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PRB 00-16E
FINANCIAL HOLDING
COMPANIES: BILL C-8 AND
NEW OPTIONS FOR FINANCIAL CONGLOMERATES
Prepared by:
Alexandre Laurin
Economics Division
12 October 2000
TABLE OF CONTENTS
INTRODUCTION
CURRENT PERMITTED
ORGANIZATIONAL STRUCTURES
INNOVATIONS
IN THE DELIVERY OF FINANCIAL SERVICES,
AND THE NEED FOR MORE STRUCTURAL FLEXIBILITY
A. Innovations in Financial
Markets
B. Competition and the
Regulatory Burden
RISKS
ASSOCIATED WITH A HOLDING COMPANY STRUCTURE FOR BANKS
A. Quality of Capital
and Excessive Gearing
B. Contagion
C. Abuse of Regulated Safety
Net
D. Commercial Links and
Self-dealing
E. Public Perception
THE PROPOSED LEGISLATION
FINANCIAL
HOLDING COMPANY LEGISLATION AROUND THE WORLD
A. Supervision
B. Ownership Rules
C. Permitted Investments
D. Corporate Governance
CONCLUSION
APPENDIX:
ILLUSTRATIVE EXAMPLE OF MULTIPLE COUNTING OF CAPITAL
FINANCIAL HOLDING
COMPANIES: BILL C-8 AND
NEW OPTIONS FOR FINANCIAL CONGLOMERATES
INTRODUCTION
In 1996, the Minister of
Finance asked the Task Force on the Future of the Canadian Financial Sector
to advise the government on what was needed for the Canadian financial
system to remain strong and dynamic. In its 1998 report, the Task Force
made a number of recommendations, including the suggestion that the government
permit banks and demutualized insurance companies to be organized as non-operating
financial holding companies. Following two parliamentary reviews (House
of Commons Finance Committee and Senate Banking Committee), the Minister
of Finance released the federal government White Paper (Reforming Canada’s
Financial Services Sector: A Framework for the Future) which called
for the creation of financial holding companies, a proposition which follows
the lines of the Task Force recommendation. In June 2000, Bill C-38 was
given first reading, but died on the Order Paper with the calling of the
2000 election. Bill C-8, its successor, was given first reading in February
2001.
Worldwide, the financial
services’ marketplaces are in a state of general transformation,
deregulation and consolidation. And with the current pace of progress
in information and communication technologies, the financial industry
in Canada and abroad is set for major changes in the future. The need
for financial regulatory reform has been spurred by:
- the wave of worldwide consolidations;
- the emergence of new competitors;
- expanded choices for consumers, and their
increasing level of sophistication; and
- the increasing complexity of the institutions
and financial products themselves.
By allowing bankers and
insurers to form holding companies, the government hopes that additional
structural flexibility will promote competition and result in efficiency
gains for the Canadian financial sector. Most likely, banks will reorganize
their activities under a holding company structure which would help them
to: better compete with unregulated financial institutions; better tackle
and take advantage of innovations in financial markets; and, combined
with new ownership rules, form joint ventures with foreign and/or domestic
institutions.
The six remaining sections
of this paper:
CURRENT PERMITTED ORGANIZATIONAL
STRUCTURES
Schedule I Banks
– Schedule I banks are required to be "widely held," i.e.,
no shareholder may acquire more than 10% of any class of shares of a Schedule
I bank. Mutual insurance companies, by their very nature, are effectively
widely held. This restriction ensures that Schedule I banks cannot be
owned and controlled by another institution or corporation, or individual.
A bank cannot act as a trustee for a trust or underwrite insurance risks,
and is limited in the scope of its securities-dealing activities. However,
following the 1992 legislative revisions, any regulated financial institution
can own any other regulated financial institution as a subsidiary. Thus,
a bank can now own investment dealers as well as insurance and trust companies.
Because Schedule I banks (and mutual insurance companies) are required
to carry on many of those related financial services through subsidiaries,
they are de facto operating financial holding companies.
DIAGRAM 1
The Financial Institution Parent Organizational Model
(also known as Operating Financial Holding Company) Currently Imposed
on Schedule I Banks and Mutual Insurance Companies
|
In-house Banking
(or Insurance) Activities
|
|
Securities Activities
|
Insurance
(or Banking)
Activities
|
Trust Activities
|
Other Permitted
Financial Activities
|
|
subsidiary
|
subsidiary
|
subsidiary
|
subsidiary
|
Domestic Schedule II
Banks – Domestic Schedule
II banks may be closely held by a widely held Canadian financial institution,
much like in the diagram above where a bank is a subsidiary of a mutual
insurance company. This organizational structure for Schedule II banks
does not enable it to circumvent the widely held requirement.
Foreign Schedule II Banks
– Foreign Schedule II banks may be closely held by an eligible foreign
financial holding company, an eligible foreign bank, or a widely held
foreign financial institution. However, foreign Schedule II banks may
adopt a variety of structures to conduct financial services in Canada.
For example, a foreign bank holding company may carry on regulated financial
activities (such as securities-dealing activities) in Canada as the Canadian
part of the bank’s foreign securities operations, separate from its
banking subsidiaries in Canada and abroad. The Minister may require the
foreign institution to carry on all regulated financial services in Canada
exclusively through a Schedule II bank subsidiary.
