Finance Canada
Reforming Canada's Financial Services Sector -- A Framework for the Future: 3
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3    Fostering Domestic Competition Highlights The government is acting to increase the degree of competition in the domestic marketplace 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. Fostering competition benefits consumers Strong competition is essential to quality, price and innovation in the marketplace. It is also a necessity if financial institutions are to serve Canadians well and succeed in the international marketplace. Policies to foster competition are among the most fundamental and effective methods for government to promote consumer benefit. Overall, Canada's financial services sector is already quite competitive. Canadians can choose from a variety of suppliers for a full range of financial services: Canadian chartered banks, foreign banks, credit unions and caisses populaires, life insurers, securities dealers and specialized finance companies. However, the Canadian banking sector has a poor record of new entry. Since 1987, there have been only two new Schedule I banking charters in Canada, while the U.S., for example, had 207 new banking charters in 1997 alone. The lack of new entry is not in the best interests of Canadian consumers. The government intends to facilitate new bank entry while at the same time introducing initiatives to strengthen the "second tier" of smaller financial institutions, often community-based, that provide an alternative to the larger financial institutions. Public policy must strike a balance between the benefits of increased competition and the need to ensure the continued safety and soundness of the financial sector. Measures to increase competition, though certainly beneficial to consumers and to the economy as a whole, may increase risk to the financial system. It is also important that the supervisory system be capable of ensuring that any increased risks can be appropriately managed. Chapter 5 proposes several enhancements to the supervisory system that provide the necessary tools to discourage imprudent behaviour by financial institutions. Enhanced Competition The Task Force concluded that "Canadians will be best served by a dynamic, competitive marketplace, open to the world, with many successful Canadian providers and with opportunities for many new entrants," but that "individual Canadians and small businesses, in particular, are not as well served as they should be and can be." Task Force on the Future of the Canadian Financial Services Sector, Change, Challenge, Opportunity: Report of the Task Force, September 1998, pp. 14-15. The new ownership regime will make it easier to start a small bank To enhance competition, the government will establish a size-based ownership regime and reduce minimum capital requirements to facilitate new entry, strengthen the financial co-operative sector, expand access to the payments system, and permit foreign banks to offer services to businesses and individual consumers via branches as well as through subsidiaries. Encouraging New Entrants The New Size-Based Ownership Regime Ownership Rules for Banks The current ownership rules can present barriers to new bank entry. One way to increase competition is to make the ownership rules less of a hurdle to prospective new entrants. Current Rules As noted earlier, ScheduleI banks must be widely held. Schedule II banks may be closely held by certain institutions and individuals subject to a "fit and proper" test. Those eligible to have a significant interest (in excess of 10 per cent of the shares) in a Schedule II bank are: a widely held Canadian financial institution other than a bank ("eligible Canadian financial institution"); a foreign bank or a widely held foreign financial institution ("eligible foreign financial institution"); or any person for the first 10 years of the bank's operations. In addition, Schedule II banks are required to have 35 per cent of their voting shares traded in the public market once equity exceeds $750 million. The existing rule requires all banks not held by an eligible financial institution to become widely held after 10 years regardless of size. This means that entrepreneurs who take on the risk of starting a new bank are required to sell all but 10 per cent of their shares within 10 years, possibly just when the bank is starting to become profitable. This acts as a disincentive to new entry because many entrepreneurs would not want to start up a business that they must subsequently sell. New Rules The new size-based ownership regime will be more welcoming to new entrants. The new rules will be based on size with the widely held requirement applying only to the largest banks, where the concerns regarding the impact of failure on depositors and the wider economy are greatest. Small and medium-sized banks will have the added flexibility of being able to be closely held indefinitely. The new ownership rules will have three size classifications – small, medium and large – based on the size of the bank as measured by equity. Equity "‘Equity', in respect of a bank, means the sum of the shareholders' equity of the bank and the minority interests in entities controlled by the bank as they appear in the consolidated financial statements of the bank." Bank Act, subsection 381(4) Subsection 381(4) of the Bank Act currently defines equity for the purposes of the $750-million public float requirement. The calculation of equity for the purposes of applying the size-based ownership thresholds will be based on this approach. Canada's large banks (whose equity is currently greater than $5 billion) will continue to be widely held, under the new definition of "widely held." As is now the case, eligible financial institutions, that is, widely held Canadian and foreign financial institutions, and foreign banks, will be able to closely hold a bank whose equity grows past $5 billion. Medium banks with equity of between $1 billion and $5 billion will be allowed to be closely held, but will be required to have a 35-per-cent public float of voting