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Task Force on the Future
of the Canadian Financial Services Sector
Report of the Task Force on the Future of the Canadian Financial Services Sector in response to a request by the Secretary of State (International Financial Institutions)
July 11, 1997
Table of Contents
I. Introduction.
II. Background.
III. Relevant Factors.
IV. Approach.
V. Recommendations and Criteria to be Applied.
VI. "Failing Firms" Doctrine
VII. Conclusion.
This Report is the Task Force's response to your letter of June 24, 1997, requesting the preliminary views of the Task Force on the appropriate criteria the Government should take into account in reviewing particular transactions. The Report contains recommendations as to the policy framework and analytical approach that the Government should use to assess such transactions. It also sets out criteria that should give guidance to such assessment. It does not attempt to apply the framework, approach or criteria to any specific transaction. You have not asked us to do this. Moreover it is something the Task Force was not created to do and would be reluctant to undertake. Also, you are not requesting at this time our views on the 10% widely-held rule for domestic banks, or the appropriateness of a merger of Schedule I banks.
Although our work is at an early stage we have concluded that we can responsibly provide you with this Report. We stress, however, that the Report has been prepared without benefit of public discussion, submissions on the issues raised in the Discussion Paper, and the results of the research in progress. We therefore ask you to recognize that we will undoubtedly be reviewing these issues further and that our recommendations at this time do, indeed, represent "preliminary views." We understand that you intend to make this Report public and we endorse that approach. We believe that the issues we address in this Report are important and that the process that you are about to follow with respect to the particular transactions to which you must respond, as well as our ongoing process of preparing a final report, will benefit from public comment on this Report.
There are three main points of background to this Report that we wish to emphasize:
i) It is important to recognize that the past ten years have seen an increasing integration of financial services not only in Canada but in all countries. Our preliminary research has indicated clearly that technology, demographics, and globalization are driving a process of consolidation in the financial services sector and the pace of that consolidation is accelerating. The ways in which people are choosing to save and invest are changing, and technology is facilitating the ability of providers, including new providers, to meet customer needs more effectively. New competitors are emerging, new alliances are being formed, new and innovative product offerings are being developed, and new distribution channels are emerging. Many organizations are being redefined along functional lines as major financial service providers increasingly seek to serve global markets and the standards needed to be internationally competitive continue to increase.
In every major country, legislative regimes are under review to ensure that they facilitate the effective adaptation of the financial services sector to these forces of change, so that the sector can continue to serve the efficient operation of the economy, contributing to economic growth, customer choice and employment. This Task Force has been set up to examine these issues, but it is important to note that Canada's legislative framework for the financial services sector has already evolved considerably in ways that support these trends. Canada has over the past decade, been on the leading edge of change in the framework governing the regulation and supervision of financial institutions. It is important that this be maintained.
ii) We note that there is nothing of general applicability in current legislation that precludes transactions considered in this Report from going ahead. Indeed, from 1992 forward, our legislative framework has allowed banks to own trust companies or insurance subsidiaries; insurance companies can own trust companies and widely-held insurance companies can own Schedule II banks. In response to this legislative freedom, many insurance companies now have deposit-taking subsidiaries, all major banks now have trust company subsidiaries and almost all major banks have insurance company subsidiaries.
Transactions such as those considered in this Report may be subject to review under the Competition Act, and in the course of such review issues may arise that call into question, on the basis of anti-competitive impacts, whether such transactions should be allowed to proceed. Any such issues would, however, result from the specifics of such transactions and not from any general legislative prohibition. Similarly, such transactions require the approval of the Minister of Finance. The Minister, in reviewing the specifics of such transactions, may conclude that they are not in the public interest and should not be approved. Again, we stress that such a conclusion would be based on the specifics of such transactions rather than any general legislative prohibition.
iii) Notwithstanding the legislative framework, there is a general perception that Government policy has, for some time, precluded large financial institutions from acquiring other large financial institutions. This "big shall not buy big" policy has no legislative base. It appears to reflect two concerns: the first is that a merger of two major players could give rise to anti-competitive behaviour; the second is that as the traditional four pillars began to crumble in the mid-1980s it was felt desirable that institutions have an opportunity to adjust to the new competitive challenges and opportunities free from the immediate threat of major new competitors emerging as a result of the consolidation of industry leaders.
