U.S. and Canadian Financial System:
“Tales of Two Countries”
I. American Banking System
Summary
U.S.
Commercial Banking
Investment Banking
Fractured Regulation
Highly Regulated
(Federal SEC)
Dominant
Canada
Highly Regulated
Dominant
Fractured Regulation
(provincial SECs)
Major firms owned by
Commercial Banks
• Canadian and American banking system
share a lot of similarity. Broadly, they used
to belong to the same British Specialized
Banking System, which has the
characteristic separation of commercial
banking and securities business, or
(confusingly) “ banking and commerce”.
The American Story
1. Characteristics of U. S.
(Commercial) Banking Industry
1) Dual Banking System
Some banks are regulated by the state agency
and others by the Federal agency
• Pre-1863 State Banking only
• 1863
National Banks (Act) emerging
• 1913
Federal Reserve System
• 1934
Federal Deposit Insurance
Corporation
2) Multiple Regulatory Agencies: “Crazy Quilt
System”
• The Office of the Comptroller of the Currency
: in primary charge of “Charter” for national banks
• Fed
:in secondary charge of national banks, and in
sole charge of bank holding companies
• FDIC and State Banking Authorities
: in charge of state banks with FDIC insurance
• State Banking Authorities
: in sole charge of state banks without FDIC
insurance
3) Fractured Commercial Banking Industry
• A Large # of Banks: 12,000 until the early 1990
• Many Lacking “Scales of Economies
-> only 325 banks have assets above $1 billion
(’94)
-> until recently, some states had “Unit Banking
System”.
-> Consolidation and Simplification: Key Issue of
Presidential Reforms
2. Historical Background
1) The Fractured C Banking Industry is the results of long-standing strugges
between Federal versus State interest forces
regions, parties and interest groups.
1) Parable
-“The Wizard of Oz as a Monetary Allegory” by H. Rockoff
• Background: Depression in the 1890s
• Allegories:
Dorothy: an Average conscientious true American
Scarecrow -Western Farmer
Tin Woodman- Unemployed Industrial Workers
Cowardly Lion -“William Jennings Bryan”
versus
Wicked Witch of the East- Eastern Business and Financial Interests
Munchkins -Average Americans
Wicked Witch of the West - Grover Cleveland
•
Western(Local party) Solution
silver shoes: magic
water that melt the witch: solution – watershed – inflation (through printing money)
A Lesson:
- So much socio-political problems and
regional interests were intertwined with
Monetary policies (and banking
practices):
- The complexity of the current banking
system of the U.S. is a on-going legacy
of the long tradition of these
complicated political Struggles bet
2) Anti Trust Acts of 1920s to 1930s
have shaped the U. S. Banking System
• McFadden Act of 1927: limits and prohibits
inter-state banking and branching
• Glass-Steagall Act of 1933: Anti-Trust Act
separating Banks and Commerce; you can be
either a commercial bank(lenders) or an
investment bank(securities holders), but not both.
* Apparent Rationale Underlying the
Separation of Commercial and Investment
Banking: Glass-Steagall Act
In favor of Specialized Banking as opposed to Universal
Banking
If banks are engaged in securities business, there may
occur
• Conflicts of Interests;
• Unfair Competition;
• Risk of Safety and Soundness;
• Concentration of Power;
• Unfair Stretch of Federal safety net
However, Glass-Steagall Act deprived 1)
commercial banks, now mere lenders
without management participation, of
Monitoring Venues against Moral Hazards
while it also deprived 2) investment bank
of Venues for Active Management
participation, which are no longer allowed t
have board representation.
3) Turn Around
1.Evolution of Bank Holding Companies
2. Reigle-Neal Act of Interstate Banking and
Branching Act (1994)
: Opening up M & A for “Efficiency” in banking sectors
2.Gramm-Leach-Bliley Financial Modernization
Act (1999)
: Banks are allowed to form Financial Holding Companies
across industries and even to carry out “merchant banking”
or equity investments in non-financial firms.
* How American Commercial
Banks Merge?
• The number of banks has
been decreasing;
currently as of 2006,
about 7,800 or so.
# of Banks
16000
14000
• While mergers between
banking groups have
slowed, there has been a
move towards
diversification as the
barriers between
commercial and
investment banking have
finally broken down.
12000
10000
8000
6000
4000
2000
0
'75
'80
'85
'90
'95
'00
Investment Banking in U.S.
