P R E V I E W
1Commercial banks in Canada are called chartered banks, because they can be established only by charter granted either in a special act of the federal Parliament or by the Minister of Finance.
the chartered banking industry in detail and then discuss the near-banking indus- try, which includes trust and mortgage loan companies, and credit unions and caisses populaires. We spend more time on chartered banks because they are by far the largest depository institutions, accounting for over two-thirds of the deposits in the banking system. In addition to looking at our domestic banking system, we also examine forces behind the growth in international banking to see how it has affected us in Canada.
H I S TO R I C A L D E V E LO P M E N T O F T H E C A N A D I A N B A N K I N G SYS T E M
The modern Canadian banking industry began with the creation of the Bank of Montreal in 1817 by nine merchants in Montreal. Initially, the Bank of Montreal was without statutory authority, but a charter was approved by the legislature of Lower Canada and confirmed by royal assent in 1822. Meanwhile, other banks opened for business, and the Canadian banking industry was off and running; the Bank of New Brunswick received royal assent in 1820 and the Chartered Bank of Upper Canada in York (Toronto) in 1821. (As a study aid, Figure 11-1 provides a timeline of the most important dates in the history of Canadian commercial bank- ing before World War II.)
C H A P T E R 1 1 Banking Industry: Structure and Competition 253
F I G U R E 11- 1 Timeline of the Early History of Commercial Banking in Canada
The Bank Act of 1891 restricts bank entry
The Bank Act of 1901 simplifies the merger and acquisition procedures
The Bank of Canada is created The Bank of Montreal is formed
The Bank of Upper Canada collapses;
the Provincial Notes Act of 1866 authorizes the issue of provincial notes and ends the banks monopoly power to issue notes
The Dominion Notes Act of 1870 gives the government a monopoly over small-denomination (Dominion) notes
The First Bank Act sets the regulatory environment for the development of Canadian banking practices The Free Banking Act of 1850
establishes small unit banks, along American lines
Suspension of the gold standard;
the Finance Act of 1914 allows the Department of Finance to act as a pseudo-central bank The Bank Act of 1913 calls
for bank audits and introduces some flexibility in the management of the
money supply
1817 1850 1866 1870 1871 1891 1901 1913 1914 1935
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All these banks were authorized to issue notes (redeemable in specie, essen- tially British or American gold or silver coins, on demand), receive deposits, and lend for commercial purposes only; no bank was allowed to lend funds on mort- gages, land, or real property. There were, however, some differences between the charters of these banks. For example, the terms of the charter of the Bank of New Brunswick followed the banking tradition of New England. The charter of the Bank of Montreal almost duplicated the terms governing the Bank of the United States (see the FYI box, The Dual Banking System in the United States), which had elements of both a private and a central bank, a government institution that has responsibility for the amount of money and credit supplied in the economy as a whole. Also, the Bank of New Brunswick had to submit regular annual statements to the government and was not allowed to open branches (additional offices for the conduct of banking operations), whereas the Bank of Montreal had to provide statements only on request and was allowed to open branches in any part of Upper or Lower Canada.
Until 1850, no national currency existed in Canada, and banks obtained funds pri- marily by issuing banknotes (currency circulated by the banks that could be redeemed for gold). No banks failed, but because banking regulations were extremely lax banks regularly experienced substantial declines in bank capital due to business failures; their banknotes tended to become scarce. The government tried various schemes to guarantee the provision of stable money, including the issuing of its own notes, but it was significantly influenced by the concept of free banking, implemented in New York in 1837. This system, as the name suggests, permitted the organization of a bank by any group that met certain established cri- teria concerning the amount of equity capital and maintenance of reserves.
The Free Banking Experiment
The Dual Banking System in the United States FYI
The banking industry in the United States began when the Bank of North America was chartered in Philadelphia in 1782. A major controversy involving the U.S. banking indus- try in its early years was whether the federal government or the states should charter banks. The Federalists, particularly Alexander Hamilton, advocated greater centralized con- trol of banking and federal chartering of banks. Their efforts led to the creation in 1791 of the Bank of the United States.