Against these three background points, we wish to record the following relevant factors that have helped shape this Report:
With respect to these types of transactions, you are seeking preliminary views on criteria that would apply within the existing legislative framework. While we accept that assumption for purposes of this Report, we caution that our further work could result in proposals to change the legislative framework in ways that might affect transactions such as these in the future.
- The major question at issue is whether "big shall not buy big" should apply as a general policy, for transactions not involving the merger of two Schedule I banks.
- The process for reviewing these transactions will involve: obtaining clearance from the Director under the Competition Act; obtaining a recommendation from the Superintendent of Financial Institutions with respect to prudential consequences of the proposed transactions; and, finally, review by the Minister of Finance taking into account these factors and any other relevant factors.
Our approach to the issues considered in this Report is set out in Sections 1.10 and 1.11 of the Discussion Paper released June 13, 1997. In brief, we feel that Government intervention in the market should be limited to that necessary to give effect to public policy objectives and that where Government does intervene, care should be taken that the degree of intervention does not exceed what is reasonably necessary to attain these objectives. We put considerable emphasis on the roles that competition and disclosure can play as controllers of market conduct. We believe that effective competition and disclosure, together with well-targeted regulation, will provide an environment wherein the ability of financial institutions to adapt successfully to the forces of change will be maximized. Successful adaptation of the sector to those forces will enhance its efficiency and competitiveness. A healthy, well-functioning, competitive financial sector will enhance economic growth, customer choice in financial services, and employment.
This approach is buttressed by our analysis to date of the structure of the financial services sector. On conventional economic tests, the sector as a whole contains no dominant player and is exposed to the forces of competition. As at December, 1996, the major chartered banks are the largest participants in the sector. Together the six major banks account for 62% of deposits, 50% of residential mortgage loans, and 65% of consumer loans. But the largest of them accounts for only about 17% of deposits, 13% of residential mortgage loans, and 16% of consumer loans. The five largest life and health insurance companies have 47% of the market for individual life insurance, with the largest company having 16% of the market. The property and casualty insurance sector is less concentrated, with the five largest firms having 28% of the market.
The preceding paragraphs are not intended to suggest that there are no anti-competitive implications in such transactions, or that the overall state of competition in the Canadian financial services sector is as healthy as it might be. And we caution that, as transactions such as the types considered in this Report are reviewed, concerns about competition should extend beyond considerations of whether the transactions themselves would result in anti-competitive impacts and include questions of whether the overall framework of regulation encourages competition to the extent it might. In this connection we note the recent measures that the Government proposed with respect to foreign bank branching as positive and we return to this issue of competition when we discuss Benefits to Customers later in this Report
V. Recommendations and Criteria to be Applied
On the basis of the background we have sketched above, the relevant factors we have identified, and our approach, we set out below four general recommendations and a number of criteria that we conclude should be examined by those responsible for reviewing the specific transactions.
- We recommend that a "big shall not buy big" policy, as it affects transactions between entities other than two Schedule I banks, should not have general application and that any such proposed transactions be reviewed for approval on their merits.
We expect that any transactions that may be considered between now and the time the Task Force reports will be considered within the existing legislative framework, and we also indicated the possibility that the Final Report of the Task Force might recommend changes to the legislative framework that would affect such transactions. We do not expect the world to wait for our Final Report. Changes are taking place quickly, decisions must be made and it would be unrealistic to put everything on hold until our processes have concluded. We do believe, however, that if the Government in response to our Final Report makes legislative changes that would affect transactions that occur after our Final Report is submitted, such changes should – to the degree practical – also apply to any transactions that are approved between the submission of this Report and our Final Report. We want to be clear that we are not proposing that completed transactions be unwound. But if there are conditions of behaviour that are sought from participants in future transactions then it seems reasonable to us that such conditions be sought from participants in the type of transactions we are now considering, to the extent it is feasible for such conditions to be met.
