-12-

Fourth is the continued dominance of Canadian financial markets
by the federally chartered banks. Even though the Green Paper takes the
view that concentration is not necessarily inefficient, the Government has
been under increasing political pressure to redress the degree of
concentration in segregated and aggregate financial markets, and the
dominance of chartered banks in Canadian financial markets. Near-banks have
pressured the government to allow them to more actively participate in
markets that have been the traditional markets of chartered banks. Many of
these near-banks are not widely-held corporate entities, and thus cannot be
federally chartered as banks. The government would however like to see more
competition in Canadian financial markets and would like to encourage
diversification by owners of financial institutions.

In summary, the Government of Canada has several motives for
proposing financial market reform: (1) address recent system stability and
institutional solvency problems; (2) deal with the problems of equity in
regulation, conflict of interest, and self-dealing -- prudential and
fiduciary problems that have surfaced as a result of recent failures and
gradual structural change in financial markets; (3) meet the desire of
financial institutions to be competitive and to diversify while satisfying
the objectives in (1) and (2).

Overview of the Government's Proposal

The proposal addresses three main areas: (1) the organizational
structure of financial institutions and the services offered by any one
institution; (2) prudential and stability related concerns; and (3)

modernization and simplification.


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- 16 -
Ownership:
(a) if a FHC is financial, then it can own a majority interest in
the Schedule C chartered bank;
(b) foreign ownership requirements of chartered banks, insurance
companies, and trust and mortgage companies are unchanged
(currently, transfers of ownership of Schedule-A banks, exist-ng
life insurance companies, and existing trust and mortgage loan
companies to nonresident restricted to maximum ownership of 10
percent and total foreign ownership of 25 percent; and there are
no restrictions on foreign ownership of newly created insurance
and trust and mortgage loan companies):
-- foreign interests in FHCs must be independent of institutions
and investors that own a Schedule-B bank; and
-- foreigners can set up their own FHC but it cannot include a
Schedule-C bank.
Jurisdictions: federal government will not supersede provincial
governments' traditional role (such as in providing its own
deposit insurance, as in Quebec, and in regulating securities
firms).

Enhanced Regulatory and Supervisory Role by the Federal

Government .
Because the "widely-held" requirement does not apply to the newly
formed Schedule-C banks, there is a greater potential for abuse of consumers.

The government's proposal calls for a revamping of the regulatory and

supervisory environment. The proposal specifically calls for the following:


Canadian Financial Markets: The Government's Proposal for Reform

Garry J. Schinasi

Introduction and Summary

Structural changes have taken place in Canadian financial
markets, which blurr the distinctions between traditional institutions and
challenge the authority of regulations and supervisory controls. The
Government of Canada has proposed sweeping regulatory reform of financial
institutions to encourage more competition for the traditionally
dominant! chartered banks, establish better safeguards to protect
consumers, to ban self-dealing, and insure the stability of the financial
system. If implemented, the proposal may alter the traditional roles of
financial institutions and the relationship between them and the government.

The proposal breaks with tradition in two fundamental ways:
first, it re-affirms and further encourages the erosion of traditional
market segmentation and specialization; and second, by creating a new class
of chartered bank, it eliminates the traditional requirement that Canadian
banks be "widely-held" (i.e. owned by many agents rather than one or a few).
The proposal encourages a relatively new form of organization in Canada, a

financial holding company (FHC), which brings together non-bank financial

laithough this point about dominance is debated, in 1984 chartered banks
issued 66 percent of all deposit liabilities, held 45 percent of total
business financing, and extended 73 percent of commercial credit, 67 percent
of consumer credit, and 25.3 percent of mortgage credit. Trust and Mortgage
loan companies, whose principal business has been mortgage financing,
extended 25.9 percent of all mortgages in 1984, only .6 percentage points
more than chartered banks. There is considerable competition, however,
among the top five or six chartered banks.


