Monday, July 10, 2006

Banks Find Little to Celebrate in Federal White Paper

Investment Executive, James Langton, 10 July 2006

If Canada’s banks were expecting the Harper government to be any friendlier to their cause than its predecessor, then a new federal white paper has dashed their hopes. It appears the banks have more work ahead of them if they hope to win meaningful legislative reforms in the future.

The long-awaited paper on financial industry reform, released in mid-June and out for comment until July 21, dodges the big questions of bank mergers and the banks’ desire to pursue insurance business more actively.

The big banks have long had an uneasy relationship with Ottawa, and have been frustrated by their treatment ever since 1998, when the federal government squelched two proposed mergers. The banks grudgingly accepted the verdict denying the mergers, but pleaded with the then-Liberal government for clarity surrounding the merger process. Such clarity, they said, would allow them to consider their strategies properly.

Although clarity was often promised, it never came. Without guidance, the banks found themselves dreaming up deals and then quietly sounding out the federal government on their political palatability. Deal-making proved elusive.

The banks had hoped the recent change in government, and a shift in focus from mergers and toward increasing their ability to market insurance, would make a difference.

The white paper, however, does not address the banks’ desire to market insurance actively. That’s not a big surprise, considering Canada has a minority government, but some in the industry no doubt had expected more.

In answer to the latest legislative review, the Canadian Bankers Association had submitted a list of 57 recommendations for reforms it wanted to see to financial services legislation. The wish list included changes dealing with everything from improving regulatory efficiency and corporate governance to a litany of technical amendments.

It’s not just the banks that had hoped for a more progressive federal policy for the financial services industry. Before the release of the white paper, a Toronto-based think tank, the C.D. Howe Institute, had published a short paper exhorting the government to focus on improving productivity in the financial services industry, arguing that a competitive, efficient financial industry is critical to the economy and “a vital policy goal.”

Canadian labour productivity has been lagging, and the financial services sector has been a particularly poor performer of late, experiencing five consecutive quarters of declining labour productivity, the report notes. One of the problems, it suggests, is that much of the financial sector “operates behind protective barriers that dampen competitive forces and may sustain uncompetitive cost structures.” Laws limit foreign ownership in banking and require that large banks’ shares be widely held, preventing cross-border or cross-pillar acquisitions of domestic firms. Rules also inhibit scale-building domestic mergers and limit competition among the sector’s parts, it adds.

The institute has called on the government to depoliticize the merger issue, to consider opening up the insurance industry to greater competition and to broach a federally mediated solution to the fragmented securities regulatory system.

None of the issues are addressed in the government’s white paper. Instead, it focuses on a variety of lesser changes — some of which should benefit the industry, while others have consumers in mind.

On the customer front, the white paper proposes, among other things: improving disclosure to bank clients around deposit-type investments such as GICs and term deposits; enhancing fee disclosure and borrowing cost disclosure; improving disclosure about the complaint-handling process; reducing cheque “hold” periods; and lowering the level at which the mortgage insurance requirement kicks in.

For the industry, the government white paper proposes raising the thresholds at which the “widely held rule” applies to $8 billion from $5 billion in equity value. This rule requires that no single shareholder can own more than 20% of the voting shares of banks classified as “large”, which effectively prevents takeovers of those firms. The proposal is most relevant to National Bank of Canada which is approaching the $5-billion equity value threshold, and would ensure that it will remain classified as a medium-sized bank for the foreseeable future. (Medium-sized banks can be closely held, but must maintain a public float of 35% of voting shares).

The paper also proposes streamlining ministerial approval for certain transactions and introducing electronic cheque imaging.

“The proposed recommendations will go a long way toward eliminating red tape, improving disclosure to consumers and fostering a strong and dynamic financial sector,” Finance Minister Jim Flaherty said upon releasing the paper.

The document clearly neglects the big issues, particularly as far as the banks are concerned. At the top of their list is greater freedom to market insurance in their branches. The CBA has called for banks to gain permission to distribute information about their insurance products in their branches, and the ability to provide referrals to “insurance professionals” to obtain information and advice about insurance. The banks haven’t gone so far as to seek permission to sell insurance in their branches.

“We are extremely disappointed the government hasn’t adopted our four simple insurance proposals,” says Ray Protti, the CBA’s president and CEO. “With the changes the government has made over the past several years — privacy legislation, prohibitions on coercive tied-selling, allowing insurers to restructure to become among the largest financial institutions in Canada — we don’t think it makes sense to maintain the current restrictions on insurance.”

Protti adds that the CBA will continue to lobby for greater freedom to operate in the insurance business, arguing that more competition will benefit consumers and increase business volumes for agents and brokers.

Although the CBA is obviously disappointed not to see progress on the insurance issue, it is pleased that the white paper addresses issues such as cheque imaging that, it says, “will strengthen the efficiency, security and maintains the competitive advantages of Canadian payments systems, and bring important benefits to Canadian consumers.”

Finn Poschmann, associate director of research and senior policy analyst at C.D. Howe and author of its brief on the legislative review, agrees that there is some good in the government’s effort. “The paper has good rhetoric about the importance of the sector, and the role of an effective and efficient financial sector in backstopping good economic performance,” he says, adding that it proposes a few positive legislative changes, too.

But much of it is “resolutely ho-hum,” he says, “as might be expected from a minority government in a field in which champions are few and there are no rewards for going down fighting.”

The existence of a minority government naturally discourages bold policy moves, but productive reforms don’t necessarily demand a huge political battle. For example, the government could have laid out a course for a less political bank-merger approval process that would have reduced the risk to a minority government by putting increased onus on competition authorities and industry regulators to approve any deals.

Giving the banks more room to operate in the insurance industry is surely a greater political risk, but enhanced competition would be the right policy direction for an industry that labours under too many outdated protectionist measures. In Europe, where there is greater crossover between banking and insurance, firms have enjoyed greater profitability and improved credit quality as a result of diversification.

For now, however, the changes coming to the Canadian financial sector will be modest. The government expects to introduce legislation in the fall enacting its slate of proposed changes.

More substantive reforms are going to have to wait. “I credit the government and the minister for keeping up the ‘pro consumer, pro competitive’ argument, and remain optimistic — or at least hopeful — that it will eventually lead to matching policy,” says Poschman.