Furthermore, a foreign bank
may carry on unregulated financial activities in a narrow market segment,
such as credit card operations, through an unregulated entity once an
exemption order is obtained from the Minister. In 1999, Bill C-67 amended
the Bank Act, permitting foreign banks to have branch operations
in Canada. A foreign bank is now able to conduct wholesale banking activities
through a branch of the parent bank as well as retail banking, including
retail deposit-taking activities, through a Schedule II bank subsidiary.
Foreign banks have the structural flexibility to divide their wholesale
banking operations from their retail banking business, and take advantage
of the reduced regulatory burden that applies to a foreign bank’s
branch.
However, "most of the
foreign banks in Canada are involved in wholesale banking or niche financing,
and their physical presence often consists of a head office and one branch.
An exception is the Hongkong Bank of Canada, which has an extensive branch
network and accounts for close to one-third of foreign bank assets in
Canada."(1)
Other Financial Institutions
– The Task Force stated that "there is currently no wide-ownership
requirement for trust companies or stock insurance companies and these
institutions can be, and often are, owned by holding companies. Such companies
are not regarded as financial institutions and are not regulated."
For example, federal trust and insurance companies may be owned by unregulated
non-financial holding companies. Therefore, these unregulated companies
may carry on almost all of the same regulated financial services as banks,
through trust affiliates, while still carrying on bank-restricted commercial
activities such as automobile leasing in other unregulated affiliates.
They thus enjoy a regulatory advantage over banks. In practice, the Task
Force stated that "OSFI [Office of the Superintendent of Financial
Institutions] obtains undertakings from the owners of financial institutions
held by unregulated holding companies. These provide OSFI with reasonable
assurance that it can discharge its responsibilities with regard to the
safety and soundness of the Canadian-regulated financial institution."
INNOVATIONS
IN THE DELIVERY OF FINANCIAL SERVICES,
AND THE NEED FOR MORE STRUCTURAL FLEXIBILITY
A. Innovations in Financial Markets
"Traditional"
core banking functions have changed considerably in the past century.
For example, until 1954, banks were unable to provide residential mortgages.
Since then, banks have been gradually taking on new functions as markets
changed. As a result of the 1992 legislation, banks are now able to provide
insurance, trust, and securities-dealing services through their subsidiaries.
The financial markets are in constant evolution, and new products are
emerging at an accelerated pace. In recent years, banks have begun to
convert loans, such as mortgages and credit card balances, into securities
that are sold to investors – a process known as securitization. Securitization
helps move assets off the balance sheet, reducing the need to hold regulatory
capital and allowing investment in potentially higher-yielding opportunities.
As financial markets change
and innovate, the role and functions of banks are shifting as well. Traditionally,
banks’ basic role has been to act as the intermediary between depositors
and borrowers. The way banks fulfil this basic function is changing, and
will probably undergo even more transformations in the near future. Three
of the many factors that are pressing banks worldwide to reorganize and
redefine their role are presented below.
Customer Sophistication
– Customers are becoming more sophisticated in their demands for
financial services, as their preferences and their tolerance for risk
change.
Customers
are becoming more involved, more knowledgeable, and more aware of financial
product characteristics and provider choices. Their concerns about the
potential loss of government- and employer-supported retirement programs,
combined with lower inflation and lower returns on deposits, have led
them to become more involved in their own investment planning and decisions.
With this increasing sophistication, customers have also become more
accepting of non-traditional providers and more comfortable with alternative
delivery methods, including electronic channels.(2)
With the rapid technological
change in the information technology and communication (ITC) industry,
customers are now able to fulfil most of their investment and banking
needs on electronic platforms. As a result, customers have more choices
and more convenience, there is less customer loyalty for financial services
providers, and the opportunities to integrate a wide range of services
under the same umbrella have increased.
Above all, customers have
gained access to a much larger pool of financial information and advice,
and at a very low cost. As access to convenient information increases,
the level of involvement and sophistication in individuals’ own investment
planning rises as well.
New Delivery Channels
and Select Product Lines –
Increasingly, consumers are shifting away from their traditional deposit
accounts and are investing their savings in other product lines which
are close substitutes. For example, consumers can bypass deposit accounts
and invest directly in capital markets through mutual funds, stocks, bonds
and other instruments. Insurance companies offer products such as deferred
annuities, which are similar to Guaranteed Investment Certificates sold
by banks. Some other companies specialize in selected product lines, and
are able to offer very competitive prices and returns. The advent of Internet
banking has opened the door to a truly integrated personal financial management
platform, where consumers are able to quickly compare and assess the characteristics
of different financial products, empowering these consumers to directly
invest in and borrow from the institutions they choose.
E*Trade Group, one example
of such branchless financial institutions currently operating in the United
States, is composed of:
Such Internet-only financial
institutions can offer cheaper services. As well, they are able to offer
much better interest rates than those offered by traditional "bricks-and-mortar"
institutions. For example, E*Trade offers a free Internet chequing account
combined with free unlimited bill payments, free cheques and free unlimited
ATM operations. Customers can also transfer money into a trading account,
where they can directly invest in stocks, mutual funds and other capital
market products. Customers are also only clicks away from purchasing insurance
products, auto loans, mortgages and credit cards. Everything is processed
through the Internet, which saves money and time.
Customers have responded
positively to those new institutions. The total assets of E*Trade Bank
grew from $1 billion in 1998 to $7.5 billion in 2000, a 750% increase
in only two years. Since 1998, at least five other Internet-only banks
emerged in the U.S., and they all experienced phenomenal growth.
