This is the second instalment in Access Denied, a four-part series on protectionism in Canada and beyond. Read part one here.
The Big Six banks probably do not need much in the way of protection. They are among the country’s most profitable companies and, judging by their expansion into the United States and elsewhere, their more pressing concern at the moment may be breaking into other markets.
For example, Bank of Nova Scotia is growing its footprint in Latin America; Toronto-Dominion Bank has become one of the biggest retail lenders in the U.S.; Bank of Montreal and Canadian Imperial Bank of Commerce are duelling for customers on the streets of Chicago; and Royal Bank of Canada made its show business debut by buying Los Angeles-based City National Bank.
If anything, their would-be challengers may welcome some protection of their own, since the rules in place here can act as their own sort of moat for the banks — a kind of protectionism via regulation.
Canada has a reputation for having a relatively steady banking sector and the high degree of regulation is intended to keep the financial system safe. Yet the same rules keeping everything on an even keel could also have the unintended consequences of limiting competition and consumers’ choices.
Current rules include restrictions around ownership and anti-money laundering practices, but there are also certain regulatory requirements for capital and other well-meaning standards that set a high bar to clear for any potential newcomers.
“The bigger and perhaps new conversation in Canada about the ease of access or competitiveness of our financial services sector in my opinion is where Canada practices protectionism,” said Sue Britton, chief executive and founder of the FinTech Growth Syndicate Inc., in a written response to questions from the Financial Post.
“We have organizations, policies and regulations designed to reduce risk and, therefore, access to consumers by new competitors in financial services — for example, new startups cannot access the systems to process payments without having a bank partner — and that is the big discussion right now.”
Regulation can have the side-effect of pumping the brakes on innovation. A December 2017 study by the Competition Bureau noted there were a number of heavily regulated “barriers” at both the federal and provincial levels that could hinder technology companies trying to enter the financial services market.
“Although these regulatory frameworks are unquestionably important in safeguarding consumers and mitigating risks to the financial system as a whole, they can inadvertently deter innovation and the competitive benefits that follow,” the study said.
We have organizations, policies and regulations designed to reduce risk and, therefore, access to consumers by new competitors in financial services
For instance, robo-advisers, which can challenge the traditional wealth management offerings of the banks, must hire “advising representatives to be involved in portfolio decision-making,” the report said, “increasing costs and impeding the development of automated solutions.”
And when it comes to lending, “technology-driven financing platforms are subject to the same regulations as their bricks-and-mortar counterparts, despite potentially different risks associated with their business models.”
But for banks, the main piece of relevant legislation is the Bank Act, the first version of which was passed in 1871, though it has been periodically updated ever since. A federal government document called the Evolution of the Canadian Banking System Since Confederation noted the first Canadian banks were even in business before the passage of the bill, and that “the early practice of banking in Canada reflected, as well, a British heritage.”
“The British valued bank stability over experimentation, and the Colonial Office maintained close control on early practices in British North America,” the document said.
That cautiousness extended to what has now become one of the biggest money-makers for Canadian banks: home loans.
“The longstanding prohibition against mortgage lending by banks was removed in the 1954 Bank Act revision,” the document said.
In its current iteration, the Bank Act generally also sets out that bigger Canadian banks, such as RBC or TD, must be broadly owned, which hinders takeover possibilities.
A Department of Finance Canada official said in an email that a person can buy up to 10 per cent of any class of shares of a financial institution in Canada. However, they added, an investor can acquire a larger stake in a bank if they receive approval from the federal finance minister.
“Approval involves conducting a fit and proper test on the applicant,” the official said. “A fit and proper person is one that has the character, integrity, and sound business plans and resources to own and operate a financial institution.”
Despite this, a single investor’s ownership stake in a large bank — lenders with equity of $12 billion or more — is typically capped at 20 per cent of any class of voting shares, the official said.
“The widely held requirement is one of the strengths of Canada’s financial system, which has proven to be resilient in the recent economic crisis,” they added. “The widely held rule helps prevent inappropriate self-dealing, including the potential distortion of credit allocation by a commercial owner. It also imposes a high degree of transparency and market oversight.”
Foreign banks can set up shop in Canada, but the Bank Act again sets out a number of considerations the government must take into account before allowing one to do so. Those considerations include “the business record and past performance of the foreign bank,” and “the best interests of the financial system in Canada.”
The process to opening a bank branch in Canada can also be a gradual one, as realized by Silicon Valley Bank. The lender in May 2017 applied to establish a branch in Canada; it received an order from Canada’s finance minister authorizing that branch this past March, but said it was still subject to further approval from the Office of the Superintendent of Financial Institutions, Canada’s banking regulator.
An online explainer from law firm Norton Rose Fulbright on foreign banks said that branches are merely the Canadian office of an internationally headquartered bank and would not need separate capital or a board.