shares. Publicly floated stocks refer to shares that are listed and posted for trading on a recognized stock exchange in Canada and that are owned by persons who: have no significant interest in any class of voting shares; and are not entities controlled by a person who has a significant interest in any class of voting shares. The 35-per-cent public float requirement ensures that any bank with equity over $1-billion is subject to disclosure requirements under the securities laws in the interest of transparency. This enables the scrutiny of professional market analysts, rating agencies and other stakeholders. The 35-per-cent requirement also serves as a transition stage for a bank as it grows through the $1-billion threshold and approaches $5 billion. Small banks with equity of under $1 billion will have unrestricted choice in ownership structure. This means that new banks can be 100-per-cent owned, even by a commercial enterprise, as long as their equity is under $1 billion. For existing Schedule I banks with equity of less than $5 billion, their widely held status will be maintained. However, there may be circumstances where it could be advantageous for one or more of these banks to consider a closely held structure. Therefore, if requested by a bank, the Minister of Finance will have the discretion to change the status of the bank to that of the new regime for banks under $5 billion. When a bank grows from one threshold level to the next, it will have three years to make the transition to the ownership rule applicable to its new size category, but may apply to the Minister of Finance for an extension if unusual circumstances prevent it from getting fair value for its shares during the transition period. A similar rule is already in place with respect to the current $750-million threshold. Table 3.1 Ownership Regime for Domestic Banks Equity Ownership restrictions Large (greater than $5 billion) Widely held – no shareholder can own, directly or indirectly, more than 20 per cent of the voting shares or more than 30 per cent of the non-voting shares. Medium (between $1 billion and $5 billion) 35-per-cent public float of widely held voting shares.  Small (less than $1 billion) No ownership restrictions. Ownership Rules for Demutualized Life Insurance Companies There are two broad types of life insurance companies in Canada, distinguished by the nature of their ownership. Mutual insurance companies are owned by their participating policyholders, the people who are covered by the policies that the firm issues. In contrast, stock life insurance companies are owned by shareholders, separating the ownership of the firm, and therefore the raising of capital, from the coverage of the policies that the firm issues. Since the 1950s, the largest segment of the life insurance sector has been the mutual life insurers. The effect of this has been that, as with our Schedule I banks, they have been widely held. When legislation was passed in 1992, it was specified that large demutualized insurers would remain widely held. Therefore, the widely held concept was extended to these insurers even as they were to be converted to stock companies. Consistent with the approach to bank ownership, the government believes that there is merit to continuing to have the large mutual life insurers widely held after demutualization. At the time of tabling the recent demutualization legislation, the government announced that it would review the wide ownership policy two years following promulgation of the regulations. The government has decided to define the policy now. All demutualized insurers will have a two-year transition period following demutualization during which no one shareholder can hold in excess of 20 per cent of the voting shares and 30 per cent of the non-voting shares of the insurer. No mergers among, or acquisition of, demutualized firms will be permitted during the transition period. This transition period will allow the firms sufficient time to adjust to their new form of ownership. The application of this process would need to take into account changing circumstances in the condition of the companies. Once the transition period ends, the demutualized insurance companies will be subject to the same ownership regime as banks. As a condition of demutualization, all demutualized insurers that have equity in excess of $5 billion will be required to meet the new widely held rule after the two-year transition period. As with the widely held banks, these companies cannot be acquired. Large mutual life insurers will continue to be widely held after demutualization Having these large demutualized companies remain widely held will help ensure the maintenance of a strong insurance sector. Demutualized insurance companies under $5 billion in equity will retain their widely held status. However, as with the banks, if requested by the institution, the Minister of Finance will have the discretion to change their status to closely held, subject to the 35-per-cent rule. If permitted to become closely held, demutualized insurers with equity between $1 billion and $5 billion will be subject to the 35-per-cent rule. Demutualized insurance companies with equity of less than $1 billion will be subject to no ownership restriction other than "fit and proper" tests. Ownership Rules for Trust Companies Under the current ownership regime, trust companies can be closely held but are subject to a 35-per-cent public float requirement of their voting shares when they reach $750 million in equity. A number of firms have found this to be an effective means of holding an interest in a deposit-taking institution. The government proposes to maintain this ownership rule for trust companies. However, the threshold will be moved to $1 billion in equity. Ownership Rules for Stock Life Insurance Companies Federal stock life insurance companies are not currently subject to a widely held rule, but are required to have a 35-per-cent public float of voting shares if equity exceeds $750 million. For these firms, the 35-per-cent public float requirement will be maintained, but the threshold will be raised to $1 billion in equity. Table 3.2 Summary of New Ownership Regime Equity Banks Life Insurers Trust companies P&C Insurers Demutualized stock company1 Other stock company Large (greater than $5 billion) Widely held2 Raises current ownership limit from 10% of shares to 20% voting and 30% non-voting Widely held2 Raises current ownership limit from 10% of shares to 20% voting and 30% non-voting 35% public float No change 35% public float No change 35% public float No change Medium (between $1 billion and $5 billion) 35% public float3 Threshold raised from $750 million to $1 billion. 