Transcript
CHAPTER 18:
Chartered Banks:
History and Performance
FOCUS OF THE CHAPTER
This chapter surveys the history and performance of chartered banks in Canada. The evolution and development of commercial banking, the Bank Act and its revisions, and the performance of chartered banks are discussed in detail.
Learning Objectives:
Explain free banking, and legal restrictions as they relate to the role of the banking sector and its interaction with government
Describe how banking developed from commercial banking
Determine how and why banks obtain charters in Canada
Identify the major aspects of the Bank Act and how it governs and restricts the behaviour of banks
???List and describe the key issues facing the chartered banks today
Determine the prospects and forces that will influence chartered banks in the future
Explain the financial performance of chartered banks in Canada in terms of asset-liability management, size, and profitability
SECTION SUMMARIES
The Evolution of Commercial Banking
A chartered bank is a bank that obtains a charter from the federal government and is federally regulated under the Bank Act. Custom, as well as inflation and the deregulation of recent times, has fundamentally changed the way the chartered banks do business. But they are, for the most part, recognized by their commercial lending function.
Free Banking: Free banking consists of a financial system that is largely unregulated and that can be entered relatively easily. The basic idea is that economic activity, in the absence of regulation, will evolve in a fashion that minimizes the cost of doing business. The competition generated by free banking does not produce financial instability, but, rather, fosters stability. The current global trend toward deregulation of financial services undoubtedly will promote the development of free banking.
Legal Restrictions: A different perspective on the evolution of banks is the legal restrictions view. Proponents of this view claim that regulation has shaped our current financial institutions (including chartered banks), and that only regulation can force the public to hold non-interest-bearing government debt (i.e., currency).
The Development of Commercial Banking in Canada
Originally, banks had the important function of issuing bank notes. These notes were a form of money convertible into specie (often convertible into gold) and gave the holder the benefit of convenience. But the government didn’t want its citizens exposed to the dangers of “money” that might suddenly become worthless. As a result, the regulation of bank notes was developed.
Obtaining a banking charter was, in earlier times, a difficult task. The conservative banking practices of Britain were entrenched amongst its colonies–and Canada was no exception. Initially, a bank charter authorized an organization to: a) issue notes; b) lend for commercial purposes and incur debt; c) open branches (usually); and
d) report to the government on its financial activities. This regulated pattern set the standard for a Canadian banking system that was quite different from the banking system of the United States at the time.
In later years, an experiment with free banking emerged with little success. Only five new banks were founded, with two failing; the remaining banks converted to charters. By the 1860s, the scope of banking had increased, with banks now being permitted to lend against goods still in the possession of the borrower–an arrangement that did not meet the strict definition of a self-liquidating loan.
Tracing the Evolution of Banking Regulation: The Bank Act
At the same time that commercial banking was spreading throughout Canada, the government was beginning to add regulation. This was, and remains, much an interventionist approach. The most important regulation of banks has taken the form of the federal Bank Act (see Table 19.1 in the text).
The First Bank Act: The Bank Act of 1871 was the first legislation in this area, consistent with the division of powers outlined in the Constitution. The government monopolized the issue of $1 and $2 notes. One possible reason for monopolizing the low-denomination note issue was to protect the least sophisticated individuals from the effects of a bank failure.
The Bank Act over the Years: Over the years, two overriding themes have emerged: 1) widening of the scope of chartered banking operations, and 2) concern over bank safety. The first major overhaul of the financial system took place in 1891 with the introduction of more stringent start-up capital requirements and more extensive supervision over private note issue. During the first half of the 20th century four important events shaped revisions of the Bank Act: the Great Depression, the creation of the Bank of Canada, the push for global markets, and the two World Wars.
The Crisis of 1907: The crisis of 1907 originated in the United States. A very poor crop amongst western Canadian farmers, combined with the banks' heavy loans to farmers, led to several bank failures. The government stepped in and, in doing so, established its role in providing credit and influencing the portfolios of the chartered banks. The Finance Act (1914) effectively made the government the lender of last resort. The Act also meant Canada was no longer under the gold standard. The Act also heralded the introduction of a monetary market of sorts.
The 1920s and 1930s: The failure of the Home Bank led to more stringent oversight of the chartered banks and reinforced the government’s role as lender of last resort. Increasing regulation may have proved its value in the 1930s. While US banking experienced significant difficulties, Canadian banks experienced no failures or runs. Moreover, government involvement in the workings of the financial system increased, culminating in the creation of a central bank, the Bank of Canada.
The Modern Period: Strong post-war economic growth provided relative calm for the banks until the oil price shocks of the 1970s. The consequent inflation led to the creation of new financial products. In a break with the past, this era was marked by a commitment by government to deregulate the banking industry. Chartered banks were allowed to enter the residential mortgage-lending field, to engage in financial leasing, and to provide data-processing services. Moreover, the government took steps to end the separation of commercial lending from securities underwriting.
