Foreign Bank Entry Policy - Consultation Paper: 2
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III. Other Elements of Foreign Bank Entry Policy

Existing Foreign Bank Entry Regime

In reviewing the existing foreign bank entry regime, it is important to first note that there are two broad categories of foreign banks which may carry on business in Canada: regulated foreign banks and "near banks".^[2]

Regulated foreign banks are entities which are regulated as banks in their home jurisdiction and for whom financial services constitute a large part of their operations.

"Near banks" are entities that do not generally take deposits, are not regulated as banks in their home jurisdiction, but provide one or more banking-type services (e.g., consumer loans).

Entry Regime for Regulated Foreign Banks

Regulated foreign banks currently can provide financial services in Canada through several different entities. First, they are permitted to operate through the following regulated financial institutions:

• a foreign bank subsidiary;
• another federally-regulated financial institution such as a trust, loan or insurance company; and
• a securities dealer.

As noted in the previous section, a regime is being developed to allow regulated foreign banks to operate through a branch in Canada.

Over the past few years, a small number of regulated foreign banks have received approval to operate in Canada through unregulated financial entities. An "unregulated" entity (for the purposes of this paper) is a financial entity other than the above-listed regulated financial institutions, which is not subject to solvency-based federal or provincial regulation^[3].

Approvals to operate through unregulated entities were provided under section 521 of the Bank Act. Each case was considered on an ad hoc basis, with approval based on the specific circumstances of the applicant and the limited nature of activities it wished to undertake in Canada.

When the government announced the review of foreign bank entry policy in February, it outlined an "interim policy", for the review period, governing unregulated operations of regulated foreign banks. Under this policy, regulated foreign banks currently offering a narrow range of financial services and which now operate unregulated in Canada can continue to do so; new foreign bank entrants can also carry on activities without being regulated, provided they meet certain criteria, principally no deposit taking and maintaining Canadian assets below $200 million.

Entry Regime for "Near Banks"

A number of changes were recently made to ease the regulatory requirements for "near banks", under the 1997 Act to amend certain laws relating to financial institutions (Bill C-82). As is the case with regulated foreign banks, foreign "near banks" can establish the following regulated financial institutions in Canada:

• a federally-regulated financial institution such as a trust, loan or insurance company; and
• a securities dealer.

However, "near banks" cannot generally establish a foreign bank subsidiary, nor would they be allowed to establish a foreign bank branch, once the new branching regime is in place.

Foreign "near banks" can also operate unregulated financial entities in Canada, provided their Canadian activities do not include taking deposits. Furthermore, they only need a one-time approval under section 521 to enter the Canadian market on an unregulated basis. However, "near banks" must inform retail customers that their investments are being held by an unregulated financial entity and are not covered by CDIC deposit insurance.

Given these recent substantive changes regarding the operations of "near banks" in Canada, this review focuses on entry options for regulated foreign banks.

Options to Facilitate Foreign Bank Entry

Given the pace of change in the global banking environment and ever-increasing competitive pressures, regulated foreign banks have expressed a desire for clarity and consistency in the entry rules, as well as greater flexibility in structuring their Canadian operations. This is particularly important to regulated foreign banks that have corporate structures different from those of banks in Canada. Some regulated foreign banks are interested in alternative entry vehicles to provide a more limited range of activities than a regulated entity like a bank or trust company would generally provide. Giving them greater flexibility in entering Canada would encourage new foreign bank entrants, thereby enhancing competition in the Canadian financial services sector.

The Department has developed two possible options for discussion. Both options are intended to apply to regulated foreign banks.

In assessing these options, interested parties are invited to refer to the four considerations outlined earlier in the Introduction. While individual groups will undoubtedly assign somewhat different degrees of importance to each, their views are sought on whether these options reflect the considerations, and if not, how the options might be modified.

1. Choice Between "Regulated Stream" and "Unregulated Stream"

One option is to allow regulated foreign banks to carry on financial activities in Canada through either regulated financial institutions or unregulated financial entities, but not both.

In essence, regulated foreign banks could choose between a "regulated stream" and an "unregulated stream" for providing financial services in Canada.

"Regulated stream": Those regulated foreign banks that want to provide deposit-taking, fiduciary, insurance or securities services could establish a foreign bank subsidiary or branch, a federal or provincial trust or loan company, a federal or provincial insurance company, or a securities dealer. In doing so, they would be permitted to establish other regulated financial institutions, but would be precluded from directly owning unregulated financial entities^[4]. If a regulated foreign bank operating through regulated financial institutions in Canada subsequently wished to establish an unregulated entity, it would first have to cease its regulated Canadian operations.

"Unregulated stream": On the other hand, if a regulated foreign bank wants to engage in a limited range of financial services such as consumer or small business lending and does not wish to operate a regulated financial institution, it could simply establish an unregulated financial company. An unregulated company would not be permitted to take deposits, underwrite insurance or offer fiduciary services. A regulated foreign bank that establishes an unregulated entity would be permitted to establish other unregulated entities but not regulated financial institutions. If a regulated foreign bank operating through unregulated entities in Canada subsequently wished to establish a regulated financial institution, it would first have to cease its unregulated Canadian operations or transfer its Canadian activities to a regulated financial institution.