35% public float3 May become closely held after transition period, with 35% float requirement at $1 billion 35% public float Threshold raised from $750 million to $1 billion 35% public float Threshold raised from $750 million to $1 billion 35% public float Threshold raised from $750 million to $1 billion Small (less than $1 billion) No restrictions3 Removes all ownership restrictions for small banks No restrictions3 No ownership restrictions for small demutualized insurers after transition period No restrictions No change No restrictions No change No restrictions No change 1.    A transition period of two years has been established for demutualized life insurance companies. During the transition period, the companies cannot merge or be acquired. 2.   Banks and demutualized life insurers held by an eligible financial institution will not be required to meet the widely held requirement if they grow over $5 billion in equity. 3.  Existing banks and demutualized insurance companies below $5 billion in equity will remain widely held. The Minister of Finance will have the discretion to allow them to become closely held. Ownership Rules for Property and Casualty (P&C) Insurers Federally regulated P&C insurance companies are also not currently subject to a widely held rule, but are required to have a 35-per-cent public float of voting shares if equity exceeds $750 million. For P&C firms, the 35-per-cent public float requirement will be maintained, but the threshold will also be raised to $1 billion in equity. The approach taken to the ownership regime for trust companies, stock life insurance companies and P&C insurers recognizes the fact that the historical development of the ownership structure for these companies has been different than that of our banks and mutual life insurers. Reduced Minimum Capital Requirements Governments require a minimum amount of money to be paid into a regulated financial institution. This minimum level of capital is required to ensure that: the principal shareholders are strongly committed to the institution; and the new financial institution has enough capital to support its operations from the outset, and thereby reduce the likelihood of failure. The need for substantial minimum capital requirements must be balanced against the desire to encourage new entry. Overly restrictive minimum capital requirements can effectively preclude a range of new entrants to the market. This is particularly true in regions where there are relatively few potential investors with substantial capital. Easing ownership and capital requirements may lead to the creation of community-based financial institutions It is the government's view that the current minimum capital requirement of $10 million is overly restrictive and may limit new entry into the market. In order to address this concern, the minimum capital requirement to start a new bank, trust or insurance company in Canada will be lowered from $10 million to $5 million. All applicants will remain subject to a full "fit and proper" test before being granted a charter. It is hoped that the less restrictive ownership requirements and the lower minimum capital requirements will lead to the creation of smaller financial institutions, including ones established to serve their particular community. Expanding the Financial Co-operative Sector Caisses populaires and credit unions have historically been among Canada's most innovative financial services providers Canada's caisses populaires and credit unions are member-owned, community-based financial institutions. These local co-operative institutions play an important role in providing financial services to Canadians in every province across the country, often in communities where no other financial institutions are present. Historically, financial co-operatives have been among the first in the Canadian market to provide innovative services, such as extended service hours, bank machines, telephone banking and the virtual bank. However, the structural fragmentation of the credit union system outside of Quebec has been identified as a potential barrier to future growth for the credit union industry. Several specific challenges have been identified in this regard, including: the inability to service members moving to other provinces; the constraints on opportunities to pool resources and skills among credit unions in different parts of the country; the duplication of backroom activities and administrative costs between individual credit unions and between provincial centrals; and a lack of co-ordination in areas such as common products and services. The credit union movement is seeking to meet these challenges with two initiatives: Some credit unions are spearheading an initiative to permit them to evolve into a two-tier structure, with enhanced co-ordination. Other credit unions are considering a national co-operative bank structure. The government recognizes that credit unions are an important priority for the provinces and will be seeking their views on these initiatives. In keeping with the democratic philosophy of governance in the credit union movement, the individual credit unions will be given an opportunity to assess and approve these proposals. Creating a National Service Entity for Credit Unions One proposal calls for the current three-tier structure of local credit unions, provincial centrals and the federal central to be collapsed into two by eliminating the provincial centrals. The top tier in the system is to become a new National Service Entity. These