-13-

The central feature of the Proposal is the introduction of a new
organizational possibility for Canada's financial institutions: a federally
chartered financial holding company (FHC) that would allow the combination
within one corporate grouping of a wide range of financial institutions,
offering a variety of products on both the asset and liability side. This
range of institutions includes a new form of chartered bank -- a Schedule-C
bank-~that differs from existing chartered banks in that it need not be
widely-held.

Complementing the introduction of FHCs are the prudential and
stability aspects of the proposal, that introduce new initiatives to
enhance consumer protection, to ensure the soundness of institutions, and
ensure the stability of the financial system. Regulators will play a larger
role under the government's proposal. Specific initiatives include a strict
ban on self-dealing with few exceptions, measures to control the abuse of
conflicts of interest, and enhanced powers for supervisors to allow them
properly to discharge their legislated duties. In addition, the proposal
aims to modernize and simplify where necessary, the legislation and
regulations which define and guide the various financial institutions. It
is the government's view that the establishment of FHC's under the
government's proposal would at once support previous desirable changes and
satisfy the government's objectives.

In summary, the import of the current proposal is twofold: (1) it
allows the formation of FHCs that can wholly own a chartered bank as well as
other types of financial institutions; and (2) it explicitly places existing

chartered banks in a glass-cage until their regular legislative review


-19-
goals regarding soundness, stability, and consumer protection. 16 Trusts
and other near-banks, although supporting the FHC concept, are opposed to
separateness qualifications and dislike the Schedule-C bank concept.
Existing conglomerates, now faced with the possibility of openly competing
with chartered banks on the one hand, and being federally regulated on the
other, have been relatively silent; it is generally believed that they see
these changes as a political and economic triumph. Regulators, although
generally supportive of the overall proposal, have reservations about the
ability of supervisors to execute the difficult tasks delegated to them
under the proposal, particularly in the area of self-dealing.

Major questions remain over the actual changes that would occur
if the proposals are implemented. Even if FHCs were perceived as a viable
and profitable way of doing business in Canadian financial markets, the
threat of heavy regulation and supervision may discourage their formation.
Why should a profitable trust company or mortgage loan company now offering
bank-like services become federally incorporated as a Schedule-C bank, or
join an existing or new FHC, when it entails further supervision of their
activities? On the other hand, if FHCs become widespread, the large,
complex, and highly integrated financial conglomerates will pose seemingly
endless and impossible supervisory problems and demands for regulatory
bodies. How will regulators detect and then prevent conflicts of interest?
How will. self-dealing be recognized within an endless web of financial

transactions of large numbers of entities belonging to one corporate group?

16since they cannot participate, chartered banks support diversification and
the FHC concept.


-15-
summer of 1984). This class of banks owns only 3.6 percent of total assets

of financial institutions in Canada.

Major Features of the Proposal Regarding FHCs

The major features of the proposal regarding FHCs are listed on
the following pages:

Federal Incorporation:

(a) a FHC must be federally incorporated if it owns two or more

regulated financial institutions one of which is federally

incor porated!4,; each institution is subject to legislation and

regulation applying to its own type; and the federal government is

responsible for supervision of Schedule-C banks and the FHC; and

(b) each part of a FHC must maintain a separate corporate identity

making its own decisions, having its own directors, financial

reports, etc., although they can share certain services, such as

computing facilities.

Regulation and Supervision:

(a) provisions for avoiding double counting of capital; a strict
ban on self-dealing; strict controls on all transactions within a
FHC group and between the group and affiliated businesses; common
distribution arrangements, or networking, would be allowed, but
tied or conditional selling would be prohibited; and

(b) directors of FHCs will be held to higher standards than

currently required under the Business Corporations Act.

this is the language used in the proposal. Discussion with Department of
Finance staff suggests the government intended "federally regulated" rather
than "inecrporated".


-~ 10 -

and changed their structure, and permitted banks to issue convent ional
mortgage loans.8 Banks, however, were forced to divest their holdings of
trust and loan companies. Although not part of the Bank Act, trust and
mortgage loan companies were also allowed to participate in the Canadian
deposit insurance system which allowed them to compete more effectively with
chartered banks for deposits.

