“Canadian banks hit record results,” announced a headline in a recent issue of the Financial Times. For many people in the banking industry, these results probably came as no big surprise. For much of the 20th century, Canada’s Big 5 banks were ranked among the Top 50 financial institutions in the world. Their success was due in part to a protective regulatory regime that set the rules for bank ownership, for entry into the sector and for cross-ownership in other sectors, such as insurance. Historically, public policy was generally pro-merger, resulting in a concentrated domestic banking industry that was globally competitive. A recent announcement by the finance minister, however, indicates that bank mergers are not a priority for the new Conservative government, suggesting that there is no end in sight for the current policy paralysis.
Ironically, this protected market ultimately discouraged globalization among the Canadian banks and led to their becoming entrenched — in North America and, subsequently, in Canada. Today, while Canadian banks are unassailable in the domestic market (despite the presence of foreign players), only Scotiabank has a global footprint. The combination of a centralized Canadian banking system and decentralized capital markets was the route to success for the banks in the 20th century. But this traditional industry model is now coming into question among those public policy — makers and corporate strategists who recognize that Canadian banks need to cultivate global financial markets. This raises important questions: what are the correct strategies for domestic banks in a global financial world?(1) What will serve the public best: a model based on a capital markets framework, or one that fosters a Canadian-owned financial industry? A new brief submitted to Finance Minister Jim Flaherty concludes that mergers could create efficiencies and make Canadian banks more competitive with their counterparts in the U.S. But where are the tradeoffs?
Global Finance: The Knowledge Game
The Boston Consulting Group published two studies of the banking industry: “Winners in the Age of the Titans: Creating Value in Banking 2004” (Titans) and “Succeeding with Growth: Creating Value in Banking 2005” (Value). The Titans, defined as banks with market caps of $120 billion and an average size of $180 billion, have reconfigured the global marketplace. U.S. banks predominate on this list: Citigroup, HSBC, Bank of America and JP Morgan Chase/Bank One all make the grade. The study notes that U.S. and U.K. banks excel in the performance rankings. “The five largest banks raised their market cap by 18 per cent per year between 1999 and 2003, increasing their share in worldwide banking from 13 per cent to 16 per cent,” says the Boston Consulting Group. And size does matter, according to the Value study, which says the continuing strong market performance of the banks was fuelled by acquisitions that create new strategic options, primarily in-market mergers. The emergence of Bank of America (once Nations Bank) and JP Morgan/Chase Bank One as Titans, and the possible inclusion of Royal Bank of Scotland, clearly demonstrates the importance of in-market mergers. More tellingly, the Titan leaders come from countries with strong capital markets.
Public policy and regulatory regimes have implications beyond in-market mergers, as can be understood by looking at Citigroup in the U.S. Citigroup has a market cap several times the size of Canada’s big banks and demonstrates the new vitality of U.S. financial institutions. The traditional separation of banks from other financial groups, such as insurance companies, investment banks, equity firms and credit card institutions, for instance, is an obsolete concept. Manulife, one of Canada’s most successful global institutions, has already made this clear. Just as advances in communications and computers have allowed capital markets to break down geographic boundaries, so too have traditional boundaries between product lines disappeared. Convergence and globalization, shaped by capital markets and the financial Titans, are the name of the game.
Equally as striking as the dominance of the U.S. banks is the emergence in that country of new players and specialists, who in part owe their growth to strategic options made possible by the U.S. capital markets. Every competitive force can have an equal and opposite force — even as bigger is better, so too, small can be beautiful. Specialists or segment specialists are a key force in industry evolution. The Boston Consulting Group uses the following typology for banks: asset managers, consumer finance, investment banks, mortgage finance, transaction banks and universal banks. Thanks to capital markets and finance specialists in the U.S., new financial-services firms can form and put competitive pressure on the Titans.
Where do the Canadian banks rank? The Boston Consulting Group Value study ranked four of the Canadian banks in the large-cap category of financial institutions based on their risk-adjusted total shareholder returns for 2000-’04, with the following results:
- Bank of Nova Scotia
- Royal Bank of Canada
- Toronto-Dominion Bank
CIBC ranked sixth among mid-cap FIs, and Investors Group ranked fourth among asset managers. What role has public policy played in creating such outstanding financial results? And are these results sustainable? This paper argues that, while public policy has created a profitable industry structure, this environment is no longer sustainable, despite recent shows of strength from the banks.(2)
Global Capital Markets
Global finance, with its new products, new entrants and new technologies, is a high-tech sector dominated by three types of institutions: capital markets, financial conglomerates and segment specialists; banks and national markets no longer rule the international scene. Capital markets are the main tool for raising capital in ways that are even more customized than those available through the traditional banking system Â¯ for example, from individual investors or pools of investors (mutual funds), or through equity and debt (bonds or commercial paper) offerings. The United States, the most important capital market country, has huge size and depth; in addition, it has the strictest disclosure requirements and rules of corporate governance in the world. Today, the New York Stock Exchange and Nasdaq (and, increasingly, London) set the tone and practice for all other exchanges, making it important that other countries understand how their own markets differ and what the impact of this might be.