Once it is determined that a specific transaction should not be prohibited by the "big shall not buy big" rule, it should be assessed on its merits. Prior to consideration by the Minister, such transactions should be reviewed by the Director of the Competition Bureau in order to assess whether the merger results in a substantial lessening of competition, and by the Superintendent to assess safety and soundness considerations. There is no reason why these reviews need be sequential in timing. They could proceed together.
Then the Minister, with advice from the Superintendent, would consider the request for approval, applying criteria felt to be relevant to a determination of the public interest. For analytical purposes, we assume the Superintendent deals primarily with safety and soundness while the Minister deals with the public interest elements, although we recognize that in practice there is no such sharp distinction between their areas of responsibility.
In what follows, we comment on the criteria that we think should be employed in assessing Competition, Safety and Soundness, and the Public Interest.
- Competition
In considering competition we draw a distinction between wholesale and retail markets. In wholesale markets it is generally the case that customers are large, relatively sophisticated, and have access to multiple suppliers of financial services, both domestic and international. It is true that there are exceptions to this, but as a general presumption it is a useful distinction between wholesale markets and retail markets where, more often, individual customers (including small businesses) are provided with financial services by suppliers that tend to be resident in a specific geographic area. Again, one can find exceptions for some services provided to retail customers (such as credit cards) but as a general characterization we think this distinction between retail and wholesale is a useful one.
The operational significance of this distinction is to underscore the necessity to examine the potential anti-competitive impacts of transactions such as those considered in the Report in terms of "local or regional" markets. As we use the term, a local market is one in which a particular segment of customers in a particular geographic area is highly dependent on providers of particular financial services products that are resident in that area. The paradigm situation today may well be retail depositors in a geographical area, but small business lending is likely also to be within this category.
The appropriate geographic area for analysis is not obviously apparent nor is the list of financial products that fall within this definition. The definition of a local market in an antitrust context is important but could become a very labour-intensive process when considering the impact of a financial sector merger. The Task Force recognizes this and also recognizes that, as technology continues to change the nature of financial services products and the way in which they are offered, operational definitions of both "locality" and product range will continue to evolve.
The economic and legal literature, the established practice of the Competition Bureau and experience in other countries is broadly consistent with our emphasis on local markets as being the prime concern in an assessment of the potential anti-competitive impact of a merger. But there is a lack of consensus as to the methodology by which to assess the extent of the competitive impact in those markets.
- The Task Force recommends that the impact of mergers on the state of
competition(both wholesale and retail) in local or regional markets should be given
careful attention and efforts should be made to develop practical operational definitions
of such markets.
A merger can have favourable impacts, bringing to customers the benefits of efficiency and cutting-edge competition. In assessing potential negative impacts, the emphasis in competition law generally is on the ability of the merged entity to dictate and sustain a price increase, although other factors such as choice, quality and innovation are also considered. In the financial services sector related issues such as the potential for discriminatory pricing and coercive tied selling may merit greater concern than is generally the case with mergers in other sectors of the economy. This may be of particular importance when the influence of a merged entity in a specified geographic area results in substantial market positions in a number of complementary products, such that the potential for discriminatory pricing or coercive tied selling is less easily diminished by the ready availability of competitive offerings.
This is a topic we will analyze in our ongoing work. We cannot at this time predict whether any recommendations will emerge for changes in policy or regulations to address the issues, although we do not expect that our recommendations would lead to denial of any mergers that would pass scrutiny under the analysis set out in this Report.
We are also addressing in our work the more traditional concern of competition law with the ability of the merged entity to dictate and sustain a price increase. In March 1991, the Director published Merger Enforcement Guidelines that contain percentage principles to guide the Director in this analysis. If the Director follows these guidelines (which he is not obligated to do), it would mean that he would not challenge a merger transaction based on impact on competition within a market unless the transaction results in market shares that exceed these thresholds.
At this stage of our work we are not in a position to reach a firm conclusion about the appropriateness of these guidelines to mergers of financial institutions. We intend to pursue this issue in our research and may be prepared to offer more definitive conclusions in our final report.