The 1980 review of the Bank Act altered the possibilities for
chartered banks and near-banks. Relaxation of portfolio restrictions of
near-banks and contractual savings institutions permitted them to increase
their commercial and business financing. In addition, near-banks were
granted participation in the Canadian Payments System which was previously
controlled by the chartered banks. In principle, this made it easier for
them to compete for deposits. The review allowed the incorporation of
foreign banks, albeit on a limited scale, permitted banks to engage in
leasing through subsidiaries, and restricted banks' powers to engage in
securities dealings.

IV. The Government of Canada's proposal for regulatory reform in Canadian

banking

Reasons for Financial Market Reform

It is in the financial market environment described in previous
sections of this paper that the Government of Canada has proposed sweeping
regulatory reform of financial markets and institutions in Canada. It is an

environment in which major structural changes have occurred over time.

8on1y chartered banks are subject to reserve requirements.


- 6 -

rates during the 1970's and early 1980's and narrowing profit margins on
existing products. Other economic factors contributed as well. The large
trade imbalances and associated capital flows that resulted from the oil
erises created greater demand for international financial services. In
addition, because of increased internationalization, and Canada's proximity
to the United States, Canadian financial institutions were influenced by
foreign developments and foreign competition.

The major change has been the attempt by each type of intermediary
to become more fully integrated into financial markets and thus compete on
once traditionally separate territory. The major incentive to innovate and
diversify was provided by the desires of corporate and personal clients to
economize on cash balances held in low (or no) interest paying accounts
and long-term fixed rate deposits. Once customers demonstrated a preference
for higher returns and cash management techniques the market respcnded.
Chartered banks issued a larger volume of shorter loans in, mortgage markets
(ineluding floating rate mortgages) and near-banks created newer shorter
term interest paying accounts (such as daily interest savings accounts and
daily interest checking accounts). Trust and mortgage loan companies
issued a larger share of shorter maturity deposits and shorter maturity
mortgage loans both issued since the late sixties and early seventies as
well as adjustable rate and shorter-term mortgages first introduced during
the late seventies and early eighties. Life insurance companies issued
short term deferred annuities that are close substitutes to relatively

short-term or medium-term deposits. And over the last eighteen months,


-3-
accommodate the changes that occurred and to encourage changes that were
clearly inevitable.

I. The Traditional Framework of Canadian Financial Markets

The Canadian financial system has traditionally been composed of
four pillars representing banking, insurance, trust, and securities
industries. Each provided a distinct set of products and services to a well
defined segment of financial markets, with commercial lending by banks,
fiduciary services by trusts, insurance underwriting by insurance companies,
and underwriting and full brokerage services by securities firms.

This traditional structure evolved, partly because of market forces and
partly because of boundaries imposed by regulation, perhaps reflecting that
specialization of function was the most efficient way to provide financial
services.

Along with the separation of functions, the Government of Canada
has traditionally required chartered banks to be "widely-held".2 In the
past the government has relied on widespread ownership of financial
institutions to prevent concentration of power and safeguard against
conflicts of interest and self-dealing which are harmful to customers and
threaten solvency and liquidity. It is perceived that when ownership of

large financial institutions is placed in one or a few hands, the temptation

2a shareholder or group of associated shareholders (resident or nonresident )
cannot own more than a 10 percent share in a Schedule-A chartered bank.
Foreign ownership and participation has been traditionally limited. The
combined ownership of nonresidents cannot exceed 25 percent of any one
Schedule-A bank and can be 100 percent of a Schedule-B bank. And until last
year, total nonresident ownership of chartered banks could not exceed 8
percent of total bank domestic assets; the limit was increased to 16 percent
in June 1984,


-2-
entities and a new class of federally chartered bank yet to be established.
Taken at face value, the introduction of FHCs paves the way to a finencial
structure in which relatively large, highly-integrated, financial
conglomerates offer a full range of financial services. And the elimination
of the "widely-held" requirement -- now perceived in Canada as a
self-regulating mechanism for avoiding concentration of power and fiduciary
problems, such as self-dealing -- would imply an extensive revamping of
regulatory power and supervisory control, including a more active role by
the federal government.