Globalization
– In 1953, the Mercantile Bank of Canada became the first foreign-owned
bank to be incorporated in Canada. Since then, the legislation for foreign
banking has been considerably liberalized, allowing foreign-owned banks
to organize and carry on financial services in much the same way as domestic
banks. Forty foreign banks now operate in Canada.
Canadian banks are very
active abroad. The Canadian Bankers Association reports that approximately
49% of Canadian bank earnings are currently generated outside Canada.
Increasingly, Canadian and non-Canadian banks see the world as their marketplace.
With the advent of new forms
of electronic delivery of personal financial services, it will now become
easier for foreign business to compete with local providers. Moreover,
it makes it easier for non-financial companies and multinationals to offer
a select line of financial services to their consumers. Multinationals
such as Toyota, GM, BMW and Sony have plans to offer financial products
by expanding their operations. These companies are already benefiting
from an active global network.
Customer sophistication,
financial delivery innovations and globalization have important implications
for banks and their primary role as investment intermediary between depositors
and borrowers. Deposits represent a large percentage of banks’ personal
financial services profits, and the shift away from deposits and traditional
debt to other investment and debt products means shrinking assets for
banks. Increasingly, banks need to reorganize and develop new innovative
products to deal with a potential loss in assets and market share.
New consumer preferences
also raise questions for regulators. For example, what are the implications
for federal deposit insurance if investment activity is shifting increasingly
towards non-insured financial products?
B. Competition and the Regulatory
Burden
Banks are heavily regulated
because of their retail deposit-taking activities, which are typically
subject to deposit insurance. As well, they are the primary agents in
the payments system, and a failure in one bank could threaten the integrity
and efficiency of that system. Regulations are designed to help protect
the integrity of that system of deposit insurance as well as maintain
the safety and soundness of the financial system, which could be subject
to contagion. Other financial institutions which do not take deposits
are less regulated, or sometimes not regulated at all. As regulation is
costly for financial institutions, this has competitive implications when
a non-bank subsidiary of a bank competes in a market segment with unregulated
or less-regulated financial services providers because bank subsidiaries
(unlike their unregulated, non-bank competitors) are affected by the capital
and other requirements of bank regulation, even though they are not directly
involved in deposit-taking activities.
For example, trust companies
– which also take deposits – have the additional structural
flexibility to organize via an unregulated holding company. These companies
do not face the same structural restrictions as do banks; unlike banks,
they are permitted to disaggregate functions between regulated and unregulated
affiliates. Therefore, federal trusts and other non-bank financial institutions
that face the same restrictions on automobile leasing as do banks nonetheless
can participate in the leasing market indirectly through an affiliate
which is not subject to the same regulations.(3)
The
changing financial markets have also led to the emergence of new participants
that compete with traditional financial institutions in select product
lines. Independent mutual fund companies are dominant in the mutual
fund market, accounting for about two thirds of assets under management.
Asset-based lenders, such as Newcourt Credit Group,(4) have emerged as significant competitors
in certain commercial credit markets. Such asset-based lenders, because
they do not take deposits from individuals, are not regulated institutions.
Mutual funds fall under the jurisdiction of provincial securities commissions.
Mutual fund companies are regulated, but because market risks are assumed
by the investors, regulators focus only on market conduct and not on
safety and soundness.
There
is a growing dichotomy between activities that are not regulated or
less regulated when carried on in some institutions, and more regulated
when carried on in others. As markets become more competitive, the cost
burden of regulation on the same activities in some institutions and
not in competing institutions can affect competition in the marketplace.(5)
The venture capital industry
is one example. Independent venture capital corporations are not regulated
financial institutions. However, venture capital subsidiaries of banks
are regulated on the same basis as the parent bank, which places additional
impediments on them. These impediments include the following:
Other types of venture capital
corporations do not face these constraints. Therefore, the regulatory
environment creates a playing field that is unequal for venture capital
corporations that are subsidiaries of banks. This restricts banks’
ability to operate in that marketplace on the same basis as the competition.
The Task Force believed that two institutions performing the same functions
should have those functions regulated in the same way.
Regarding financial services,
Canada has a constitutional division of powers between the federal and
provincial governments. The federal government has exclusive jurisdiction
over banking and the incorporation of banks. Provincial governments have
exclusive jurisdiction over property and civil rights in the provinces
and the incorporation of companies with provincial objects. This suggests
that the activities of trust and loan companies, insurance companies,
securities dealers and financial co-operative institutions that are "provincial"
in scope do not fall within federal banking jurisdiction. Therefore, a
truly "functional approach" to regulation is, in practice, hard
to implement.
Although regulation must
continue to be based on institutions, it is possible to move closer to
a "functional approach" by allowing more flexible organizational
structures for regulated financial institutions. Allowing for the creation
of financial holding companies accomplishes this by helping banks to:
RISKS
ASSOCIATED WITH A HOLDING COMPANY STRUCTURE FOR BANKS
Supervisory issues are associated
with financial conglomerates, mainly because some institutions within
the conglomerate benefit from the government safety net while others do
not. Under the current operating holding company regime, the parent and
its subsidiaries are regulated on a consolidated basis whereas all the
subsidiaries face the same level of regulation. However, under a non-operating
holding company regime, some affiliates of the group may not be regulated,
or may face a lower regulatory burden than their regulated counterparts.