Allowing regulated foreign banks to choose between these two "streams" would build on the "interim policy" announced in February. New foreign bank entrants would no longer be subject to an asset limit on their unregulated Canadian operations. Appropriate arrangements would have to be in place, including disclosure, to make it clear to the public that OSFI has no ongoing responsibility for these unregulated entities (as is the case for domestic unregulated firms).

2. Introduction of "Limited-Purpose" Entities

Another possibility involves the creation of new "limited-purpose" entities to provide greater flexibility to foreign banks in structuring their Canadian operations.

Under this option, regulated foreign banks would be required to operate through regulated entities (federal or provincial) in Canada. However, two new categories of federal financial institutions would be created to provide more entry options for regulated foreign banks: a "limited-purpose" foreign bank subsidiary and a "limited-purpose" trust or loan company. These new financial institutions would have more limited powers than a fully-regulated foreign bank subsidiary or fully-regulated trust or loan company, but would also be subject to lighter regulatory requirements than the latter.

As a result, regulated foreign banks could choose from the following forms of entry:

• a foreign bank subsidiary or branch – if the regulated foreign bank wants to provide a full-range of banking services;
• a federal or provincial trust or loan company or insurance company – if the regulated foreign bank wants to provide fiduciary or insurance services;
• a securities dealer; or
• a "limited-purpose" foreign bank subsidiary or "limited-purpose" trust or loan company – this option would be available only to regulated foreign banks that do not have a foreign bank subsidiary or branch, or trust or loan company in Canada (i.e., any deposit-taking institution -- federal or provincial).

The "limited-purpose" entities" would have characteristics along the following lines:

• a "limited-purpose" foreign bank subsidiary would be a Schedule II bank with no deposit-taking powers, while a "limited-purpose" trust or loan company would be a trust or loan company under the Trust and Loan Companies Act with no deposit-taking powers;
• "limited-purpose" foreign bank subsidiaries and "limited-purpose" trust or loan companies would be restricted to a narrow range of activities in Canada; for example, a foreign bank could set up a "limited-purpose" entity to provide credit card or leasing services (if a regulated foreign bank wants to provide a wide range of banking services or fiduciary services, it would establish a fully-regulated foreign bank subsidiary, foreign bank branch, or trust or loan company);
• a "lighter" regulatory regime would be applied to the "limited-purpose" entity as follows: the Superintendent would be given powers to waive the application of certain regulatory requirements, such as corporate governance, capital requirements, reporting and investment rules; and
• the Superintendent would be given powers to take action to protect creditors.

The introduction of "limited-purpose" entities would provide a worthwhile alternative to new entrants interested in providing a limited range of financial activities in Canada, with reduced levels of regulation.

IV. Cross-border Delivery of Financial Services

Background

Cross-border delivery of financial services (where a bank in one country provides services "across the border" into a second country, instead of establishing a separate entity in the second country to provide services) is not new. For example, many Canadians who travel frequently outside Canada have relationships with foreign banks abroad, and they may occasionally conduct transactions with their foreign bank through a correspondent bank in Canada.

There is potential for significant growth in cross-border activities by foreign banks, not just in Canada but worldwide. Technological advances and new delivery channels such as Internet banking and electronic money facilitate cross-border provision of financial services. Some foreign banks are already actively pursuing Canadian customers cross border through general advertisements or more targeted forms of solicitation, and others might do so in the future.

The provision of services cross border by foreign banks has implications for consumers and domestic institutions. While cross-border services may provide innovative, competitively-priced options for Canadian consumers, such activities raise important consumer protection issues. There may be incremental risks to consumers dealing with a bank that has no establishment in Canada. For example, if Canadians deposit money in a foreign bank operating from another country, they might have less deposit insurance protection than in Canada, or possibly no protection at all. Furthermore, if there is a legal dispute between a foreign bank and its Canadian customer, the only remedy available to the customer may be to take action in the foreign jurisdiction. Some Canadians may believe that foreign banks operating cross border are subject to Canadian regulation, even though they are not.

With respect to the implications of foreign banks' cross-border activities for domestic banks, foreign banks operating from another country may have a competitive advantage over domestic banks if they are subject to lower regulatory and tax requirements in their home jurisdiction. In addition, the government would need to consider the tax implications of such cross-border activities.

The Bank Act currently contains several provisions that have had the effect of restricting cross-border activities by foreign banks. One of these prohibits foreign banks from carrying on "banking business" in Canada except as authorized. In a world where delivery of financial services across borders is becoming more and more feasible, it is important to assess whether the existing approach to regulating cross-border activities remains appropriate.

There are several important points to consider with regard to regulating cross-border activities. In a fast-moving technological environment, it is often not possible for one country acting alone to establish effective and durable boundaries for prohibited activities. In addition, there are limits to the possible scope of Canadian law, and enforcement of restrictions is challenging. These factors suggest that responding to potential concerns about cross-border activities may not be straightforward.

