting competition and innovation among financial services providers. Foreign banks have an important role to play in this regard, and their participation in the Canadian market should be encouraged.

It is essential to ensure the financial system remains safe and sound and that consumers have confidence in the system. To achieve this, a variety of rules are imposed on individual institutions, such as restrictions on permissible activities. There are also measures in place to contain systemic risk. The aim is to prevent trouble in one financial institution from putting at risk the financial system as a whole.

It is important that adequate protection be afforded consumers in their dealings with financial institutions. Safety and soundness measures and deposit insurance play a key role in this regard. Other measures aimed at helping consumers include requirements to disclose interest and fee information, and initiatives underway to enhance privacy protection and prohibit coercive tied selling.

There are different types of financial services providers in Canada, whether foreign- or domestically-owned. As the consumer protection requirements to which they are subject vary according to the kinds of services they provide, it is also important that consumers be aware of these differences in protection when dealing with different service providers.

In structuring a new foreign bank entry framework, foreign banks should not be treated substantially better or substantially worse than Canadian institutions. While it may not be possible to achieve a perfectly "level" playing field for all participants, the goal is to ensure that the rules applying to foreign banks wishing to operate in Canada are in line with those applying to comparable domestic institutions.

These considerations helped to shape the concepts presented for discussion in this paper.

Objective of this Discussion Paper

The goal of the foreign bank entry policy review is to develop a systematic and effective approach to foreign bank policy in a rapidly changing environment, an approach that benefits Canadian consumers. This paper represents a key step in this process. It is aimed at promoting discussion on the best approach to foreign bank entry policy for the future. Interested parties are invited to comment on any aspect of the paper.

In preparing this paper, federal officials (the Department of Finance, together with the Office of the Superintendent of Financial Institutions (OSFI), the Canada Deposit Insurance Corporation (CDIC) and the Bank of Canada) undertook a thorough review of existing foreign bank entry policy. Approaches to foreign bank policy in other major industrialized countries were also analyzed. The concepts presented for discussion are based on the above considerations, as well as a careful assessment of views expressed by various groups on foreign bank policy over the last few years.

II. Branching

Background

A key part of the new foreign bank entry framework will be a branching regime. As suggested earlier, the decision to develop a branching regime stemmed from the recent review of financial institutions legislation. During the review, several interested parties, as well as the House of Commons Standing Committee on Finance and the Standing Senate Committee on Banking, Trade and Commerce, recommended that the government allow direct branching. They noted that Canada was one of the few developed countries that does not permit branching. Foreign banks also noted some of the main benefits associated with branching, including greater operational flexibility, increased lending capacity (basing loan size limits on the parent bank's capital), and reduced corporate governance requirements.

At the time of the announcement on the branching regime in February, the government outlined general parameters for the regime (see the foreign bank entry section in the February 14th Finance Canada News Release (97-012)). Since then, officials have been working to build on those parameters.

The following section provides further details on the proposed branching regime.

Features of the Proposed Branching Regime

Entry Criteria

The criteria and application procedures for foreign banks wishing to operate branches in Canada should be similar to those for foreign banks wishing to incorporate a foreign bank subsidiary in Canada, including those set out in the OSFI publication " A Guide for Foreign Banks". A foreign bank wishing to establish a branch would generally be required to:

• have at least $25 billion in assets on a world-wide basis;
• be widely-held;
• have international banking experience;
• have the consent of the regulator in their home jurisdiction;
• demonstrate favourable performance over the past five years; and
• be regulated as a bank and supervised on a consolidated basis in its home jurisdiction, in line with internationally-recognized regulatory standards and in a manner acceptable to Canadian regulatory authorities.

A foreign bank would have one branch in Canada. A foreign bank branch could have "offices" in various locations in Canada, but all of these offices would be regulated as part of the one branch.

Capital Requirements

Branches would be subject to a capital equivalency requirement. The requirement would be to hold, with an approved Canadian financial institution, a deposit of high quality securities equal to the greater of $10 million or 5% of liabilities to persons other than offices of or affiliates of the foreign bank. The deposit would have to be free from encumbrances.

Powers

In general, foreign bank branches would have all the same banking powers and be subject to the same rules and restrictions as Canadian banks. The only major difference in powers between a foreign bank branch and a Canadian bank would be a prohibition on branches accepting retail deposits. Retail deposits would be defined as deposits under $150,000^[1], which is the same threshold used for the purposes of the government's recent initiative to allow banks taking only "wholesale" deposits to opt out of CDIC coverage.

In order to maximize competition, a foreign bank would be able to operate both a branch and a foreign bank subsidiary in Canada, even if the latter takes retail deposits. "Self-dealing" rules would apply to transactions between a foreign bank branch and a foreign bank subsidiary. These rules are designed to control transactions between a financial institution, such as a foreign bank subsidiary, and persons who are in positions of influence over, or control of the institution, such as the foreign bank parent and its branches.

In cases where a foreign bank had both a foreign bank branch and subsidiary in Canada, it would be important to ensure that the public could clearly distinguish which is the CDIC-insured subsidiary and which is the branch. Therefore, a foreign bank with both kinds of operations in Canada would be required to maintain separate premises and implement disclosure procedures. However, the foreign bank branch and subsidiary would be permitted to share certain services, including "back office" and treasury operations.