This might give rise to
situations of regulatory arbitrage and moral hazard that were not present
under the current regime. Sub-sections A. and B. expose prudential risks
present in both types of financial conglomerates regime, while sub-sections
C., D. and E. deal with prudential risks mainly present in non-operating
holding company regimes, because in such regimes the level of regulatory
supervision imposed on deposit-taking institutions can well vary from
the regulatory burden faced by the non-bank (and possibly commercial)
affiliates.
A. Quality of Capital
and Excessive Gearing
The term "excessive
gearing" (also known as multiple counting of capital) refers to the
fact that:
[…]
it is possible for all entities in a group to fulfil their capital requirements
on an individual basis, but for the own funds of the group as a whole
to be less than the sum of those requirements. Such a situation occurs
where the same own funds are used simultaneously as a buffer more than
once – i.e., to cover the capital requirements of the parent company
as well as those of a subsidiary (and possibly also those of a subsidiary
of a subsidiary).(6)
In such circumstances, the
evaluation of the total capital of the conglomerate overstates the real
value. However, this can be avoided by adopting a consolidated measure
of capital adequacy (an illustrative example of that is provided in the
appendix).
The quality of capital available
in the holding company to support its downstream affiliates is another
important issue. This problem can arise where the holding company issues
capital instruments of one quality and then uses the proceeds to invest
in downstream entities as instruments of a higher quality. On this subject,
the OSFI mentions that:
From
a safety and soundness standpoint, the attributes of capital raised
by a holding company should, inter alia, be consistent with the attributes
of the capital subsequently invested in downstream financial institutions.
If this principle is not respected (e.g., if limited-term capital raised
by a holding company is reinvested in permanent capital of a financial
institution subsidiary), what might appear to be a very well capitalized
financial institution could be vulnerable to unexpected pressures from
a parent who may be struggling because of the demands imposed by a weaker
(i.e., less permanent) capital position.(7)
A situation of excessive
leverage is an example of that. In this case, the holding company issues
debt and uses the proceeds to finance a regulated affiliate in the form
of equity or other elements of regulatory capital.
[…]
the greater the propensity for a bank holding company to use debt to
finance equity investments in its subsidiaries, whether regulated or
unregulated, the greater the risk of undue pressure on the regulated
financial institution subsidiaries to generate sufficient income and
cash flow to support dividend payments required by the holding company
to meet its debt servicing requirements. The resulting focus on the
need for upstream cash flow could skew management decisions in the regulated
financial institutions toward short-term objectives and away from more
appropriate long term goals. This kind of situation also puts pressure
on management of financial institutions in the group to institute questionable
accounting and other practices in order to boost income. When this occurs,
the holding company that is expected to be a source of strength for
its financial institutions subsidiaries can instead become a destabilizing
factor, indeed a source of weakness.(8)
[…]
we have seen several examples of this in Canada with some of the financial
institution failures of the last ten years.(9)
B. Contagion
Contagion is probably one
of the most important issues in a holding company structure. Contagion,
or domino effect, occurs when problems in one entity of the group are
transferred to other parts. The Bank for International Settlements (BIS)
has identified two types of contagion.(10) The first of these essentially relates to market perception,
where financial difficulties in one part of the group results in a drop
in public confidence in other entities of the holding, notwithstanding
their individual financial situation. The reluctance of capital markets
to deal with a tainted group can significantly impair the holding company’s
ability to capitalize its liquidity-restrained subsidiaries.
The second type of contagion
relates to the potential transfer of capital from the regulated entity,
as might occur when it attempts to rescue another group member from financial
difficulties. Such intra-group transfers may be evident, as in the case
of loans, investments and guarantees, or may be hidden through biased
pricing of intra-group transactions. The BIS noted that intragroup exposures
can significantly exacerbate problems for a regulated entity once contagion
spreads to it.
OSFI
has experienced a number of cases where financial difficulties afflicting
a closely-held financial institution were precipitated or accentuated
by problems in upstream holding companies and/or other parts of the
conglomerate structure. Each situation varied depending on its own particular
circumstances, but it has been recognized that contagion played a role
in the downfall of a number of financial institutions in Canada and
elsewhere.(11)
C.
Abuse of Regulated Safety Net
In a holding company structure
where different entities face different levels of regulation, there is
an obvious risk of regulatory arbitrage, i.e., the shifting of certain
activities within a conglomerate, either to avoid a situation of relatively
more strict prudential supervision compared to another, or to abuse from
the safety net linked to some financial institutions. Also, there can
be management bias at the holding company level to influence banks and
other regulated financial institutions to support other unregulated affiliates.
Some
believe that, where a conglomerate structure includes both financial
institutions that benefit from the safety net and other unregulated
financial service entities that do not, there is an incentive to place
riskier loans and investments in the regulated financial institutions
and higher quality assets in the unregulated entities. The premise for
this argument is that the latter entities may be more sensitive to market
scrutiny because of the nature of their funding activities and their
lack of direct access to the safety net.(12)
D. Commercial Links and Self-dealing
Commercial links between
controlling shareholders at the holding company level (this applies especially
to closely held conglomerates) and other non-financial entities can lead
to conflicts of interests, where the resources of regulated financial
institutions are unduly used for shareholders’ other commercial interests,
to the detriment of the financial institution.