Section 29 of the Competition Act precludes the Bureau from disclosing any information to which it is entitled to conduct its examinations "except to a Canadian law enforcement agency or for the purpose of the administration or enforcement" of the Competition Act. The Director can, with the approval of the merging parties, disclose to other parties information provided to him and his position relating to this information.
- The Task Force recommends that the Director of the Competition Bureau seek, and the parties to such transactions supply, a waiver under Section 29 of the Competition Act that would allow the Director to share information, subject to appropriate arrangements to protect confidentiality, with OSFI and the Department of Finance.
B. Safety and Soundness
We have not conducted research as to the analysis used by the Superintendent of Financial Institutions in the application of safety and soundness standards to the consideration of a proposed acquisition or merger. This is, obviously, a critical element of the approval process but we have no reason to believe that any change is needed in the approach adopted to date by the Superintendent.
We expect the Superintendent will take into account any potential dilutive impact of a transaction on the capital of the merging institutions, and the accounting implications, for example as to the treatment of goodwill.
Among the additional questions to be considered in a safety and soundness analysis is whether prudential considerations flow from differences in activities of the merging institutions. In the United Kingdom, for example, there has been discussion of the prudential implications of a merger between a major bank and a major life insurance company. The discussion focuses on differences in the types of risk undertaken by the two businesses, on accounting differences and on how best to formulate capital requirements for the consolidated enterprise. We do not refer to these considerations by way of suggestion that they should defeat such a transaction, but rather as matters the Superintendent should consider in the course of the safety and soundness review.
The Superintendent should identify any transaction-specific concerns that merit consideration. For example, the Superintendent might wish to consider all of the transparency implications if the acquiring institution proposes to continue to distribute products of the acquired institution under a name that is different from the acquiring institution. We recognize that this is an issue that concerns the Superintendent and on which the Office has acted in past transactions.
- The Task Force recommends that the Superintendent of Financial Institutions acting with other appropriate regulatory bodies should, where transactions are approved, put in place at the outset arrangements to ensure that customers are informed, in a meaningful way, of the relationship between the two institutions that would be under common ownership, including appropriate information on the relevant product insurance or compensation plans that apply.
- The Public Interest
Under the process outlined above, the Minister of Finance must assess the broad public interest considerations that ought to be brought to bear. In our view, if a financial institution merger of the type considered in this Report does not have anti-competitive considerations and does not involve difficulties from a safety and soundness standpoint it ought ordinarily to be approved, subject to considerations such as those noted below. In appropriate cases it is and should be open to the Minister to consider other policies. Areas where consideration could well be appropriate include:
- The impact of a proposed transaction on the international competitiveness of the financial system; on the benefits to customers, on employment; and on the adoption of innovative technologies.
- The precedential implications of the transaction for the development of the financial system.
International Competitiveness
As discussed above, financial services are going through a major transition in all countries. Some analysts conclude that the financial market for wholesale services is now effectively global and that technological advance is leading quite rapidly to a similar internationalization in the supply of retail services. These trends imply greater choice and lower prices for customers. They also imply that competition worldwide will continue to intensify.
Our major domestic institutions (both banks and life insurance companies) have historically conducted a considerable part of their business and derived substantial revenues from their operations outside of Canada. Their success abroad has been based in large part on their strength in the domestic market and has, in turn, enhanced their ability to serve Canadian customers well. The Task Force is undertaking research to understand better the relation between size and international competitiveness. This research is at an early stage and we have no firm conclusions to put forward at this time. But we do believe that it is important to recognize that we have been well served in Canada by financial institutions that have, historically, been internationally competitive and the extent to which such transactions contribute to more internationally competitive enterprises should be an important criterion in the Minister's assessment.