Until 1863, all commercial banks in the United States were chartered by the banking commission of the state in which they oper- ated. No national currency existed, and banks obtained funds primarily by issuing bank- notes. Because banking regulations were extremely lax in many states, banks regularly
failed due to fraud or lack of sufficient bank capital; their banknotes became worthless.
To eliminate the abuses of the state- chartered banks (called state banks), the National Bank Act of 1863 (and subsequent amendments to it) created a new banking system of federally chartered banks (called national banks). This legislation was origi- nally intended to dry up sources of funds to state banks by imposing a prohibitive tax on their banknotes while leaving the banknotes of the federally chartered banks untaxed.
The state banks cleverly escaped extinction by acquiring funds through deposits. As a result, today the United States has a dual banking system in which banks supervised by the federal government and banks super- vised by the states operate side by side.
The Free Banking Act was passed in Canada in 1850, with the purpose of facil- itating the entry of small unit banks along American lines. It allowed the establish- ment of a bank, without a legislative charter, by any group that met the lax requirements set out in the free banking legislation. Under this legislation, the min- imum amount of net worth to organize a bank was $100 000, branching was not allowed, and although the banknotes of the free banks were untaxed, the amount of note issue was limited to the amount of government debt held by the banks.
The move to free banking was a step in the right direction, but Canada s experi- ence with free banking was a failure. It did not lead to the establishment of a large number of new banks; only five new banks were established, two of which soon failed, and the other three converted to legislative charters.
The restriction on branching and the issue of banknotes based on government debt, rather than on commercial loans, were blamed for the failure of Canada s free banking experiment. The most important factor, however, was the fact that the option of a legislative charter was still available, unlike the situation in the United States where the provision of a legislative charter was simultaneously abolished in those states where free banking was established. In Canada, free banking with its restric- tive provisions, particularly the restriction on branches and the less-liberal provision for note issue, proved to be less profitable than banking under legislative charters.
In 1850, there were fifteen chartered banks in Canada; eight in Central Canada and seven in what was to become Atlantic Canada. From 1850 until Confederation in 1867, and except for a short period after 1857, the Canadian provinces experi- enced an economic expansion and thirty new banks were established. However, eleven of these failed or closed their doors for other reasons, leaving thirty-four chartered banks with a total of 127 branches at the end of 1867.
In the years before Confederation, governments were anxious about the char- tered banks control of the note issue. They believed that the best way to pro- tect the public from some of the consequences of bank failures would be to separate the currency of the country from the banking interests. In 1860, Alexander Galt, finance minister of the Province of Canada, proposed the sub- stitution of a government-issued paper currency for banknotes. His proposal, however, was defeated by his critics, especially the chartered banks, for obvious reasons; the substitution of interest-free government debt for interest-free bank debt would have directly reduced their profits.
In the midst of a minor financial crisis in 1866, with the collapse of the Bank of Upper Canada (Canada s first chartered bank failure), the proponents of government- issued paper money finally achieved their objective with the enactment of the Provincial Notes Act. The Act authorized the issue of provincial notes, which because of their legal reserve status could be substituted for specie. With the cooperation of the Bank of Montreal, which had become the government s fiscal agent in 1864 by replacing the Bank of Upper Canada, the banks began to hold the new currency, thereby surrendering their power to issue notes.
Canada was created by the Constitution (formerly the British North America Act) in 1867. The Act granted the new federal government of Canada exclusive juris- diction over all matters pertaining to currency and banking, and the first problem to be tackled was the issue of paper money. With the failure in 1867 of the Chartered Bank of Canada (the second chartered bank failure in Canadian history), the Dominion Notes Act was passed in 1870. The Act confirmed the rights of banks to issue banknotes on their own credit, but restricted to large-denomination (over
The Provincial Notes Act, 1866
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The Dominion Notes Act, 1870
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$5) notes, thereby giving the government a monopoly over small-denomination ($1 and $2) notes, the Dominion notes.