changes will provide a mechanism for participating credit unions to reduce costs, eliminate duplication and overlap, promote stronger co-ordination and create national brands. This will enable them to better meet the needs of their individual members at a lower cost. To accommodate this initiative, the government will introduce legislative amendments to permit a restructured two-tier system with an enhanced national presence. Creating a Framework for Co-Op Banks Several members of the co-op system want to develop a co-operative bank structure under which they could operate on a national basis. One such structure being considered is along the lines of successful co-op bank models in other countries, such as Rabobank in the Netherlands. The government is supportive of the general direction of these proposals and is prepared to assess legislative steps that can be taken to accommodate a co-op bank structure. In this regard, the government will work closely with interested credit unions over the next several months as details on their proposals are more fully developed. The Payments System Canadians enjoy the benefits of one of the most reliable and efficient paper-based payments systems in the world. In fact, the system works so well that it is largely taken for granted. The efficiency with which cheques and other paper-based payment items are cleared and settled, together with a high level of confidence in the system, allows payees, in most instances, to receive immediate use of funds when they deposit a payment item in their account at a financial institution. This is the case even though settlement does not take place until some time later. What is the Payments System? The payments system in Canada is a network of competing and complementary services that facilitates transactions involving the exchange of a means of payment in return for goods, services, real assets and financial assets.  The means of payment can take on many forms -- from traditional instruments such as currency and chequable deposits in banking institutions, through debit and credit cards, to modern electronic vehicles such as stored-value cards and network tokens in a electronic purse.  The instruments, rules, institutions and technical processes that facilitate the transfer of value to discharge the payment obligations, and that govern the intermediary agents involved, form the architecture of the payments system in Canada.  As a central element in the economic infrastructure, the payments system has a significant effect on the operating efficiency of the Canadian economy. In 1996, the government announced that it would undertake a review of the structure and operations of the Canadian payments system. A Payments System Advisory Committee was established, which included individuals from the financial sector, consumer groups and academia. The staff of the Bank of Canada and the Department of Finance published four background papers in support of the Committee's work. These covered a number of areas, including public policy objectives for the payments system, access to the system and system governance. The review identified three key public policy objectives for the system: efficiency, safety and the consideration of consumer interests. It was recognized that these objectives could be competing. For example, an excessive preoccupation with efficiency might undermine the need to preserve the safety of the system. Thus, the policy challenge is finding the appropriate balance among these objectives. An important dimension of access to the various payments systems in Canada is membership in the Canadian Payments Association (CPA). Created under federal statute in 1980, the CPA plays a central role in co-ordinating payments system activity. Membership in the CPA is presently limited to federally and provincially regulated deposit-taking institutions. The CPA operates two national clearing and settlement systems: the Large Value Transfer System, which became fully operational in February 1999 and is designed to handle large-value time-sensitive payments, and the Automated Clearing Settlement System (ACSS), which handles all other payments. To be a participant in either system, an institution must be a member of the CPA. In the case of the ACSS, CPA members are further differentiated as Indirect and Direct Clearers. To be a Direct Clearer, an institution must account for a minimum of 0.5 per cent of the total national clearing volume. Deposit-taking institutions may also apply to Interac to be a card issuer. After a review of the competition and prudential issues relevant to the payments system, the government has concluded that access to the system should be broadened to accommodate the entry of life insurance companies, securities dealers and money market mutual funds, provided that the concerns discussed below are appropriately addressed. Since money market mutual funds and securities dealers are provincially regulated, there will be further discussions with provincial regulators to explore rules and conditions under which these institutions can enter the payments system. The review was based on criteria outlined in the Department of Finance Payments System Review Discussion Paper released in July 1998. These criteria were developed to assess potential entrants and to ensure that broader access would not adversely affect confidence in, or the operation of, the payments system. The first criterion was that potential new entrants be subject to formal regulatory and supervisory oversight to ensure that all payments system participants follow guidelines of prudent behaviour. Life insurance companies meet this criterion, and it is recognized that securities dealers are subject to a form of prudential oversight. While money market mutual funds are not subject to the prudential regulation applied to other financial institutions, the nature of these funds is such that they should not impose significant credit risk on the payments system. The second criterion requires that potential new entrants have access to an immediate, reliable source of liquidity since payments system participants