The
potential for conflicts of interest in a financial conglomerate is heightened
when investors with substantial holdings in the conglomerate have contractual
relationships with businesses in the group. In many financial conglomerates
– although not necessarily confined to them – there is a distinct
possibility that shareholders’ interests may conflict with the
interests of creditors, particularly those whom the supervisor has a
duty to protect.(13)
However, the government
has historically supported the separation of banking and commerce by requiring
domestic banks to be widely held (the 10% rule), which avoids potential
conflicts of interest.(14)
The
concern that financial institutions can be abused by way of non-arms-length
transactions with significant shareholders or affiliated entities has
long been a concern associated with closely-held financial institutions.
As already noted, one of the benefits of the 10% rule has been to ensure
that no single shareholder can unduly influence a bank. However, even
under a widely-held holding company structure, a bank is likely to have
both regulated and unregulated affiliates, and the risk of transactions
taking place that may benefit some parts of the group to the detriment
of the bank or other financial institutions in the group cannot be discounted.(15)
E. Public Perception
OSFI noted that there is
a possibility that:
[…]
the public could perceive all entities, regulated and unregulated, that
are part of a bank holding company group, as benefiting from the government
safety net. This could arise due to the fact that major components of
the group (a bank or other financial institution, and possibly the holding
company) would be regulated. As a result of this perception, creditors
of a financially troubled unregulated bank affiliate in the group could
expect the regulator to take action to protect their interests when,
in fact, the regulator is more likely to be taking action to protect
the depositors, policyholders, and other creditors of the bank and other
financial institutions in the group. Indeed, OSFI’s mandate could
lead it to take actions that are at odds with the interests of the unregulated
entities in the group and their shareholders and creditors.(16)
Moreover, if the Superintendent
extends his/her regulatory supervision to include the unregulated entities,
there is a risk of reinforcing the public perception that the unregulated
entities are somewhat covered by the government safety net as well. Despite
the lack of an immediate solution to this problem, OSFI pointed out that
initiatives designed to broaden the regulatory oversight to include unregulated
entities "may need to be accompanied by other measures designed to
mitigate against the risk of casting a ‘regulatory aura’ over
the whole group."(17)
Finally, the use of nearly
identical corporation names within a holding company group composed of
both regulated and unregulated affiliates, or an unregulated controlling
holding company, can further confuse public perception. Canada experienced
some of these problems in the past where confusion surrounded financial
conglomerates which possessed a regulated trust company somewhere in the
empire. The Parliamentary Sub-Committee on Financial Institution submitted
the following thoughts in its 1992 Fourth Report to the Committee:
Investors
assess different institutions differently and would attach different
levels of risk to a financial holding company as opposed to a regulated
trust company. The assessment on the part of investors is made more
difficult when the trust is called Central Guaranty Trust Company while
the management company is called Central Guaranty Trustco. The names
of associated companies should be able to reflect such associations,
but they should not mislead. We see the use of the word "trustco"
as serving no useful purpose while leading to much confusion.(18)
THE PROPOSED LEGISLATION
Bill C-8 proposes to allow
for the creation of non-operating bank holding companies. Because holding
companies would be required to be non-operating, they would only be allowed
to acquire, hold and administer permitted investments, and to provide
management, advisory, financing, accounting and information-processing
services to entities in which they have a substantial investment. They
would not be permitted to undertake any core banking or financial services
such as credit assessments.
DIAGRAM 2
The Non-Operating Financial Holding Company Model
|
Non-Operating Holding Company
|
|
Banking Activities
|
Securities Activities
|
Trust Activities
|
Insurance and
Other Permitted
Financial Activities
|
|
affiliate
|
affiliate
|
affiliate
|
affiliate
|
The permitted investments
for bank holding companies would be the same as for banks. Moreover, a
bank holding company and its subsidiaries could only acquire shares or
ownership interests of an entity, other than permitted investments, up
to a point that the aggregate value of those ownership interests, plus
the value of its interests in or improvement to real property, did not
exceed the prescribed percentage of its regulatory capital. Finally, a
bank holding company could not hold more than 10% ownership of a non-financial
entity.
Existing banks could convert
to a bank holding company structure. The ownership structure of the bank
would automatically become the ownership structure of the bank holding
company. The bank holding company would also be required to own a majority
of the shares of its bank subsidiary, which would result in de jure
control of the bank. Other regulated affiliates would be subject to control
"in fact," where a minority of shares can be held, but control
can nevertheless be exercised by direct or indirect influence. The same
control restrictions would apply to affiliates that engaged, as part of
their business, in any financial activity that exposed the entities to
material or credit risk (e.g., credit cards, small business loans, consumer
loans).
Bank holding companies would
be divided into three main classes: ones with equity of $5 billion
or more, ones with equity of between $5 billion and $1 billion, and ones
with equity of less than $1 billion.
A bank holding company with
equity of $5 billion or more would have to be widely held, i.e., no shareholder
could hold more than 20% of any class of voting shares, and no more than
30% of any class of non-voting shares. Moreover, the widely held requirement
would apply to the total direct and indirect ownership of a bank subsidiary
that is itself controlled by a widely held bank holding company with equity
of $5 billion or more:
-
other than
the controlling bank holding company, no other shareholder could hold
more than 20% of any class of voting shares of the bank subsidiary,
and no more than 30% of any class of non-voting shares;
-
no shareholder
who held more than 10% ownership of the bank holding company could
also hold more than 10% of the bank subsidiary.