This paper discusses Canada's traditional financial sector, recent
institutional changes, and the Government of Canada's proposal and its
likely impact if implemented. Canada's financial markets are dominated by
traditional financial institutions (often called the "four pillars"), which
are dominated by chartered banks. Although traditions and regulatioris have
contributed to the evolution of Canadian financial markets, economic
conditions and customer-provided incentives have created the major impetus
for change. Most notable among the economic conditions were the high and
volatile Canadian (and U.S.) interest rates of the late 1970's and early
1980's.

Structural changes have occurred along three separate but related
tracks: product and service innovation by banks and near-banks
integration of all types of institutions into the larger financial
marketplace (i.e., less specialization); and conglomeration. Political

pressures have led the federal and provincial governments involved to


-W1-
These changes have stirred concern by participants in financial markets and
the Government of Canada about several key issues.

First is the move toward conglomeration of financial institutions
(not including chartered banks) under one corporate umbrella. Some of these
conglomerates, which have access to large flows of deposits, are owned by
families or small groups of individuals, and some of them combine financial
and nonfinancial entities under one board of directors. The existence of
conglomerates has raised questions about the increased potential for
self-dealing, as in the case of closely-held ownership, and conflicts of
interest, as in the case of nonfinancial and various financial entities
operating together under one decision making unit.9

Second are the recent failures of several relatively large trust
companies. !0 These failures have renewed concerns about self-dealing and
therefore the stability of the financial market structure and the relevance
of existing regulations and supervision in detecting and eliminating
problems of liquidity and solvency in Canadian financial institutions.

Third is the blurring of the lines of distinction between types of
financial institutions. This has raised concerns on the part of these
institutions and the government about fairness and equity in the federal

regulation of institutions that offer like services.

9For a detailed discussion of the "separateness" issue see Cornyn, et. al.

10More recently, two chartered banks, Canadian Commercial Bank and Northland
Bank, have been liquidated. Their combined assets were about 1 percent of
total bank assets. Mercantile Bank has experienced liquidity problems, and
is seeking a merger partner.


-5-
liabilities, offer a wider array of maturities particularly on the liability
side, and more closely match the maturities of their assets and liabilities.
The changes that have taken place have occurred on three separate but
related tracks: product innovation by near-banks; integration by financial
intermediaries into the larger financial marketplace, often circumventing
regulatory barriers to diversification; and the conglomeration of different
types of financial intermediaries under a single corporate group.6

The impetus for change in Canada's financial markets during the
1970s originated predominantly in economic conditions and technological
advances in information processing industries. Change did not originate in
deregulation or regulatory reform, although changes in the regulatory
structure did support and encourage changes that were already in progress.
This is in contrast to the recent experience in the United States, where
some changes could not have occurred without deregulation, and economic
conditions accentuated the difficulties in the transition to the new
unregulated environment.

The most important economic factors leading to product and
service innovations by near-banks and expansion of services by all financial

intermediaries were the high and volatile interest rates and inflation

6pespite these moves towards integration and conglomeration, however, the
traditional "four pillars" nevertheless have been kept distinct. This is
the result of overlapping jurisdictions between Federal and Provincial
authority, the clear delineation of the services provided by chartered
banks (and near-banks), and the dominant role played by chartered banks in
the Canadian financial structure. The federal government has jurisdiction
over chartered banks and other institutions that choose to be federally
chartered, excluding securities dealers. Provincial governments have sole
jurisdiction over securities dealers and local credit unions and like the
federal government can have jurisdiction over other nonbank institutions
that choose provincial charters. Jurisdictions will often overlap.


-17-
(a) consideration of a possible consolidation of the federal
government's regulatory agencies responsible for banks and for
trust and mortgage companies, and insurance companies (Office of
Inspector General and the Department of Insurance);

(b) creation of new office to deal with conflicts of interest;

(ce) enhanced regulatory powers to obtain information and data and

to intervene in the operations of financial institutions such as

cease and desist orders, forced divestitures, seizeure of
assets, and generally intervene.