Benefits to Customers
The Task Force believes that transactions such as those under consideration should provide benefits to customers. We use the word customer in the most general sense as including both individuals and businesses, small and large, that use the services of financial institutions. A finding under the Competition Act that such transactions do not substantially lessen competition is a necessary condition for such benefits to be provided. As indicated above we assume that such examination will extend to the assessment of potential for anti-competitive practices that go beyond pricing to include behaviour such as price discrimination and coercive tied selling. Even where it is concluded, however, that competition is not substantially lessened it does not automatically follow that the competitive structure in the marketplace (and particularly in some markets) will be robust enough to provide reasonable assurance that the efficiencies, synergies and innovative results of the transactions will be reflected in benefits to customers in the short term as well as in the longer run. It is open to analysis and examination as to whether such transactions need to be reviewed with regard to their particular impacts on, for example, access to financial services for low income Canadians, confidentiality of personal information, and availability of finance to small businesses or knowledge based industries.
At this stage in its deliberations the Task Force has no specific recommendations to make in this area. It does recognize, however, that these concerns that impact on the benefit to customers may be best examined in the context of the specific characteristics of individual transactions.
It is also important that individual transactions be examined against the background of existing and potential competition in particular sectors. To the extent that the general policy framework is conducive to new sources of competition, one can be more confident that the market environment will lead to customers reaping the expected benefits of such transactions. This is an important area that the Task Force will examine.
Employment
The impact of transactions on employment is a significant criterion in assessing the public interest. It is important to distinguish between indirect and direct effects, and long-term and short-run impacts. By indirect effects we refer to the impact on employment elsewhere in the economy that comes from the contribution of the transaction to efficiency and economic growth, as distinct from the direct employment impacts of the transaction itself. Long-term impacts include not only the indirect impacts on the rest of the economy, but also the longer-term direct impacts that result from the future growth of the merged entity. Short-term impacts refer to the employment consequences of merging the operations of the parties to the transaction.
One would normally expect the indirect impacts to be positive and the longer-term direct impacts might be positive or negative, depending upon the nature of the transaction. Short-term impacts will usually be negative.
An important consideration to take into account in assessing employment impacts is the rapid internationalization and increasing competitiveness of the worldwide financial system. Canada is not an island unto itself, and it is unlikely that attempts to preserve the status quo in a rapidly changing world will best serve the public interest. The Task Force believes that mergers that can be shown to increase competitiveness, enhance innovation and benefit customers will – over the longer term – contribute to greater economic growth and greater employment opportunities for Canadians than we would otherwise enjoy. But in the short run there will most likely be transitional impacts that result in job loss.
The Task Force intends to examine these issues further. It will consider areas such as the importance of attrition and severance and retraining packages and it may, in its Final Report, provide conclusions and recommendations about ways in which transitional impacts can be most appropriately managed. At this stage of our work, we flag this as an important public policy issue for the Minister to take into account in reviewing the transactions.
The Adoption of Innovative Technologies
This is an area in which the Task Force has commissioned research that will provide insight as to the effectiveness of our domestic financial institutions in adopting new technologies that can provide a broader range of choice to customers and contribute to a vibrant financial sector. The changes that are taking place in the world are leading to a competitive advantage for institutions that can maintain themselves at the leading edge of technological developments. To do so increasingly requires relatively large expenditures. The Minister of Finance should consider whether transactions have a positive or negative impact on the capacity of institutions to adopt innovative technologies.
Precedential Impact
As a final comment, we point out that approval for certain transactions – in the context of relaxing the "big shall not buy big" rule – may have precedential impact on decisions in the sector. We do not feel that these potential impacts are so serious at this time to cause us to reconsider our recommendation that the "big shall not buy big" rule not apply. However, we recognize that this is an issue that the Minister may legitimately wish to address.
There is a well-recognized exception in competition law to accommodate a merger that rescues a failing firm, even if the merger might not otherwise have been acceptable. Historic practice of the Minister in considering the approval of financial sector transactions recognizes similar considerations. We believe this exception should be preserved, and we recommend that it be applied where appropriate. The nature of a financial institution's business is such that serious problems can occur very quickly after the deterioration process has begun.
The Task Force believes that this Report will be helpful to the Minister of Finance in providing criteria to assist in his review of transactions. We do stress again, however that these views are preliminary and we will be continuing to consider them as our work progresses.
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