Changing Face of Canada's Banking Sector

Canadian banks have experienced relatively strong profitability in recent years in spite of intense competition, margin compression and pricing pressures. Regulatory changes and advances in technology have allowed banks to diversify their operations into other financial services businesses, as well as reduce the barriers to entry into the domestic banking market. However, long-awaited bank mergers remain in limbo on the back of political indecision and consumer disapproval.

Banking Landscape

Canada’s banking sector is dominated by six domestic chartered banks (known as the big six), whose combined assets account for close to 90 per cent of the total assets of the sector. The remaining 10 per cent of the sector’s C$1.8 trillion in assets are held by 13 smaller domestic banks, 27 foreign bank subsidiaries and 22 foreign bank branches.

Banks operating in Canada are classified as Schedule I, II and III banks. Schedule I banks are domestic banks and are authorized under the Bank Act to accept deposits, which may be eligible for deposit insurance provided by the Canadian Deposit Insurance Corporation (CDIC). Schedule II banks are foreign bank subsidiaries – controlled by eligible foreign institutions – authorized under the Bank Act to accept deposits, which may be eligible for deposit insurance provided by the CDIC. Schedule III banks are foreign bank branches of foreign institutions that have been authorized to do banking business in Canada, subject to certain restrictions.

Of the big six, Royal Bank is the largest in terms of market capitalization, followed by Scotiabank, TD Bank, Bank of Montreal, CIBC and National Bank of Canada. Royal Bank, with assets of $417bn, is five times larger that the smallest of the big six, National Bank of Canada (see table below).

Foreign banks, of which HSBC Canada is the largest, account for almost 7 per cent of total assets. Most foreign banks operating in Canada specialize in corporate and investment banking services, but banks such as ING Canada, HSBC Canada and ICICI Canada also actively compete in the retail space.

Canadian banks operate through an extensive national network that includes over 8,000 branches and more than 18,000 automated banking machines (ABMs) across the country. More than 70 per cent of all banking transactions are done electronically: via the Internet (23 per cent); ABMs (34 per cent); telephone (8 per cent); and a combination of electronic channels (6 per cent). In fact, Canada currently has one of the highest penetration rates of electronic banking and the highest number of ABMs per capita in the world. Advances in technology have also facilitated virtual, branchless banks and expansion into grocery, hardware and convenience stores, thereby reducing transaction costs. The big six banks have spent almost C$29bn on technology between 1996 and 2004.

Ranked by assets, Canadian banks are relatively small on a global scale. The country’s largest, Royal Bank, ranks 47; TD ranks 58; CIBC 60; and Scotiabank and Bank of Montreal 62 and 63, respectively. However, pre-tax returns on assets are currently either in line with or better than the top 10 largest banks in the world. Return on equity of the big six Canadian banks averaged 18.3 per cent over the past 11 quarters ending with the third quarter of 2005.

Business Expansion

Over the past 15 years, many of the barriers prohibiting financial institutions from competing in each other’s business have disappeared. As a result banks have expanded into businesses such as life insurance, securities, brokerage, trust and mutual funds. The big six banks own the major securities and brokerage firms; insurance arms (or are actively involved in insurance distribution); trust companies; and mutual fund companies that are among the largest in Canada.

This strategy will have long-term implications for the banks. According to Statistics Canada National Balance Sheet Account, Canadians rely on a wide variety of financial institutions to manage their household assets. The banking sector held 20 per cent of assets, while 11 per cent were held by insurance companies and 69 per cent by other financial firms. A high level of competition has therefore provided the impetus for the banks to diversify out of their core business. A shift from share of market to share of wallet is also a driver of diversification leading Canadian banks to integrate their wealth management subsidiaries and mutual fund companies.

In 1999, banks were permitted to have a more flexible ownership structure and to form strategic alliances. Changes in regulations also reduced the barriers to entry into what was traditionally the banking business, allowing several large unregulated participants to offer products such as residential and commercial mortgages, credit cards, motor vehicle and equipment financing. Among the institutions entering the market were GE Capital, General Motors Acceptance Corporation, Ford Credit, CIT Group and Dell Financial Services.