Vv. Analysis and Conclusion
The government's proposal breaks with tradition in two fundamental

ways. First, it further encourages the erosion of traditional market

segmentation and traditional specialization of function by financial
institutions in Canada. Secondly, it proposes eliminating the traditional
requirement that Canadian banks be "widely-held."

The major change proposed is the introduction of federally
incorporated financial holding companies (FHC) that can wholly (i.e.,
solely) own any number of different types of financial institutions
including a new form of chartered bank -- a "Schedule-C" bank. The
regulatory and supervisory proposals complement the establishment of
federally incorporated FHCs and address the increased potential for
conflicts of interest and self-dealing.

Establishing FHCs potentially accomplishes several objectives.
First, it makes it easier for non-bank institutions to enter markets that

were traditionally the domain of chartered banks. This satisfies the


International Finance Discussion Papers
Number 269

November 13, 1985

CANADIAN FINANCIAL MARKETS:
THE GOVERNMENT'S PROPOSAL FOR REFORM

by

Garry J. Schinasi

NOTE: International Finance Discussion Papers are preliminary materials
circulated to stimulate discussion and critical comment. References in
publications to International Finance Discussion Papers (other than an
acknowledgment by a writer that he has had access to unpublished
material) should be cleared with the author or authors.


- 8 -
the above services.7 Table 1 compares the services currently provided by
each of the four pillars with the services they provided under their
original charters.

In summary, none of these changes would have occurred were it not
for changes in economic conditions, economic incentives, and the relaxation
of key restrictions on chartered bank and near-bank activities. But the
pressures for change were primarily economic conditions.

III. The Structure of the Canadian Financial Sector

The Composition of the Financial Sector

The financial sector in Canada is composed of a diverse group of

highly competitive financial institutions (particularly the five or six

largest chartered banks) offering a large number of financial goods and
services. Nevertheless, the Canadian financial sector is a highly
concentrated one, in which chartered banks dominate both the asset and
liability side of an aggregate financial industry balance sheet. At the
close of 1984, chartered banks (twelve domestic and fifty-eight foreign) as
a group accounted for about 54 percent of the total assets held by all
financial institutions in Canada (see Table 2). The second largest
financial institution was life insurance companies, accounting for 11.9
percent of total assets, followed by trust companies with 8.7 percent,
credit unions with 7.4 percent, and mortgage loan companies with 6.6

percent.

Toredit unions in British Columbia can provide virtually all banking,
fiduciary, insurance brokerage, and brokerage services under one roof. And
in Quebec, the Insurance Act permits insurance companies to own other
financial intermediaries and to own up to 50 percent of their assets in
subsidiaries.


-7T-
securities dealers have paid interest and provided check writing privileges
on idle customer balances that were awaiting a good trading opportunity.

The transition to the new cash conscious economic environment was
relatively easy for chartered banks whose traditional business was matching
short to medium-term commercial loans with short-term liabilities in the
form of checking accounts and short-term deposits. But it was more
difficult for near-banks and insurance companies that either dealt in medium
to long-term maturities or never issued deposits but carried long-term
liabilities. As the near-banks competed for market shares they were
ereative in responding to market pressures and adept in escaping traditional
habits in the new higher and more volatile interest rate environment.

Traditional distinctions in the services offered by financial
institutions have become blurred. Chartered banks have issued consumer
loans since the late 1950s, government insured mortgage loans since 1954,
and non-government insured mortgages since 1967 as well as traditional
commercial loans. They also take deposits of varying maturities and offer
access to discount brokerage services. Brokerage houses now offer interest
bearing checking accounts on client cash balances. Insurance companies
offer short term deferred annuities that are close substitutes to time
deposit accounts of different maturities. Trust and mortgage companies
offer a wide range of "banking" services. And new institutions,

conglomerates, have surfaced providing the marketplace with combinations of


-4y-
is on ocassion, "overwhelming" to take improper advantage of access to
funds from the financial institution.3 Limited ownership of financial
institutions has thus played a central role in Canadian tradition and
thinking on the prudential and fiduciary aspects of financial
intermediation.