This would mean that no
single investor would be able to use the holding company to exceed bank
ownership restrictions for widely held banks.
Bank holding companies with
equity under $5 billion could be owned and controlled by a commercial
enterprise. However, bank holding companies with equity of $1 billion
or more would be required to maintain a 35% public float of voting shares,
i.e., 35% of voting shares would be traded on a recognized stock exchange
in Canada and not owned by any major shareholder. Finally, bank holding
companies with equity of under $1 billion would have unrestricted
choice in ownership structure.
The bank holding company
would be subject to consolidated supervision. The Superintendent of Financial
Institutions could request, by order, information and documents from the
bank holding company or any of its affiliates, to review both financial
and non-financial activities conducted under the holding company. From
time to time, the Superintendent could examine and inquire into the business
and affairs of each holding company. If necessary, the Superintendent
could order the bank holding company to undertake necessary actions to
comply with regulations, or to remedy a situation believed to be prejudicial
to the interests of depositors, policyholders or creditors.
The holding company group
would be subject to consolidated capital adequacy requirements, and the
Superintendent could require the holding company to increase its capital
and liquidity where circumstances warranted. Also when warranted, the
Superintendent could, by order, direct a bank holding company to divest
a subsidiary or other investments.
When a contract was being
considered by a bank holding company, any director or officer who was
in a conflict of interest would have to disclose in writing, or request
to have entered in the minutes of the meetings, the nature and extent
of that personal interest. Moreover, the director would have to be absent
from any meetings of directors while the contract was being considered
(some exceptions would apply). Ultimately, the Superintendent could, by
order, remove from office a director or senior officer of a bank holding
company if the Superintendent believed that this person was not suitable
to hold that office.
Finally, a bank holding
company would not be permitted to adopt a name that is substantially similar
to that of a bank unless the name contained words that, in the opinion
of the Superintendent, indicated to the public that the bank holding company
was distinct from any bank that was its subsidiary. Moreover, every bank
holding company would have as part of its name the abbreviation "bhc"
or "spb."(19)
FINANCIAL HOLDING
COMPANY LEGISLATION AROUND THE WORLD
OSFI commissioned a study
of the legislation and regulation of financial holding companies in foreign
jurisdictions.(20) This section reviews the main conclusions
of this study that relate to the proposed legislation in Canada.
Non-operating financial
holding companies are commonly found in other countries, and some jurisdictions
go as far as to require the establishment of such holding companies when
different non-banking businesses are bundled with banks. However, financial
conglomerates in many countries have a variety of options in how they
may organize their activities, and they have responded by choosing a variety
of organizational structures. There is thus no empirical evidence that
the holding company structure is necessarily more efficient than other
structures, provided that rules governing all types of structures are
similar.
A. Supervision
All around the world, financial
holding companies are highly supervised and regulated. The key concern
is to protect depositors and policyholders, and to ensure the stability
of the financial system. In some instances, for example in the U.S., the
mandate of supervisors includes consumer protection.
Most jurisdictions have
adopted the principles of consolidated regulation and supervision at the
top of the holding company structure. In terms of capital adequacy, both
the capital of the consolidated holding company and its affiliate entities
are examined. This is consistent with the proposed legislation.
Bill C-8 also proposes to
give the necessary powers to the Superintendent to permit ongoing access
to a wide range of information concerning the financial business of holding
companies and their affiliates. This practice is similar to that in other
countries.
The European Commission
specifies that the aggregate value of inter-company transactions for credit
institutions (or bank holding companies) should not exceed 25% of the
group’s equity. This is to limit the level of exposure a bank has
to a single client, or a group of connected clients, as well as to control
affiliates’ transactions to limit the risks of contagion.
In Canada, the proposed
legislation would impose a limit on the value of the transactions that
a bank may enter with an affiliate(21) (under the same holding company umbrella)
to 5% of the bank’s regulatory capital. Furthermore, the limit would
be at 10% for all the transactions with all of the affiliates.(22)
B. Ownership Rules
A major change included
in this legislation is the new size-based ownership regime that would
apply to banks and bank holding companies. The bill proposes to allow
for small- and mid-sized bank holding companies to be closely held and
controlled by commercial or financial interests, subject to a "fit
and proper" test. Large institutions would have to remain widely
held, but the limit on ownership by a single shareholder would be increased
to 20%, from the current 10%. Thus, there is a clear intention in this
bill to allow individual shareholders to have a greater stake in financial
institutions. This would favour strategic alliances within Canadian institutions,
but also with foreign institutions which could facilitate expansion in
cross-border financial services. This new ownership regime would also
be in line with the international experience.
Countries
differ in their practices concerning closely held financial holding
companies. Many jurisdictions are not concerned over this matter. Regulators
and supervisors in Germany, for example, have no thresholds for reporting
changes in a bank’s ownership and control. Similarly, in the U.S.,
both closely and widely held holding companies are allowed. In practice,
in that country, closely held holding companies are far smaller in size
and are often family owned. In most countries surveyed, regulators and
supervisors believe that closely held financial institutions pose little
problem as long as the ownership structure is transparent. Close relationships
that could hamper the task of regulation and supervision are prohibited
in Denmark and monitored in other countries through "fit and proper"
tests.