An important issue for branches is access to Canadian clearing and settlement systems. Like other financial institutions operating in Canada, foreign bank branches could obtain indirect access through a direct participant in a Canadian clearing and settlement system (this could include a Schedule I bank, a Schedule II bank, or another non-bank direct participant).

For foreign bank branches to obtain direct access to Canadian clearing and settlement systems, Canadian authorities would need to be satisfied that the application of foreign insolvency laws would not render the netting measures used in these systems ineffective, or make it difficult for surviving participants or the Bank of Canada to realize on collateral pledged by the defaulting institution. A foreign bank seeking to establish a branch in Canada would be required to provide a legal opinion regarding the application of foreign laws in the case of insolvency. Only when foreign banks produce satisfactory opinions as to the enforceability of netting and collateral arrangements where foreign laws apply would their branches be permitted to obtain direct access (subject, of course, to any other access criteria that clearing and settlement systems may have).

Supervision

The Superintendent of Financial Institutions will supervise foreign bank branches. Branches would be required to submit regular financial reports similar to those submitted by Canadian banks and would be examined annually. Examinations would generally focus on the management and operations of a branch, the suitability of branch policies and procedures, and compliance therewith. In addition, assets held by the branch would be examined. Foreign banks would also be required to appoint external auditors to conduct an annual audit of the branch and report to the foreign bank and the Superintendent.

Branches would be subject to the Superintendent's powers to issue Orders of Compliance under the Bank Act. In addition, the Superintendent would have the authority to require branches to maintain assets in Canada (other than capital equivalency deposits described above) in such an amount and of such a type as is satisfactory to the Superintendent. These powers would be exercised in situations where the Superintendent is concerned about the operation of a branch or the status of the foreign bank.

The Superintendent will also assess the foreign bank, the ultimate support for a branch, on a regular basis. As the branch is not a separate legal entity, the status of the whole foreign bank is extremely relevant. Therefore, arrangements satisfactory to the Superintendent would have to be in place for information sharing with foreign supervisors and for the Superintendent to obtain key information on the whole foreign bank, as necessary. The supervisory approach would be in keeping with the Canadian practice of reliance on external bank auditors.

Management

A principal officer would be appointed to be the focal point of contact between supervisors and the foreign bank regarding the operation of the branch. The principal officer would be a Canadian resident and an employee of the foreign bank.

Foreign banks would be required to establish appropriate policies and procedures for the operation of their branch and ensure compliance therewith. Internal auditors from the foreign bank would be responsible for reviewing branch operations.

Insolvency and Liquidation

It is proposed that, in the case of insolvency of a foreign bank, the branch in Canada would be liquidated as if it were a separate entity under Canadian law. Other assets of the foreign bank in Canada, not just the assets of the branch, could be used to satisfy claims on the branch. The rights of depositors of related Canadian subsidiaries would need to be protected.

Taxation

The Department is currently developing a framework for taxing foreign bank branches in light of the proposed regulatory framework outlined in this paper. Tax policy considerations relating to foreign bank branches differ somewhat from the general foreign bank policy considerations outlined earlier. Key tax policy objectives are to ensure that there is a reasonably level playing field between foreign bank branches and domestic banks, including Canadian subsidiaries of foreign banks, and to provide consistency with the general tax treatment of other industries.

In developing the tax framework for foreign bank branches, the Department is reviewing such areas as the tax treatment of foreign bank branches in other major industrialized countries, and the tax treatment of Canadian branches of other foreign businesses, both financial and non-financial. The framework for foreign bank branches will take into account the unique features of the banking industry.

The capital tax base of foreign bank branches will reflect assets employed in Canada by the branches, as is the case for other businesses. This could be achieved through a factual assessment of the amount of capital used by a foreign bank in connection with its Canadian branch operations, a system developed to serve as a proxy for a factual assessment, or a combination of both approaches. However, the capital equivalency deposits to be maintained for regulatory purposes, as described in this paper, could not form the sole basis for the capital tax, as they will not be reflective of all of the activities of foreign bank branches.

Similarly, the amount of income of non-resident banks attributable to Canadian branches for tax purposes could be determined through a factual approach, a system serving as a proxy for a factual approach, or a combination of both approaches. However, a proxy approach should take into account a fairly broad spectrum of banks' income sources.

Other branch level taxes may be imposed, as necessary, to maintain a reasonably level playing field with Canadian banks, including Canadian subsidiaries of foreign banks. The principle of maintaining a reasonably level playing field between businesses with branches and subsidiaries is embodied, to a certain extent, in the existing branch tax rules applicable to other foreign businesses. The extension of rules of this nature in an appropriate form to foreign bank branches would result in treatment generally consistent with other industries.

Notes:

^[1] In addition, the branch would be permitted to have limited deposits of less than $150,000, as long as the sum of all such deposits is less than one percent of all deposits held by the branch. This approach mirrors that used in the initiative to allow banks to opt out of CDIC coverage, as provided for in the recently-proclaimed Act to amend certain laws relating to financial institutions, S.C. 1997, c. 15 (previously Bill C-82). [Return]

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