The Bank Act of 1991: This Bank Act offered many changes. One major shift in policy resulted in the virtual elimination of the four pillars approach to financial institutions. Instead of legislating one branch of the financial system in isolation from the others, the new act introduced a comprehensive set of reforms for all types of financial institutions. Other changes included: the phasing out of required reserves; allowing chartered banks to pursue real estate development; and the revision of ownership rules. Debate continues over the question of whether chartered banks should be allowed to sell insurance directly.
The Bank Act of 2001: At the end of June 1999, the minister of finance outlined a framework intended to provide a basis for the next Bank Act. The proposed framework is intended to: give financial institutions added flexibility; lighten the regulatory burden; increase consumer protection; and improve the monitoring of financial institutions’ policies toward lending to small- and medium-sized businesses. In general terms, these objectives are designed to increase industry competitiveness.
Canada must continue to take steps towards liberalizing cross-border transactions by breaking down barriers. Globalization has forced consolidation amongst the worldwide financial services sector, yet Canadian legislators have made little progress in this area. Also of major concern is the issue of ownership of the chartered banks, and relating to this, the issue of mergers. It is expected that future legislation will deal with these concerns.
Recent legislation has provided some changes to the current system. Bank holding companies will be permitted, and enhanced consumer protection is expected to result from the creation of the Financial Consumer Agency of Canada and from the creation of a Canadian Financial Services Ombudsman.
The final piece of legislation is no longer just a Bank Act and covers the entire financial services sector.
The Changing Business of Banking
Innovation: Many Bank Act revisions have reflected a desire to adapt regulations to existing and future financial innovations. Automated banking machines, along with the associated debit cards and Interac system, have changed the way Canadians do their banking. Moreover, chartered banks are evolving into full-service institutions which rely on fee-based services to complement their interest revenues. A cashless society may be a dream today, but could be a reality tomorrow. A trend toward adopting new technologies is emerging. Banking on the World Wide Web and the use of “smart” cards are two such technologies that promise to decrease our collective reliance on cash. An amendment to the Bank Act in 1999 permitted “virtual banks” to set up shop in Canada, subject to some restrictions.
Other Issues: Two other issues that Bank Acts and other Canadian financial legislation have attempted to address are market concentration and regional concerns.
Market Concentration, Mergers, and Acquisitions: The Canadian financial system is heavily concentrated (the extent to which a small number of firms in an industry account for a large proportion of its output, profits, and assets, etc., is a measure of the degree of concentration). However, despite the fact that a majority of assets are held by the five largest chartered banks, there is little evidence that Canadians suffer from a lack of competition. This concentration, and the associated lack of competition, is the principal argument against bank mergers–a politically sensitive issue.
Regional Concerns: The industry’s desire to concentrate financial centres in Montreal and Toronto became quite evident by the 1920s, as institutions moved to the centre of the country. Both the Atlantic region and the Western provinces have, over the years, expressed discontent over this “centralization.” This discontent led ultimately to the formation of several Western banks, most of which failed miserably. The tension between regional and national concerns no doubt will continue to shape and influence chartered bank policy.
Lending to Small- and Medium-Sized Businesses: Another politically sensitive area has been the large banks' reluctance to lend to small- and medium-sized businesses. However, since the last recession, banks have changed their practices and viewed these businesses as having relatively greater potential for growth. Nevertheless, a recent report indicates that this segment of the market receives sub-par service in comparison to small- and medium-sized business abroad, especially in the United States.
The Performance of Chartered Banks
Asset and Liability Composition: Certain trends have emerged over the years, as a result largely of two factors: government regulation, and the dramatic rise in interest rates since the late 1970s, followed by their decline in the 1990s. Banks have reduced their reserves and their holdings of government bonds, and increased their exposure to corporate securities, their share of residential mortgages, and their general (mostly commercial) loans. On the liability side, some clearly identifiable trends have emerged. Advances from the Bank of Canada have been negligible and the share of demand deposits has decreased, while until just recently notice deposits rose. Additionally, the banks have shown a growing reliance on foreign currency liabilities.
Asset and Liability Management: Most assets held by the chartered banks are fairly liquid and rate sensitive. Chartered bank assets and liabilities are fairly well matched, and, at present, indicate a positive gap. This is a signal that the banks anticipate a rise in interest rates. Advances and the creation of new financial instruments have complicated the financial picture of the banks. There exist a couple of concerns when analyzing the balance sheet of a bank: classifying assets according to the degree of risk can be difficult, and balance sheets do no reflect many derivative items.
Size: The banking industry in Canada is relatively concentrated. A majority of the assets are held by the five largest chartered banks. These banks continue to have their headquarters in either Toronto or Montreal, further raising concerns that the banking industry in Canada has a regional bias.
Profits: Banks accumulate wealth for their shareholders by earning profits. Bank profits do not increase when interest rates increase. According to gap analysis, bank profits are a function of the management of assets and liabilities. If a bank is able to lock in assets at relatively high interest rates, and then borrow at lower rates, profits will rise. In addition, no empirical evidence links the size of a bank (as measured by bank capital) and its profitability–bigger does not imply better. Canadian banks, when compared to their global counterparts, perform quite well in terms of profitability.