Technically,
foreign ownership or control is not legally prohibited in most countries
although some (e.g., U.K.) have unwritten rules discouraging foreign
ownership of major clearing banks. At the other end of the scale are
countries which require financial institutions to be widely held. In
Australia, for example, there is a 10% ownership limit. However, this
restriction can be waived by the government. […] Norway also has
a 10% rule which applies to a holding company if it has a wholly owned
bank subsidiary.
Whether
or not they allow financial institutions to be closely held, most jurisdictions
require notification when ownership changes. In reacting to such notices,
regulators and supervisors are concerned about the regulatory and supervisory
regime in the home country in the case of applications from foreign
banks. They also assess the roles of key individual controllers of those
licensed banks. Similar rules are common in insurance regulation and
supervision.(23)
On the other hand, most
jurisdictions recognize that commercial ownership of credit institutions
poses some concerns. For that reason, such arrangements are generally
allowed only in special cases that generally involve smaller institutions.
In Europe, many countries(24) comply
with the European Commission Second Banking Directive which subjects to
regulatory consent any ownership position in a credit institution of more
than 10% of the voting rights, or any significant influence over its management.
Switzerland imposes no restriction on non-financial ownership of banks.
This move toward more flexibility
allows commercial groups such as supermarket chains (e.g., Sainsbury in
the U.K., Loblaws in Canada) and telecommunication firms to form conglomerates
that include banks and insurance companies. New information technologies
are contributing to a widening of competition in the delivery of financial
services, making it easy for other firms, institutions and organizations
to do the same. Consequently, new competitors seem to be coming from every
sphere of commercial business.
C.
Permitted Investments
Generally, bank holding
companies are allowed to diversify across a broad range of investments
in non-banking financial activities. Sometimes, this can only be done
through a non-operating holding company structure, but many jurisdictions
permit a variety of organizational structures.
The most common restriction
prohibits the underwriting of insurance risks in deposit-taking institutions.
Insurance risk must be underwritten in a separate legal entity. The sale
of insurance products is a completely different matter. For example, in
the U.S., France, Netherlands, Norway, Belgium and Switzerland, banks
may sell the insurance products of a subsidiary or affiliated insurance
company through their branch network. However, banking and insurance underwriting
cannot be combined in the same legal entity.
Traditionally in North America,
regulators and supervisors separated banking from commerce. In the United
States, a bank holding company can participate in the capital of non-financial
firms, but the investment is not permitted to account for more than 5%
of the firm’s outstanding voting shares. Likewise, in Canada, the
proposed legislation would prohibit bank holding companies from controlling
more than 10% ownership of a commercial firm, and the holding company
could not commit more than the prescribed percentage(25)
of its regulatory capital to all investments in commercial entities.
On the other hand, some
jurisdictions permit bank holding companies to control commercial enterprises.
In
Australia, at least one bank has diversified into non-financial enterprises.
In the U.K., the Bank of England’s tolerance for commercial activities
by financial holding companies is high especially when such activities
involve smaller financial institutions. Concern arises only when such
activities distract from the sound management of the holding company.
At the other extreme, Switzerland discourages mixed conglomerates by
requiring them to hold far higher levels of capital.(26)
Not all countries regulate
the association between banking and commerce as restrictively as in Canada
and the United States. The European Commission (EC) Second Banking Directive
does not prevent a bank from owning a non-financial firm, but the size
of qualifying investments is limited to no more than 15% of a bank’s
own funds for investment in a single firm, and no more than 60% for all
investments in non-financial firms. Many European countries – including
Austria, Finland, France, Germany, Greece, Ireland, Luxembourg, Netherlands,
Spain and the U.K. – adopted this EC Directive. Belgium adopted more
restrictive rules.
D. Corporate
Governance
Restrictions on the structure
of boards of directors are common. Such rules may stipulate a minimum
number of directors on the board and may put restrictions on the number
of directors who are employees of, or affiliated with, the bank holding
company. Nearly all legislation contains the power to deny the nomination
of directors and officers or to remove them from office, based on a test
of competence, experience, conduct and overall fitness. Canadian legislators
impose similar rules on directors and officers.
CONCLUSION
In many respects, the proposed
legislation responds adequately to the prudential concerns enumerated
in the earlier section "Risks Associated with a Holding Company Structure
for Banks." It is also consistent with international regulations
and supervision principles, although some facets are more restrictive.
Except for the prohibition of the sale of insurance products in bank branches,
the Canadian legislation on holding companies resembles that of the United
States.
On the other hand, it is
still uncertain whether the bill’s proposals will improve banks’
ability to face competition and respond more efficiently to innovations
in financial markets. Many details are left to regulations, and the bill
is designed to be neutral (in the sense of powers and investments) with
respect to organizational structure. Until the regulations are known,
it is difficult to assess to what extent the regulatory burden on bank
affiliates will be lessened, especially those affiliates that would otherwise
be unregulated institutions.
APPENDIX
ILLUSTRATIVE EXAMPLE OF
MULTIPLE COUNTING OF CAPITAL (27)
This example illustrates
a situation of multiple counting of capital. The parent is a bank which
owns completely an insurance company which in turn owns completely a securities
firm.