Possible Policy Options

The issue is whether to complement the existing restrictions in the Bank Act by adding new measures. One approach would be to introduce specific regulations governing solicitation activities, which are key to successful cross-border operations. Without initial solicitation through general advertising or more targeted marketing, a foreign bank operating cross border would find it difficult to attract new customers in Canada. Regulation of solicitation activities could be undertaken to ensure that Canadian consumers are not misled.

There are a number of possible options. One would be to ban targeted solicitation for financial services or selected financial services, such as deposit taking. Another variant would be to ban all solicitation, both general and targeted, for deposit taking. It is recognized, however, that it would be difficult to fully enforce such a ban without the cooperation of governments in other countries.

Another possibility is to allow cross-border solicitation but impose disclosure requirements on foreign banks to protect Canadian consumers. There are different forms of disclosure that could be considered. For example, foreign banks could be required to disclose that they are not regulated in Canada or insured by the CDIC in Canada. Other possible disclosure requirements would relate to interest on deposits, service charges, and the cost of credit. These requirements are currently imposed on domestic financial institutions and foreign bank subsidiaries in Canada.

V. Other Technical Amendments to Foreign Bank Entry Policy

In the context of the broad review of foreign bank entry policy, it is also proposed to make two technical changes aimed at removing outdated regulations applying to foreign banks.

1. Definition of Entities "Associated" with a Foreign Bank

The first technical change proposed is to narrow the definition of an "entity associated with a foreign bank" under section 507 of the Bank Act to reduce the range of entities in a foreign bank conglomerate that are subject to the entry regime.

Under the Bank Act, the Canadian investments of an entity "associated" with a foreign bank affect what the foreign bank can do in Canada. Currently the definition of an entity "associated" with a foreign bank is broad. For instance, if a foreign entity has 12% of the voting shares of a foreign bank and controls an industrial company, the industrial company is considered to be "associated" with the foreign bank even though the entity controlling the industrial company does not control the foreign bank. At present, a foreign bank cannot have a foreign bank subsidiary in Canada if an entity "associated" with the bank has a substantial investment in certain Canadian entities.

This approach is now perceived as overly restrictive (particularly in light of changes to the investment powers for domestic banks in 1992). It is therefore proposed to narrow the definition of "associated entity" to "affiliate" of a foreign bank. An "affiliate" is an entity that controls a foreign bank, is controlled by a foreign bank, or is controlled by the parent of a foreign bank. By narrowing the definition, we can lessen the impact of investments of entities not closely linked to the foreign bank on the foreign bank's own Canadian investments.

2. Commercial Lending Limits for Trust, Loan and Insurance Companies

The second proposal is to modify the commercial lending limits for trust, loan and insurance companies. Currently, the Trust and Loan Companies Act and the Insurance Companies Act limit commercial loans to 5% of a trust, loan and insurance company's assets if the company has $25 million or less of regulatory capital.

Foreign banks have noted that the 5% limit would prevent them from taking full advantage of the recent Bank Act amendment allowing them to own federal financial institutions (and securities dealers) directly instead of through subsidiaries. Some foreign banks argue that while they may establish a Canadian trust company, for example, with less than $25 million in capital, the parent foreign bank has both the expertise in commercial lending and ample capital to support the company.

These arguments have merit. It is therefore proposed to amend the Trust and Loan Companies Act and the Insurance Companies Act to authorize the Superintendent to permit commercial lending of greater than 5% of assets for trust, loan and insurance companies with less than $25 million in regulatory capital where the trust, loan or insurance company is controlled by a regulated financial institution that has expertise in commercial lending and more than $25 million in capital.

VI. Concluding Remarks and Next Steps

The Department looks forward to hearing the views of interested parties on the various elements of this paper. Comments are welcome on the range of technical issues involved in the development of a branching regime. Readers should view the two options to increase foreign bank entry as possible approaches for further discussion. In the area of cross-border delivery, views are invited on whether any policy changes are desirable and if so, whether the possible options outlined in this paper or other approaches to dealing with cross-border activities by foreign banks would be appropriate.

Written comments on any aspect of the paper should be forwarded, by October 24, to: Frank Swedlove, Director, Financial Sector Division, Department of Finance, 140 O'Connor Street, Ottawa, Ontario, K1A 0G5.

Notes:

^[2] These categories were articulated in the government's consultation paper on financial institutions legislation in June, 1996, and are reflected in an Act to amend certain laws relating to financial institutions, S.C. 1997, c. 15. They are also the subject of a July 1997 OSFI note to foreign banks, entitled, Note on Designation of Foreign Banks Pursuant to Section 521 of the Bank Act. [Return]

^[3] It should be noted that "unregulated" financial entities would be subject to some other forms of regulation, notably provincial consumer protection requirements such as cost of credit disclosure requirements. [Return]

^[4] However, foreign banks with regulated Canadian financial institutions would be able to own certain unregulated entities indirectly through the regulated financial institutions, as permitted under statutes such as the Bank Act and the Insurance Companies Act. [Return]

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