“However, branches are required to maintain ‘capital equivalency deposits’ in Canada to provide some cushion for their Canadian liabilities,” the law firm said.
Other barriers could be thrown up by the incumbent banks themselves, such as the cost of switching accounts to a new company. According to the Competition Bureau, “fees and penalties for switching increase the costs and difficulty for consumers, which makes adoption of new services or products less likely to happen quickly.”
There’s another side to the money issue. The Competition Bureau said some stakeholders suggested “the dearth of investment focused on fintech companies is contributing to the exodus of financial services sector innovators seeking more fintech-friendly jurisdictions and putting Canada’s global competitiveness at risk.”
Other non-regulatory barriers include a high level of trust in incumbent institutions, making it difficult for new players to entice customers away from them.
Britton agreed there are “big barriers” facing companies trying to break into the financial services sector, but said the current conversations about this are too high level.
“We need to be more specific and talk about payments separately from ICOs or robo-advisers,” she said. “Why? Because our regulatory framework and policies that govern who gets access and who doesn’t is different for virtually every financial offering. Trying to determine who to even talk to in order to assess what regulations apply to your product as a startup is almost impossible.”
Even so, the renegotiation of the North American Free Trade Agreement managed to give the banks a bit of a jolt. Among the U.S. objectives for the trade talks, as laid out a year by the Donald Trump administration, were expanding “competitive market opportunities for United States financial service suppliers” and improving “transparency and predictability in … respective financial services regulatory procedures.”
Trying to determine who to even talk to in order to assess what regulations apply to your product as a startup is almost impossible
Such was the unique nature of the situation that Toronto Mayor John Tory went to bat for the city’s financial services industry, telling BNN last summer that “we’re the ones that are in need sometimes of protectionism, as big as some of our banks are.”
Dave Bauer, a spokesperson for the Canadian Bankers Association, said the “overarching priority of the industry” for the trade talks should be preserving “the spirit and structure of NAFTA’s existing trilateral framework of rules and commitments.”
Still, the industry group suggested that one area where NAFTA could be improved is better coordinating regulations around cross-border financial services activity.
“We are supportive of ways to improve transparency, predictability and coordination in each country’s financial services regulatory procedures,” Bauer said. “All this must be done within the context of each country’s domestic prudential framework that protects investors, depositors and policyholders as well as the integrity and stability of the financial system.”
The CBA also noted that Canada is already home to 22 U.S.-based bank subsidiaries and branches that control more than $80 billion in total assets.
“Similarly, in the U.S. and Mexico, Canadian banks have grown their footprints significantly meeting a wide cross-section of American and Mexican businesses and consumers, as well as Canadian businesses who have taken advantage of NAFTA,” Bauer said. “These benefits were evident during the financial crisis when Canadian banks purchased U.S. banks in financial difficulty, providing stability to local markets.”
The Finance official said that, as in any free-trade negotiation, “our NAFTA negotiating objectives include the preservation of the integrity of the Canadian prudential regulatory framework.”
“We seek to ensure that trade obligations do not require changes to the regulatory framework that would undermine our primary goal of maintaining a sound, well-functioning financial sector in Canada,” they added.
While NAFTA gets sorted, Canadian banks continue to eye international expansion, particularly in the U.S.
“By and large, commentary from BMO and TD suggests that with uncertainty removed around U.S. tax reforms, the trajectory from Fed rate hikes, and a more supportive regulatory environment, the appetite for U.S. expansion appears to be more receptive,” Barclays Capital recently noted.
“And, while CIBC continues with its integration of Private Bank, and its focus remains largely on organic growth and executing its (stock buyback), complementary tuck-in acquisitions to support the PVTB acquisition, still remain on the bank’s radar.”
The domestic atmosphere may even be making the foreign forays possible. Britton said the Big Six banks “have a disproportionately large share of the market” of around 90 per cent. “And because of that, they control (and are slowing) the pace of innovation to a great extent in Canada.”
However, Bauer noted the federal government recently passed legislation that “modernized” the Bank Act. The updates, he said, allow lenders more opportunities to “collaborate and partner with new entrants, and enables banks to act as a catalyst for innovation across Canada by bringing the fintech community much needed capital, trusted customer relationships and brand power.”
“The new legislation inextricably links banking and technology – and that’s a tremendous step forward for consumers who want more opportunity and choice in a digital world,” Bauer added.
But the status quo has put Canadians at “a significant disadvantage” when it comes to gaining access to new financial products and services, Britton said, adding the lack of competition is undoubtedly stifling growth.
“More of our own innovation has to seek first customers and revenue outside Canada to make it,” she said. “Lately, we seem to be doing a better job of encouraging investment in Canada than we are scaling up our new innovative companies.”
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