In addition, retailers such as Canadian Tire and Sears Canada also established banking subsidiaries; and Manulife, the country’s largest insurance company, established Manulife Bank. Several smaller banks also emerged as a result of regulatory change. Competition also comes from 30 trust companies (mostly owned by the large banks), over 1,100 credit unions, caisses populaires and insurance companies.

Changing Forces

Foreign banks were the major beneficiaries of regulatory change. Up until 1999, they were only permitted to operate in Canada through separately capitalized subsidiaries. Now they can establish full-service or lending branches without setting up incorporated subsidiaries. In this case, full-service branches are only permitted to take deposits greater than $150,000, while lending branches are not permitted to take any deposits and are restricted to borrowing only from other financial institutions.

Interest rate spreads, i.e. the difference between the interest rate a financial institution charges on loans to its borrowing customers and the interest rate it pays to its depositing customers, have been a key driver of competition in the banking business. Spreads have narrowed significantly in recent years, allowing borrowers to access funds at close to the bank’s cost of acquiring funds. According to the World Economic Forum 2004-2005 Global Competitiveness Report, interest rate spreads in Canada in 2003 were among the lowest in the OECD countries. For instance, spreads in Canada were 1.1 percentage points lower than in the US and 4.6 per cent lower than in Germany.

A low interest rate environment has intensified competition in spreads as banks strive to gain an increasing share of personal loans. Over the past five years, personal loans – including lines of credit, mortgages and credit cards – extended by Canada’s largest banks have increased by over 50 per cent. Banks are keen to increase their share of this business because it provides stable returns with relatively lower loan losses than corporate lending. In fact, some banks are beginning to consider lending at sub-prime rates. Another reason for banks to target increased lending is due to the fact that they are generating record levels of capital that is in excess of regulatory requirements. This capital must be loaned out, returned to shareholders or reinvested; otherwise it will become a drag on earnings.

According to the June 2005 Standard and Poor’s report on Canadian Banks, demand for corporate loans remains muted although corporate lending continues to benefit from fewer problem loans. Underwriting fees, trading revenues and, to a lesser extent, the banks’ wealth management business are all being affected by a slowdown in capital and equity market activity.

Mergers among Canadian banks continue to be the subject of much debate. Supporters of mergers argue that it is essential for mergers to take place in order for Canadian banks to remain competitive in an increasingly global economy. Opponents argue that the mergers will result in reduced domestic competition, higher fees and reduced consumer welfare. The government, on the other hand, is sitting on the fence.

Diversified Operations

In the mean time, the big banks continue to seek alternative revenue streams and efficiencies. The traditional four pillars of financial services – banks, trusts, brokerage and insurance – are now integrated and the banks are striving to diversify their operations. TD Bank, Bank of Montreal and Royal Bank have expanded south to the United States while the Bank of Nova Scotia remains the only bank that has expanded beyond the borders of the continent and currently has operations in some 50 countries. In total, Canadian banks derive about 28 per cent of their revenues overseas.

It remains to be seen if US-based expansions will be positive for Canadian banks. Royal Bank has experienced problems with its US based subsidiary RBC Centura in bringing its operations in line with its peer group. TD and Bank of Montreal have both unloaded their US based brokerage subsidiaries to focus on traditional core banking services.

The Financial Stability Assessment undertaken in 2000 conducted by the International Monetary Fund concluded that Canada has a stable and highly advanced financial system that is among the soundest in the world. This is supported by a well-developed regulatory and supervisory framework that complies with international standards. The major banks also exceed the minimum capitalization requirement standards set by the Bank of International Settlements.

Looking ahead, the major banks are currently awaiting a formal review of the Bank Act, which will allow them to sell insurance related products in existing branches. Further out, there is still hope that banks will be allowed to merge. In the immediate future, higher interest rates on the horizon pose a risk to future profitability of the banking sector and the probability of increased loan losses.