Other global changes show five converging trends to promote capital markets: global trade and significant tariff reductions; public policy changes toward market-based mechanisms, from privatization to deregulation; the opening of international capital markets, with Big Bang in London and the unregulated Euromarket in the 1970s; significant financial reforms in the U.S. (such as the Riegle-Neal Act and the Gramm-Leach-Bliley Act, which deregulated U.S. banking by removing restrictions between commercial banking, investment banking and the insurance business, allowing interstate banks to own insurance companies). The emergence of large new pools of capital — held by hedge funds and institutional investors, such as pension funds — increases the pressure on capital market players to be more innovative.
These competitive forces, reinforced by computer technologies and very sophisticated talent pools, mean that the financial sector is global in scope, global in products and global in scale. Today, most of the people living in advanced countries own publicly listed shares (more than half the population of the U.S.; a quarter of the population in Britain, Europe and Japan). Elsewhere, in countries once totally closed to capital markets, new exchanges have emerged, from Warsaw to Shanghai, Mumbai to Moscow. Individuals now count their equities as part of their personal wealth. Clearly, there is a high level of sophistication in people’s understanding of the markets and their ability to create value.
Risk analysis is a central variable, with risk factors broadly defined as market factors that influence tradable instruments. Forty countries now account for 95 per cent of global finance, and macroeconomic indices vary, from interest and exchange rates (which impact commodity spot and future prices) to stock-exchange indices, political risks and sophisticated measures of asset classes (Table 1).
Global finance has become a knowledge business involving? the arbitrage of all manner of assets, from structured debt of governments to future income streams of everything from rock stars to real estate rents. Global financial institutions take these asset classes, develop global and regional indices, monitor trading performance and sell products like mutual funds and country funds based on an allocation of asset types.
The United States is important for another reason: unlike some countries Â¯ Canada for instance Â¯ the Americans developed a banking system that is highly decentralized, if not state by state, certainly region by region. Bank centres abound in the U.S.: New York, Seattle, San Francisco, Houston, Chicago, Boston, Atlanta and Charlottesville, North Carolina. Each city is home to specialized banks and financial services (for example, Boston for mutual funds, San Francisco for venture capital). Each centre has large global firms and small, supportive supplier firms (Coca-Cola in Atlanta, FedEx in Memphis, Boeing and Microsoft in Seattle). The more players there are, the more chance there is of evolutionary success. The emergence of the Titans in the U.S. was fuelled in part by regional players focused on efficiencies and acquisitions, such as Nations Bank (Bank of America) and Bank One, not simply by the large, traditional money-centre banks.
Coincidently, the United States centralized regulation of its capital markets via the Securities and Exchange Commission, under which public policy has a large responsibility for its regulation and performance. All publicly traded firms must report all of their financial transactions. The SEC maintains a very large staff of economic, financial and legal experts, and its talents and intellectual capital are equal to private firms and financial institutions. More to the point, the law is on its side, with enormous powers of subpoena and prosecution, as recent events around diverse firms like Merrill Lynch and Citigroup, Enron and Martha Stewart illustrate. Canada, by contrast, operates with 13 separate provincial and territorial securities commissions. Can Canada and other countries afford to have such decentralized capital market regulation when capital markets crave centralization and speed so they can enhance liquidity?
The future developments of the global financial sector are set out in Table 2 and are built around two related but quite distinct operations. The first is a powerful, world-class central communications system, with state-of-the-art data banks, industry and country profiles and demographics, as well as world-class people to study and assess money flows, financial risks and sociopolitical risks for companies, industries and countries/regions. To illustrate the link between IT systems and banking, top U.S. banks like Citigroup and Bank of America each spend about $3 billion (Canadian) annually, which is about double the amount that Canada’s entire financial industry spends each year. Japan’s top city banks, the equivalent of Canada’s Big 5, together spend about $500 hundred million annually, according to data compiled by Goldman Sachs. These back-office systems now rival governments and military groups, because trade and finance risk usually precedes political or military risk.