may, from time to time, have insufficient balances to meet all outstanding obligations. Life insurance companies and securities dealers meet this criterion. For money market mutual funds, access to the payments system will be conditional on the ability to pledge assets, and borrow up to 5 per cent of a fund's net assets, as permitted by Canadian securities regulatory authorities under their National Policy No. 39, without being required to seek regulatory authorization for each borrowing or asset pledge. Life insurance companies, securities dealers, and money market mutual funds will be part of the payments system The third criterion is an appropriate legal foundation for participation in the payments system. Participants need assurance that their rights and obligations will be upheld, both in the normal course of business and in the event of the failure of a member. Securities dealers meet this criterion. However, under the federal Winding-up and Restructuring Act, in the event of the insolvency of a life insurance company, the claims of policyholders rank ahead of those of other unsecured creditors. As a result, payments system participants could face relatively higher losses in the event that a participating life insurance company failed. Moreover, there are a number of complex legal issues that may not make it possible for money market mutual funds to be Direct Clearers in the ACSS. To respond to this concern, life insurance companies and money market mutual funds will be eligible to be Indirect Clearers, but not Direct Clearers, in the ACSS system. Collateral, deposit and other requirements that may be imposed by the Direct Clearer will be determined by bilateral agreement. A final criterion for entry into the payments system is the technical and operational capacity to perform the necessary functions and actually clear items within established cycle times, and to settle balances according to established procedure. The government believes that life insurers and securities dealers have this capacity already. Money market mutual funds that demonstrate the technical and operational capacity to perform as payments system providers may be permitted to become CPA members and to act as Indirect Clearers in the ACSS. Permitting these new financial institutions to join the CPA will enable them to offer a broader range of services to their clients. This promotes increased competition for the consumer's business. For example, life insurance companies would be able to offer accounts with some of the features of deposit accounts offered by banks, such as cheques or debit cards. With respect to debit cards, authorization would be required by Interac. Foreign Bank Branching Legislation has removed an unnecessary regulatory barrier to increased competition by allowing foreign banks to offer specified services in Canada through branches, rather than requiring them to set up separate Canadian subsidiaries. For many foreign banks, this will be more cost-effective. This measure encourages a healthy foreign bank presence, which should in turn lead to a wider range of financing sources for both large and small Canadian businesses, as well as greater choice for some types of consumer lending, such as credit cards or personal lines of credit. Foreign Bank Activity in Canada Since 1980, foreign banks have been allowed to establish regulated banking operations in Canada through the incorporation of separate Canadian bank subsidiaries. These subsidiaries have the same business powers as domestic-owned banks and are subject to essentially the same regulatory oversight by the Office of the Superintendent of Financial Institutions. Many foreign banks have established bank subsidiaries in Canada over the last two decades, with foreign banks playing an important role in the Canadian financial services sector. While a few foreign bank subsidiaries engage in retail banking, most offer primarily commercial banking services. Since reaching a peak of 59 in 1987, the number of foreign bank subsidiaries in Canada has declined to just 42 in 1999. Their share of total banking sector assets, which stood at about 12 per cent in 1990, fell to just under 10 per cent by the end of 1998. With the passage of legislation in June 1999, foreign banks may operate branch operations in Canada without incorporation. A healthy foreign bank presence means greater financing sources for Canadian businesses and more borrowing options for Canadian consumers A foreign bank now has the option of establishing one of two types of branches: either a full-service branch or a lending branch. This allows the level of regulatory requirements to be tailored to the foreign bank's activities in Canada. Neither type of branch is permitted to take retail deposits, defined as deposits under $150,000 (foreign banks that want to take retail deposits in Canada still have the option of doing so through a subsidiary). Full-service branches are permitted to take deposits greater than $150,000 while lending branches are not permitted to take any deposits. In addition, lending branches are restricted to borrowing only from other financial institutions. Since this puts no individual Canadian's funds at risk, lending branches face fewer regulatory requirements than full-service branches. This initiative pre-dates the establishment of the Task Force on the Future of the Canadian Financial Services Sector. However, the Task Force, as well as the House of Commons Standing Committee on Finance and the Senate Standing Committee on Banking, Trade and Commerce, supported easing the barriers to entry for foreign banks as expeditiously as possible. The government's foreign entry regime for banks, including those changes made to allow foreign banks to establish branches, will be reviewed in the context of the new framework described in this paper. Any legislative amendments to the foreign entry regime will be made concurrent with the legislative package implementing the new framework. Until the legislation is passed, the current regime for foreign entry will be maintained.

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