Within the traditional framework, the predominant players in the
Canadian financial system have been the five or six largest federally
chartered banks. They have a far greater share of total assets and have
enjoyed greater regulatory flexibility4 than their counterparts in the
United States (the big city banks) and their competitors in Canada (the
near~banks which include trust companies, mortgage loan companies, credit
unions, and cooperatives). But traditional boundaries have been
crossed.> The existing structure of financial markets has emerged from
the confluence of strongly held traditions, regulatory constraints, and the
exercise of comparative advantage in a fast changing economic environment.

II. Pressures for change in Canadian Financial Market

Canadian financial institutions, particularly the intermediaries,
have come under increasing economic and political pressure to change. These

institutions have attempted to diversify their portfolios of assets and

33ee Bouey (1985).

4the chartered bank statute outlines what banks cannot do and says little
about what they can do while the statute for Trust and Mortgage loan
companies clearly specifies that they can provide certain services only.

5The Bank Act of 1967 allowed chartered banks to issue mortgages. Near-banks
were allowed to participate in the deposit insurance system in a separate
piece of legislation. The Bank Act of 1980 made further changes that
attempted to increase competition. This will be discussed in more detail.


- 14 -
scheduled for 1990. Existing chartered banks (Schedule-A and Schedule-B)
are forbidden from either forming FHCs or becoming part of one.!! In
doing so, the proposal allows the remaining participants: in financial
markets to gain a competitive edge with the chartered banks.

The Creation of Schedule-C Banks:

Under the new proposal a FHC could wholly own a chartered bank --
a Schedule-C bank. This new class of bank would have the same powers and
would be subject to the same reserve requirements as currently existing
Schedule-A (widely-held) and Schedule B (closely-heid) banks. 12
Schedule-C banks would however be permitted to be closely held by a FHC.
The purpose of the Schedule-C bank would be to provide FHCs access to a
wider range of markets. There are currently 10 domestic federally chartered
banks (Schedule-A) banks.13 No individual including nonresidents can own
more than 10 percent of the shares of a Schedule A bank and total
nonresident ownership cannot exceed 25 percent. As stated earlier, this
class of bank currently owns 50 percent of all assets of all financial
institutions in Canada, and the top five chartered banks in this class own
80 percent of all chartered bank assets. All but one Schedule-B banks are
foreign owned. There are currently 58 foreign owned banks. As an
aggregate, foreign owned Schedule-B banks are limited to only a 16 percent

share of total domestic bank assets (just increased from 8 percent in the

11smaller Schedule-A banks may be allowed to do so.

12a Schedule-A banks are domestically owned and all, except one, Schedule-B
bank are foreign owned. The domestically owned Schedule-B must become
widely-held within 10 years of incorporation.

13as of October 1985.


- 20 -

If regulators are completely successful in accomplishing their
regulatory and supervisory goals regarding the new FHCs, then the new form
of financial institution will probably be unattractive, and few will be
formed. Few if any of the government's objectives regarding competition
and concentration will be achieved.

If regulators are unsuccessful, then the potential for
self-dealing, conflicts of interest, and therefore financial instability
will increase greatly. In that case, the government's objectives of sound
and stable financial markets and consumer protection will not be met.

The most likely outcome will lie somewhere between these two
extremes: more competition and integration; more regulation and
supervision; and hopefully a more stable financial environment in which
conflicts of interest and self-dealing are carefully guarded if not
eliminated.

The Government of Canada hopes to bring legislation to Parliament
by the end of 1985. Insiders suggest, however, that this is overly
optimistic. The Minister of State (Finance) for Monetary Affairs has stated
clearly and emphatically that although the details of the proposal are
negotiable, the general principles are not. When legislation is brought
before Parliament, probably early in 1986, it is expected to carry the

basic principles of the government's current proposal.


Contents

Introduction and Summary... 2... ee ee eee

The Traditional Framework of Canadian Financial Markets

Pressures for Change in Canadian Financial Markets .
The Structure of the Canadian Financial Sector .. .
The Composition of the Financial Sector...