The other side of global finance is the front-office marketing network. This organizational strategy model changes over time, as individual countries become trade groups (e.g., South America), as industries become more strategic (e.g., oil and gas in Russia and Kazakhstan, or off southern Africa and in Nigeria), or as sectors evolve to Western standards of technology and output (e.g., India’s software industry or China’s aerospace sector). Retail branch networks may be important country by country to attract customers (e.g., Merrill Lynch acquired Yamaichi Securities retail stores in Tokyo). But financial firms may simply use their back-office IT systems to acquire customers without retail branches, such as ING and Capital One’s have done with their credit cards in Canada. Virtual banks and financial institutions are around the competitive corner.
In 20 short years, global money and financial services have become the world’s biggest industry Â¯ bigger than oil, autos and consumer electronics combined. The largest financial institutions have market capitalization well in excess of $200 billion, more than 25 per cent of Canada’s annual GNP. And the globalization of international finance has dramatically changed not only the nature of the game but also the manner in which public policy responds.
Canada’s Banking Sector and Financial Services
To most people, Canada’s financial system is the story of five large banks that have dominated the life of every city, town and village in the country. This view unfortunately neglects the role of the co-operative system (credit unions)Â¯which started in the Maritimes and spread into Quebec in the form of the very important Desjardins MovementÂ¯and the powerful credit unions in the West, especially Van City in B.C. But what does domestic success mean in today’s world of global finance?
At one time, Canada’s banks were among Canada’s most successful multinationals, but they are now, primarily, successful domestic players. In the formative years of nation– building, Canadian policy-makers and bankers worked to build a Canadian-owned banking system that was anchored in the core value of financial stability but was also adaptable. It was the traditional banking model first developed for Scotland: highly concentrated, centralized, with many local branches. And they succeeded: based on size, Canadian banks ranked near the top in the world. Today, however, despite their strong performance at home, Canadian banks trail the Titans in market cap. Is it possible that the strategic issues currently impacting Canada’s banks are tied to the same public policies that promoted their financial stability and domestic concentration?
Like most strategic industries in Canada (energy, health care, aerospace, the media), the banking sector has been studied to death: the Walter Gordon Commission in 1955, the Porter Royal Commission in 1964, the 1985 McDonald Commission on U.S.-Canada free trade, the 1998 MacKay Commission, plus numerous research reports on components of the financial sector Â¯ mutual funds, pensions, venture capital, a national securities commission. All of these studies have one thing in common: the straightforward conclusion that systemic changes would not seriously conflict with the need for stability in the industry.
But what does stability mean? Historically, it meant a regulatory regime based upon large, centralized banks that provided the retailing and commercial funding services needed to support a growing population and steady economic growth. Public policy-makers like the Department of Finance and the Parliament of Canada agreed that Canada’s banks should be allowed to merge and to develop strategic homogeneity with a broad range of product offerings. Sometimes this meant a bank’s operations were inefficient relative to specialists in the field. Virtually all the small, local banks closed, merged or incorporated into better-capitalized banks like the Bank of Montreal, the Bank of Commerce (later merged with the Imperial Bank of Toronto) and the Bank of Nova Scotia. Gone forever were the local banks, built around local customers and entrepreneurs: the Bank of Prince Edward Island, the Bank of New Brunswick, the Molson Bank and scores of others. Banking centres like Halifax, home in the 19th century to entrepreneurs like Samuel Cunard, founder of the Cunard Shipping Lines, lost out to Montreal in the 20th century, which in turn lost out to Toronto. Now, all of the Big Five banks, plus the lesser-known National Bank of Canada, operate out of office towers on Bay Street, emphasizing the centralized and relatively closed nature of the Canadian banking industry(3).
In some ways, bank dominance had reached its apex by the time of the Porter Commission in 1964 and the subsequent 1967 Revision to the Bank Act. The point is made clear in passages from a text published by the Institute of Canadian Bankers: “The Bank Act, once so highly valued, had turned out to be a straightjacket for those it was designed to help.” The 1967 act started a slow process to remove this straightjacket. The Porter Commission called for a new framework to permit more openness (i.e., fewer barriers to entry), flexibility (less direct government control through interest rates) and more product innovation. The chartered banks, facing unfair competition from “near banks” such as trust and loan companies, wanted a level playing field. The 1967 Bank Act removed restrictions so that the banks could compete more aggressively with the “near banks.” As an offset to their new power, deposit insurance was introduced, a presumed advantage for smaller players.