Bank (Parent Company)
|
Assets
|
Liabilities
|
| Loans |
9,000
|
Capital |
1,500
|
Book
value ownership in:
Insurance Company B1 |
|
General
reserves |
500
|
|
1,000
|
Other
liabilities |
8,000
|
| Total |
10,000
|
Total |
10,000
|
| Capital
requirement: 1,500 |
Insurance Company
B1 (Subsidiary)
|
Assets
|
Liabilities
|
| Investments |
5,000
|
Capital |
1,000
|
Book
value ownership in:
Securities Firm B2 |
|
General
reserves |
500
|
|
500
|
Technical
provisions |
4,000
|
| Total |
5,500
|
Total |
5,500
|
| Capital
requirement: 800 |
Securities Firm B2
(Subsidiary)
|
Assets
|
Liabilities
|
| Investments |
4,000
|
Capital |
500
|
| Reserves |
250
|
| Other
liabilities |
3,250
|
| Total |
4,000
|
Total |
4,000
|
| Capital
requirement: 400 |
Without accounting for the
consolidated corporate structure in measuring capital adequacy, it appears
that capital requirements for the individual entities in this group are
met. However, a portion of the capital of the parent bank, i.e., the amount
of 1,000 invested in Insurance Company B1 is levered twice, once in the
bank and again in the insurance company B1 (double counting of capital).
Furthermore, the amount invested by B1 in the securities firm B2 (500)
which has already been levered twice is now being levered a third time,
in the securities firm (when capital is being levered more than twice,
it is said to be an instance of multiple counting).
On the face of it, the group
has total capital and reserves of 4,250 to cover total capital requirements
of 2,700. If the multiple counting is eliminated, the adjusted capital
and reserves reduce to 2,750 leaving a surplus of only 50 over the capital
requirements of 2,700.
Group's Capital Adequacy
|
Individual Measurement
|
Consolidated Measurement
|
|
Total Capital
and Reserves
|
4,250
|
Total Capital
and Reserves
|
2,750
|
|
Total Capital
Requirement
|
2,700
|
Total Capital
Requirement
|
2,700
|
|
Balance
|
1,550
|
Balance
|
50
|
(1) Department of
Finance, "Canada’s Banks," September 1999.
(2) McKinsey & Company, "The Changing
Landscape for Canadian Financial Services," Research Paper Prepared
for the Task Force on the Future of the Canadian Financial Services Sector,
September 1998, p. 25.
(3) Canadian Bankers Association, "Structural
Flexibility in the Canadian Financial Services Sector," Submission
to the Task Force on the Future of the Canadian Financial Services Sector,
May 1998.
(4) Please note that Newcourt Credit Group has been acquired
by the CIT Group, the largest publicly owned U.S. company in the commercial
financial industry, in March 1999.
(5) Task Force on the Future of the Canadian
Financial Services Sector, "Organizational Flexibility for Financial
Institutions: A Framework to Enhance Competition," Background Paper
#2, September 1998, p. 45.
(6) Tripartite Group of Bank, Securities and
Insurance Regulators (BIS, IOSCO, IAIS), "The Supervision of Financial
Conglomerates," July 1995.
(7) Office of the Superintendent of Financial
Institutions, "A Proposal Regarding a Bank Holding Company Model,"
Submission to the Task Force on the Future of the Canadian Financial
Services Sector, June 1998, p. 7.
(8) Ibid., p. 15.
(9) Ibid., p. 7.
(10) Tripartite Group of Bank, Securities
and Insurance Regulators (BIS, IOSCO, IAIS), "The Supervision of
Financial Conglomerates."
(11) Office of the Superintendent of Financial
Institutions, "A Proposal Regarding a Bank Holding Company Model,"
p. 8.
(12) Ibid., p. 8.
(13) Tripartite Group of Bank, Securities
and Insurance Regulators (BIS, IOSCO, IAIS), "The Supervision of
Financial Conglomerates."
(14) However, we haven’t had the 10% rule for some
other deposit-taking institutions (such as trusts), or insurance companies.
(15) Office of the Superintendent of Financial
Institutions, "A Proposal Regarding a Bank Holding Company Model,"
p. 9.
(16) Ibid., p. 9.
(17) Ibid., p. 9.
(18) Sub-Committee on Financial Institution,
"Financial Institutions Legislation," Report to the Committee,
Fourth Report, December 1992, p. 16:11-12.
(19) BHC is the acronym for Bank Holding Company
and SPB is the French acronym for Société de Portefeuille Banquaire.
(20) The study, "Current Thought on the
Regulation and Supervision of Financial Holding Companies and Lessons
from Foreign Regulatory and Supervisory Jurisdictions," prepared
by Gordon Roberts of York University and Lawrence Kryzanowski of Concordia
University, is part of an OSFI submission to the Task Force on the
Future of the Canadian Financial Services Sector, June 1998.
(21) Except if this affiliate is a trust company,
a loan company, an insurance company or a bank, licensed under a federal
Act.
(22) Ibid.
(23) Kryzanowski and Roberts, "Current
Thought on the Regulation and Supervision of Financial Holding Companies
and Lessons from Foreign Regulatory and Supervisory Jurisdictions"
(June 1998).
(24) The list includes: Austria, Belgium,
France, Germany, Greece, Ireland, Luxembourg, Netherlands, Portugal, Spain,
and United Kingdom.
(25) The percentage is left for regulation.
(26) Kryzanowski and Roberts, "Current
Thought on the Regulation and Supervision of Financial Holding Companies
and Lessons from Foreign Regulatory and Supervisory Jurisdictions."
(27) This is a slightly simplified version of a similar
example figuring in a supplement to the Capital Adequacy Principles
paper published by the Basle Committee on Banking Supervision, http://newrisk.ifci.ch/143570.htm
|