Although the Dominion Notes Act of 1870 did not set any reserve require- ments, it required banks to hold at least half of their reserves in Dominion notes, thereby giving the government a share of the profits from the issuance of money, which is called seignorage. The Dominion notes themselves were fractionally backed by gold, and in this sense the Dominion Notes Act of 1870 confirmed that Canada would operate under the gold standard, meaning that its currency was convertible directly into gold.
Canada operated under the gold standard, keeping its currency backed by and convertible into gold, until World War I. During the years 1870 1935, Dominion notes increased in importance, but they never accounted for a major fraction of currency in circulation. They were superseded, together with the banknotes, by Bank of Canada notes, soon after the creation of the Bank of Canada (Canada s central bank) in 1935.
The first Bank Act came into effect in 1871. It was to be revised every 10 years, in light of experience and changing conditions; this sunset clause has effectively ensured that governments over the years paid periodic attention to banking reform. The Bank Act set the regulatory environment for Canadian chartered banks and for the future development of Canadian banking practices.
The Act continued the legislative chartering of banks, with each charter run- ning for a ten-year period, then to be reviewed and renewed. New banks had to meet minimum capital requirements: $100 000 paid up before they opened for business against a total of $500 000. The banks note issue continued to be restricted to large-denomination (over $5) notes and limited to the amount of their paid-up capital plus reserves. There were no reserve requirements, but one-third of a bank s cash reserves were required to be in the form of Dominion notes.
The Act continued the prohibition against mortgage lending and real estate loans, but it reinforced the commercial nature of banking by allowing banks to make loans on the security of most kinds of merchandise. Also, for the greater security of the public, bank shareholders were liable for double the amount of their subscription. Finally, each bank was required to submit a detailed statement to the government on a monthly basis, but there was no provision for government inspection or audit.
A depression followed Confederation and lasted from 1873 to 1879. During the depression years, the banks were hard hit and thirteen bank failures (four in 1878, five in 1887, and another four in 1890) wiped out the savings of many notehold- ers. To prevent future losses from such failures, the early decennial revisions of the Bank Act, in 1881, 1891, 1901, and 1913 (postponed since 1911), were intended to provide better protection for the holders of banknotes, but the Act was not substantially changed.
In particular, in the Bank Act revision of 1891, the capital requirement was increased to $250 000 paid up, thereby restricting entry into the industry. The pro- portion of Dominion notes in bank cash reserves was increased to 40%, and the notes of a failed bank were made a first charge against its assets in the event of liquidation. Moreover, in the Bank Act revision of 1891, a Bank Circulation Redemption Fund was created, each bank contributing an amount equal to 5% of its average note circulation, to insure noteholders against loss.
The Bank Act, 1881 1913 The First Bank Act, 1871
In the years between mid-1890 and the outbreak of World War I, the Canadian economy experienced a phenomenal economic expansion. While bank entry was restrained (due to the increase in capital requirements in the Bank Act of 1891), the Bank Act revision of 1901 simplified the merger and acquisition procedures, by requiring only approval of Cabinet; previously a special Act of Parliament was required for all mergers. As a result of these legislative changes, thirteen mergers took place before the end of 1914, relative to only six in the previous thirty-three- year period, and the number of banks declined from forty-one in 1890 to twenty- two in 1914. Over the same period, however, the number of bank branches increased from 426 to over 3000.
Another important legislative change occurred in the 1913 revision of the Bank Act. The Act called for a bank audit: annual, independent verification of the finan- cial statements of the banks, with the results distributed to the shareholders and the Minister of Finance. The objective was to limit adverse selection and moral hazard problems that had increased over the years and been found to be the cause of a number of bank failures, particularly the failure of the Farmers Bank in 1910.
An additional noteworthy change was the excess circulation provision that introduced some flexibility in the management of the money supply. The eco- nomic expansion in the period after mid-1890 caused banknote issues to reach the ceiling that the Bank Act of 1871 had fixed at the amount of paid-up capi- tal plus reserves. The banks did not increase their capital (and thus their note- issuing capacity), producing a shortage of currency. In order to achieve expansion in the money supply with the growth of economic activity, the Bank Act of 1913 allowed for the issuing of banknotes in excess of a bank s paid-up capital plus reserves.