Unquestionably, the banks were the clear beneficiaries of these revisions, with their many intended and unintended consequences. The 1967 act guaranteed the banking industry would be Canadian-owned and not subject to foreign competition. The entry barriers were designed to exclude the most likely source of powerful new competitors: U.S. financial institutions. Even when the 1980 Bank Act allowed foreign competitors, there were serious restrictions placed on their ability to compete. Innovations driven by dramatic global changes that had begun in the 1970s Euromarkets would have brought changes to key segments of the Canadian market (e.g., SMEs, principally by the Canadian banks).
The government also passed strict ownership rules: no single shareholder could own more than? 10 per cent of bank stock, and foreign ownership was restricted to 25 per cent. In effect, the ownership rules mandated that banks had to be widely held by Canadians. This meant that Canadian chartered banks could not be acquired by foreigners or by other Canadian concerns. This policy is the cornerstone of Canadian banking policy today: it prevents the commingling of industrial and financial institutions, something that was? a concern when so much industrial activity was dominated by large conglomerates like Canadian Pacific, Brascan, the Irvings and Argus Corp. (as a sign of its concern, the federal government established the Royal Commission on Corporate Concentration in 1976). The 1967 Bank Act also granted the banks protection from any real social control: Parliament restricted takeovers, the stock market discounted foreign takeovers, and government regulations freed bank management from direct challenges by Canadian entrepreneurs. If control blocks of stock are not in play, how easily can management be changed?
The second consequence of public policy was that a second tier of strong financial institutions failed to materialize within Canada, in contrast with the U.S. (local and regional banks), Britain (building societies) and Japan (city and regional banks). In Canada, public policy regarding the financial sector destroyed any semblance of balance between “global competitiveness” and significant “domestic competition,” especially in the personal or retail sector. In 1986, new proposals introduced by the Mulroney government started the roller-coaster process that effectively gave 80 per cent of the Canadian financial sector to the five chartered banks. In the space of 15 years, Canada’s banks have come to dominate three of the four pillars (what are the other 3 pillars??), and are well established in the fourth pillare: insurance. Canada is the only major country that allows such high levels of concentration in the retail financial sector. The withdrawal of innovative foreign players such as Merrill Lynch and Charles Schwab from the Canadian retail market illustrates the power of the Big 5, albeit with declining influence on the global stage.
Gradually, Canada’s Big 5 retreated from Britain, Europe and Japan. Even their traditional presence in the Caribbean has been usurped by other players. The Big 5’s focus was to be profitable in the domestic retail banking sector, which they totally controlled/control? via their branch network and centralized back-office systems. By 1998, as the free trade agreement with the United States accelerated Canadian industrial integration in the North American market, it was clear that the chartered banks had little room to grow in Canada. At the same time, they needed to boost their domestic returns to offset the cost of expanding into new, foreign markets.
The Merger Debate and the MacKay Task Force
In 1996, the federal government established another study commission, the MacKay Task Force, comprised of a broad range of stakeholders. Tired of waiting for its final report and despite warning? signals from the federal government and lobbyists, two Canadian bank CEOs, Matthew Barrett of BMO and John Cleghorn of RBC, announced on January 23, 1998, a proposed merger of the Royal and BMO. Within weeks, Charles Baillie of TD and Al Flood of CIBC proposed a second merger. When Scotiabank, the most international of the Big 5, was left without a dance partner, it launched a public relations campaign against the mergers. The actions by the bank CEOs to force changes demonstrably reflected their view that drastic actions were needed to deal with the new global realities. But it also cemented the breach between policy officials and bankers that had been growing since the 1970s.
These merger proposals turned out to be a public relations disaster; the resulting widespread hostility toward the bank CEOs remains to this day. Small-town Canada and the small business sector seethed at the arrogance of Bay Street and the banks, and derailed any merger talk by expressing their considerable discontent to Members of Parliament and the Liberal caucus. The pleas of the bank CEOs to change the rules of the game, albeit in a manner consistent with Canadian history, fell on deaf ears. It was evident that the hugely profitable Canadian banks were immensely unpopular outside of Bay Street. Many consumer advocates believed, and still do believe, that high bank profits are derived from excessive retail service charges imposed on domestic clients, and that the banks use these to fund their international lending mistakes, rather than to fulfill their publicly sanctioned mandate to service all communities.4 The consensus was that mergers were too important to be left to the whims of the bank CEOs or the gnomes of Bay Street. The federal government refused to approve the mergers; any changes must await the 2006 revision of the Canada Bank Act. The public policy question remains: are banks public utilities or are they just like any other business? Until this question is settled, the scope of their strategic decision making remains in limbo.