The Regulatory Environment .... +. +. eee

The Government of Canada's Proposal for Regulatory Reform in

Canadian Banking... 1. ee ee eee ee ees
Reasons for Financial Market Reform... . .
Overview of the Government's Proposal... .
The Creation of Schedule-C Banks. ......
Major Features of the Proposal Regarding FHCs .
Enhanced Regulatory and Supervisory Role by the

Government . . 2. 2. 2 ee eee ee eee

Analysis and Conclusions . .. 2... 2.1 eee eee

Federal

10
10
12
14

15

17


Table 2

Financial Sector Assets!/: 1984-Q4

Percent of Total

Excluding Including
Pension Pension

C$Billion Funds Funds

Chartered Banks2/ 405.6 59.1 52.7
Life Insurance 81.8 11.9 10.6
Trust and Mortgage Loan Companies 69.7 10.2 9.1
Local & Central Credit Unions 50.7 7.4 6.6
Property & Casualty Insurance 16.4 2.4 2.1
Financial Corporations 14.2 2.1 1.8
Investment Dealers3/ 10.2 1.5 1.3
Segregated Funds 10.2 1.5 1.3
Investment Funds 9.5 1.4 1.2
Other 4/ 17.6 2.6 2.3
Total 685.9 100.0 89.1
Pension Funds 83.8 10.9
New Total 169.7 100.0
Memo Item: Four Pillars 567.3 82.7 73.7

1/ Source is Financial Institutions, Statistics Canada, except where noted.
2/ Includes subsidiaries that are mortgage loan companies as reported in
Statistics Canada: total excluding these subsidiaries is C$370 billion, from
Bank of Canada Review, July 1985.

3/ The primary business of Dealers involves high turnover of their inventory;
their actual inventory at any time understates their participation.

4/ Includes Financial leasing corporate loans (C$2.7 billion), Business
Financing Corporations (C$7.2 billion), REITS (C$.5 billion), Closed-end Funds
(c$1.9 billion), Accident and Sickness Branches of Life Insurance Companies
(c$4.7 billion), and Trust Company Retirement Funds (C$.6 billion).


Table 3

Chronology of Recent Legislative Changes

1954 - CB's can create consumer loans backed by chattel mortgages.
- CB's can issue government issued mortgages.

1967 - CB's can issue mortgages.
- removed CB's ceiling on rates on bank loans and reduced reserve
requirements on deposits.
- created deposit insurance for near-banks (Trusts and Mortgages
Loan Companies).
- CB's required to divest holdings of trusts and loan companies.

1980 - CB's can lease via subsidiaries.
- CB's powers in security dealing restricted.
- near-banks granted participation in Canadian Payments
Association.
- non-Canadian banks can become full service banks to increase
competition.
- lowered reserve requirements.

CB's = Chartered Banks


Canadian Financial Markets:

The Government's Proposal for Reform

Garry J. Schinasi, Economist*
International Finance Division
Federal Reserve Board
October 1985

* The author would like to thank Charles Freedman, Advisor, and Clyde
Goodlet, Research Advisor, both of the Bank of Canada, and Daniel Ciuriak
of tne Ministry of Finance in Canada, for suggesting many improvements.
The paper also benefited from comments from members of the Board staff.
The views expressed in this paper are solely those of the author and
should not be interpreted as the views of the Board of Governors of
Federal Reserve System or its staff.


- 18 -

government's desire to encourage increased competition in Canadian
financial markets and satisfies the demands of near-banks to be able to
compete with federally chartered banks. Trust companies, for example, that
are not widely-held can now either form their own FHC and establish a
chartered bank, or can join a FHC and become a wholly-owned Schedule-C
bank.15

Second, it brings existing federally unregulated conglomerates
under the purview of the federal government. Existing conglomerates that own
more than two types of regulated financial institutions, one of which is
federally regulated, must become federally incorporated under this proposal,
and all financial institutions belonging to a FHC will be subject to
supervision with respect to self-dealing and perhaps conflicts of interest.