At the end of July 1914, less than a year after the revision of the Bank Act in 1913, World War I looked more and more inescapable. Canada s established banking leg- islation appeared to be inadequate and the immediate problem was to preserve the stability and liquidity of the financial system. Panic had taken hold, with depositors converting their money into gold for hoarding, and the banks and the government being concerned about their ability to convert money into gold on demand, since their gold reserves were a small fraction of their combined monetary liabilities. In light of these developments, on August 3, 1914, the government suspended the convert- ibility of Dominion notes and banknotes into gold, thereby ending the gold standard that had emerged over 40 years earlier in 1870. The gold standard was re-established in 1926 and suspended again in 1929, when the Great Depression hit the world.
A major legislative change, following the suspension of the gold standard, was the Finance Act of 1914. Patterned on the episode of 1907, during which banks could obtain cash reserves from the Department of Finance to prevent bank runs (which were triggered by bank failures in the United States), the Finance Act allowed the Department of Finance to act as a lender of last resort , that is, to provide Dominion notes to banks (on the pledge of approved securities) when no one else would, thereby preventing bank and financial panics. The Finance Act foreshadowed the increased flexibility in the management of the money supply that was provided by the Bank of Canada in 1935. We will examine in detail the economic forces that led to the creation of the Bank of Canada in Chapter 15.
The Finance Act, 1914
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F I N A N C I A L I N N OVAT I O N A N D T H E G ROW T H O F T H E S H A D OW B A N K I N G SYST E M
Although banking institutions are still the most important financial institutions in the Canadian economy, in recent years the traditional banking business of making loans that are funded by deposits has been in decline. Some of this business has been replaced by the shadow banking system, in which bank lending has been replaced by lending via the securities markets.
To understand how the banking industry has evolved over time, we must first understand the process of financial innovation, which has transformed the entire financial system. Like other industries, the financial industry is in business to earn profits by selling its products. If a soap company perceives that there is a need in the marketplace for a laundry detergent with fabric softener, it develops a product to fit the need. Similarly, to maximize their profits, financial institutions develop new products to satisfy their own needs as well as those of their customers; in other words, innovation which can be extremely beneficial to the economy is driven by the desire to get (or stay) rich. This view of the innovation process leads to the following simple analysis: a change in the financial environment will stimulate a search by financial institutions for innovations that are likely to be profitable.
Starting in the 1960s, individuals and financial institutions operating in finan- cial markets were confronted with drastic changes in the economic environment:
inflation and interest rates climbed sharply and became harder to predict, a situa- tion that changed demand conditions in financial markets. The rapid advance in computer technology changed supply conditions. In addition, financial regulations became more burdensome. Financial institutions found that many of the old ways of doing business were no longer profitable; the financial services and products they had been offering to the public were not selling. Many financial intermedi- aries found that they were no longer able to acquire funds with their traditional financial instruments, and without these funds they would soon be out of busi- ness. To survive in the new economic environment, financial institutions had to research and develop new products and services that would meet customer needs and prove profitable, a process referred to as financial engineering. In their case, necessity was the mother of innovation.
Our discussion of why financial innovation occurs suggests that there are three basic types of financial innovation: responses to changes in demand conditions, responses to changes in supply conditions, and avoidance of regula- tions. These three motivations often interact in producing particular financial innovations. Now that we have a framework for understanding why financial institutions produce innovations, let s look at examples of how financial institu- tions in their search for profits have produced financial innovations of the three basic types.
The most significant change in the economic environment that altered the demand for financial products in recent years has been the dramatic increase in the volatility of interest rates. In the 1950s, the interest rate on three-month treasury bills fluctuated between 1.0% and 5.5%; in the 1970s, it fluctuated between 3% and 14%;
in the 1980s, it ranged from 7% to over 20%. Large fluctuations in interest rates lead to substantial capital gains or losses and greater uncertainty about returns on invest- ments. Recall that the risk that is related to the uncertainty about interest-rate movements and returns is called interest-rate risk, and high volatility of interest rates, such as we saw in the 1970s and 1980s, leads to a higher level of interest-rate risk.
Responses to Changes in Demand Conditions:
Interest Rate Volatility