For many Canadians, “globalization restricted” had become “globalization denied.” Even the corporate sector began bypassing Bay Street for Wall Street. The MacKay Task Force report was indicative of a radical new model: it gave far greater weight to consumers, to domestic competition and to foreign financial service firms:
- “Enhancing the ability of existing institutions, particularly life insurance companies, credit unions, and caisse populaires, and mutual fund companies to compete with the chartered banks;
- Removing barriers for new domestic competitors;
- Increasing the opportunities for foreign banks to enter Canada and provide financial services in our marketplace; and,
- Empowering consumers so that they can act as a disciplining force in the market and make competition more effective.”
Have the Canadian banks, rejected for their merger policy and frustrated by policy drift, missed the window of opportunity to become global players? Ironically, other financial institutions in Canada were able to take advantage of those global opportunities. Manulife is now an aggressive public company with global designs and, through the acquisition of John Hancock of Boston, is competing successfully in Japan, China, India and the U.S. Power Corp. consolidated its Canadian position by buying insurance and strengthened its hold through Power Financial. Is it possible that policy-makers are hanging on to policies that benefit neither the banks nor the public? Did a perverse combination of public policy and Canadian bank strategies lead to unintended consequences: strong at home, weak abroad. Where were the growth strategies of the Canadian banks when there were opportunities in a number of financially distressed countries, from South America to Mexico? Where are Canadian banks in Japan’s bank restructuring or in China’s emerging financial sector?
In the short term, the Canadian banks need to secure their North American regional base. Bank of Montreal is well ensconced via Harris Bank in Chicago, the TD’s union with Banknorth has given it a New England base, and Scotiabank is strong in Mexico. Yet CIBC stumbled badly in the U.S. with Amicus, and RBC has clearly encountered problems in that market. The fundamental North American problem is that retail banking leaves little room for cost savings other than scale advantages from reduced overhead (fewer national offices and some IT expenses). American banks already have high P/E multiples, so acquisitions in the U.S. are very expensive for the Big 5. At home, the Canadian banks have market-to-book ratios that are respectable, but these are limited over time because of the lack of domestic growth opportunities and relatively high cost structures.
Globalization has caught up to Canadian banks. In a global world, they are neither sufficiently large nor sufficiently specialized Â¯ in short they are neither fish nor fowl. Even worse, the Canadian banks’ conglomerate-style product lines Â¯ over 40 specific product categories Â¯ now face direct competition from highly focused rivals. While conglomerates had a long record of controlling much of Canadian industry, history now shows that few of them survive when globalization and technology come into play Â¯ some firms went out of business; others survived through mergers or were taken over by foreign companies. Why should banks be any different?
Domestically, very large financial groups are accumulating assets and encroaching on turf that historically belonged to the banks. Pension funds belonging to groups such as the Ontario municipal workers (OMERS) and the Ontario teachers are moving into the area of corporate financing. GE Capital and Brookfield Asset Management are big players in corporate leasing and property financing; MD Management in wealth management; Onex Corp. in large private equity; Borealis Capital in infrastructure funding. Foreign banks are getting into personal finance in the form of credit cards, personal loans, mutual funds and mortgages; Loblaws is going the same route through President’s Choice; and retailers like Wal-Mart and Canadian Tire have started financial services ventures. Canada’s financial credit unions, too, have aggressive plans for retail banking. And with Calgary being a global centre of energy resources, can western Canadian financial services be far behind?
This Canadian banking industry case study reflects the shifting landscape for public policy and corporate strategy. In many industries, competitive forces do not reflect traditional models of performance rivalry. Varying forces, or a combination thereof, are subjected to regulatory issues imposed by the state or by larger rivalry forces??, including intergovernmental agreements. Airlines, oil companies, financial services, pharmaceutical companies and automobile firms operate under significant constraints regarding their corporate behaviour, quite independent of the narrow view of competitive rivalry. Public policy in countries much smaller than the U.S. carefully combines short-run needs with long-term requirements, weighing the rights of shareholders and investors, consumers and the public good.
Global forces such as the mobility of finance, technology and trade have direct impacts on corporate strategy and public policy. There are serious choices to be addressed in the financial services sector, such as the choice of policy options: to be neutral or to promote capital markets or financial intermediaries? Are very high levels of domestic concentration necessary for global competitiveness? Or, have Canadian capital markets and financial institutions delayed their global aspirations for too long, and, in so doing, have they lost their competitive edge?
As Adam Smith wrote many years ago5:
This free competition too obliges all bankers to be more liberal in their dealings with their customers, lest their rivals should carry them away. In general, if any branch of trade, or any division of labour, be disadvantaged to the public, the freer and more general the competition, it will always be the more so.