MULTIPLE-CHOICE QUESTIONS
1. The chartered banks in Canada
a) are provincially regulated under the finance act of 1914.
b) are federally regulated under the Bank Act.
c) were created by the Bank of Canada Act in 1935.
d) are both provincially and federally regulated.
2. Under the free banking system
a) banks would be highly regulated by the government.
b) banks would not be regulated, but barriers to entry would be imposed.
c) banks would issue their own currency.
d) monopolization of the banking sector would be strengthened.
3. The proponents of free banking argue that
a) competition promotes financial stability.
b) regulation promotes financial stability.
c) neither competition nor government regulation promotes financial stability.
d) both competition and government regulation produce financial instability.
4. The first Bank Act was enacted
a) in 1867.
b) in 1871.
c) in 1935.
d) in 1980.
5. Which of the following is correct regarding the Finance Act of 1914?
a) It effectively placed Canada under a gold standard.
b) It effectively made the Bank of Canada the lender of last resort in Canada.
c) It effectively made the government the lender of last resort in Canada.
d) It created the Bank of Canada.
6. During the period of Great Depression
a) unlike in Canada, no chartered banks failed in the United States.
b) unlike in the United States, no bank failures or runs occurred in Canada.
c) bank failures were widespread in both Canada and the United States.
d) no bank failures were recorded either in Canada or in the United States.
7. Which of the following is not correct about the Bank Act of 1991?
a) It virtually eliminated the four pillars approach to financial institutions.
b) It phased out required reserves.
c) It allowed chartered banks to pursue real estate development.
d) It allowed bank mergers.
8. Which of the following statements is not correct?
a) Canada’s financial system appears to be highly concentrated.
b) Canada’s banks appear to be less competitive than they ought to be.
c) Canada’s banks rank among the top 25 in the world in terms of size.
d) The spread between borrowing and lending rates in Canada is among the lowest
in the G-7 countries.
9. Which of the following is not an objective of the Bank Act of 2001?
a) to provide financial institutions added flexibility
b) to increase consumer protection
c) to tighten regulation of the financial system
d) to improve the monitoring of lending to small- and medium-sized businesses.
10. As of 2004, what fraction of total assets is represented by reserves as in currency plus deposits?
a) between 5% and 10%.
b) between 1% and 5%.
c) between 0.5% and 1.0%.
d) less than 0.5%.
PROBLEMS
1. Does the history of banking regulations in Canada support the view that governments are slow to adapt to financial innovations?
2. State the criteria that provided the basis for blocking proposed bank mergers in the late 1990s in Canada.
3. Does the regional distribution of assets of Canadian chartered banks indicate a regional bias?
4. Why do many believe that the Canadian financial system has high market concentration?
5. What factors account for the failures of the Northland Bank and the Canadian Commercial Bank during the 1980’s?
6. What accounting practices contributed to making these failures even more damaging?
ANSWER SECTION
Answers to multiple-choice questions:
b (see page 347)
c (see page 348)
a (see page 348)
b (see page 350)
c (see page 351)
b (see pages 351-352)
d (see pages 353-354)
c (see pages 359-361)
c (see page 355)
d (see page 365)
Answers to problems:
1. Yes. The changes in the Bank Act clearly show that government regulations have often been reactions to changes that have already taken place in the financial system. In general, regulation tends to be a lagging indicator of changes in the financial system.
2. The proposed mergers of banks in the late 1990s were blocked based on the following criteria: 1) mergers would lead to unacceptable market concentration; 2) mergers would produce a significant reduction in competition; and 3) mergers would affect the federal government’s ability to address future potential concerns.
3. Consider the following data for 1999:
Region Chartered bank assets (%) Labour force (%)
Atlantic Provinces 5.1 7.3
Quebec 16.3 23.8
Ontario 49.8 38.7
Prairie Provinces 14.9 17.3
British Columbia 13.7 13.9
These data show that Ontario had a share of chartered bank assets greater than its share of the labour force. Other regions had shares of chartered bank assets smaller than their share of the labour force. However, the difference between the two shares in British Columbia was not significant. Based on these data one can argue that there is a regional bias in favour of Ontario.
4. In an industry in which there is high market concentration, a small number of dominant firms account for a large proportion of total output, employment, profits, and/or assets of the industry. In Canada, chartered banks account for about two-thirds of all core banking activities (i.e., deposit-taking, mortgage lending, and consumer loans). Moreover, the Canadian banking system is clearly dominated by a few large banks. These are the main reasons why many people believe that the Canadian financial system has high market concentration.
5. Inexperience of these banks’ management and insufficient diversification both in terms of region and industry as many of their loans depended on the fortunes of the oil and gas sector and were based in western Canada.
6. Instead of recognizing bad loans by reporting losses and asset write-offs these banks were accruing interest and capitalizing unearned interest by issuing new larger loans to refinance loans that were in arrears.