If a strong demand for the new services develops, and if
conglomeration continues to be profitable, then the government's proposal
opens the way for a financial structure in which relatively large
highly-integrated financial entities could offer a full range of financial
products. Existing types of institutions may then disappear under a
corporate umbrella. Chartered banks, awaiting their scheduled legislative
review in 1990, may lose their market share. This of course depends on the
evolution of the new concept of FHCs and the outcome of the legislative
review in 1990.

Although chartered banks oppose several key aspects of the
proposal, the business community in general supports the government's

objectives of enhanced competition and less concentration as well as its

15qhey must then give up their estate, trust, and agency business.


Abstract

This paper discusses Canada's financial sector, recent
institutional changes, and the Government's recent (April 1985) proposal
for financial market reform and its likely impact. Canada's financial
markets have been dominated by traditional financial institutions known
as the "four pillars". Although traditions and regulations have
contributed to the evolution of Canadian financial markets, economic
conditions and customer-provided incentives have recently created the
major impetus for change. Structural changes have ocurred along three
separate but related tracks: product and service innovation by banks
and near-banks; less market segmentation; and conglomeration. Political
pressures have led the federal and ‘provincial governments involved to
accommodate the changes that occurred and to encourage changes that were
clearly inevitable. The Government of Canada is currently proposing
sweeping regulatory reform of financial institutions to encourage more
competition for the dominant chartered banks, to establish more
effective safeguards to protect consumers, to ban self-dealing, and to
insure the stability of the financial system. If implemented, the
proposal may alter the traditional roles of financial institutions and
their relationship with the federal government.


References

ld, K., Governor of the Bank of Canada, Appearance before the
nmons Standing Committee on Finance, Trade, and Economic Affairs,
de

jarles, "Financial Innovation in Canada: Causes and
3," American Economic Review, v.73, no.2 (May, 1983) p.101-106.

"Changes in the Canadian Financial Structure over the Last
1 Financial Innovations and Monetary Policy, Bank of
al Settlements, March 1984.

"Recent Developments in the Structure and Regulation of the
lancial System," from a conference on Shifting Frontiers in
arkets, Societe Universitaire Europeennede Recherches

» Cambridge, March 28-30, 1985.

jony and Jerry Hanweck, Stephen Rhoades, John Rose, Kay
"An Analysis of the Concept of Corporate Separateness in Bank
sany Regulations," mimeo, The Federal Reserve Board.

of Canada, Department of Finance, The Regulation of Canadian
istitutions: Proposals for Discussion," April 1985.

and Karen H. Johnson, "Financial Innovation, Deregulation, and
-icy," in Interest Rate Deregulation and Monetary Policy, The
2xrve Bank of San Francisco, November 1982.



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- 9 -

Chartered banks held in excess of 65 percent of deposits issued by
deposit-taking intermediaries, and accounted for 45 percent of total
business financing in Canada in 1984. In addition, chartered banks issued
over 70 percent of commercial credit and over 60 percent of consumer credit
issued by financial institutions in 1984.

Not only is there a great degree of concentration in financial
markets as a whole but there is also a large degree of concentration among
chartered banks. In 1984, the top five chartered banks owned 80 percent of
all chartered bank assets, thus giving these five banks roughly a 40
percent share among all assets held by financial institutions in Canada.

As a group the four pillars continued to play a dominant role in
1984. By the end of 1984, the four pillars held 83 percent of all assets
owned by financial institutions in Canada; chartered banks accounted for 65
percent of the assets of the four pillars.

The Regulatory Environment

The large market share of chartered banks can be traced to the
relative freedom from restrictive regulations. Unlike their counterparts
in the United States (commercial banks) chartered banks in Canada were not
generally subject to deposit rate ceilings (except for a short period under
the Winnipeg Agreement effective 1972-74), were never restricted from
paying interest on any type of accounts, until recently had few if any
restrictions on assets, and were not geographically restricted.

The legislative review of the Bank Act in 1967 provided a
significant boost to chartered banks (see Table 3). The review removed the

ceiling on bank loan rates, reduced reserve requirements on term deposits