• We now know more about Investment
Banking in the U.S. after 911
• Prime movers of M & As and Privitization
around the world
• Well-connected with Private Equities
• Cross-board M & A between
Commercial and Investment Banks was
allowed by G-L-B act of 1999.
Can we all copy this G-L-B in every country
without having the negative effect?
The negative effect could be “Lack of
Competition” which may lead to “Lack of
Protection of Small Lenders” beside banks
as big lenders.
However, in the U.S., this is not case due to
* Gramm-Leach-Bliley Act
versus U.S. Legal System
- G-L-B Act would not lead to Conflict of Interests
due to the unique U.S. legal system.
- Legal protection for smaller financial investors is
secured by “Lender Liability and Equitable
Subordination”
Read the paper by R. Kroszner (webpage
form)
- This principle does not exist elsewhere: The U.S.
case of allowing merger between banks and
commerce may not be equitably applicable
elsewhere.
II. Canadian Banking Systems
1. Evolution of Canadian
Financial System
Tradition of
“Four Pillar System” :
•
•
•
•
•
Trust, Mortgage, Fiduciary Business
Chartered Banks
Insurance
Securities Industry
(Credit Unions)
Towards
Full Service Banking
2. Initially Free Banking System, and
changed to Government Regulated System
with the Central Bank(B of Canada)
The process was “unnatual”.
Initially, all banks were allowed to issue their
own paper monies;
First, BMO helped government bonds to be
used for reserves;
1840-1870,Government started
monopolizing Money Issues
Then, B of Canada was set up in 1934;
3. Reforms in the Canadian Bank Act
• 1954
: Banks were allowed to go for household lending and to make mortgage loans insured
by NHA
• 1967
* Canadian Deposit Insurance Corporation was created
: the 6% ceiling on the mortgage loans was removed
• 1980
: banks were allowed to have mortgage loan companies and venture capital companies.
• 1981
: Foreign banks were allowed to set up Canadian subsidiaries
banks were allowed to do leasing, factoring and data processing.
Canadian Payment Association was created for nationally “open” clearing system
1987 “Financial Institutions and Deposit Insurance System Amendment Act”
:banks were allowed to own securities houses(investment banks)
: abolishing the Canadian equivalent of “Glass-Steagall Act”
1992
: banks were allowed to own trust companies
: banks were permitted to offer a number of in-house activities, such as portfolio
management, and investment counseling.
: required reserves are to be phased out.
1999
:Bill C-67
2001**
New ownership Rules; M & A Review Process; fexbile Bank Holding Company allowed;
More o pen membership to the Canadian Payment Association
• Easier Entry of New Comers
Equity Capital requirement is lowered from
$ 10m to $ 5 m.
• Some Ownership Concentration allowed
for a large bank(equity>$ 5 billions)
a single ownership limit is raised from 10%
to 20%
Expanded Access to Canadian
Payment Association
membership
• There by access to Large Value
Transactions System, and Automatic
Clearing Settlement System was given to
Insurance, Investment Dealers, Money
Market Mutual Funds.
• Now these can allow their customers to
use Checking Account and Debit Cards
- more competition for Banks
4. Other Apparent Differences
between U. S. and Canada
U.S.
• Big Increases in Mortgage
Backed Securities
<- S & L companies’ mismatch
of maturity terms of Assets
and Liabilities
• Big Surge of Money Market
Mutual Funds
<- way to get around `Regulation
Q’
Canada
• Not Much
• No Big Surge
5. Changing Characteristics of
Canadian Banking Industry
• Chart 9 of C. Freedman
6. Quantitative Analysis of Comparison of
U.S. and Canadian Banking System
• Different system leads to different results
1) Canadian commercial banks may be more efficient
than the U.S. counterpart in some senses.
(1) monopolistic competition: contestability (Allen et al):
H statistics (= elasticity of Revenue to An Increase in
Input Cost) indicates the Canadian Banking system is
monopolistic competition
(2) monopoly protection kept by spending resources on
‘legitimacy’ (Breton and Cote)
2) Different challenges
Paper on Current Financial Crisis (Han and Ibbott)
III. Japanese Banking System
• Post WWII Japanese banks were reorganized
by the U.S. Occupying Army
• Yet, they have been distinct from the U.S,
banks
• Notably, Japanese banks have been allowed
to hold equities and to participate in
management of non-financial corporations
Japanese Banks are allowed to
own Equities:
Banks are lenders as well as
owners
Pros:
- Reduces bankruptcy costs for society (legal cost;
disruption cost)
- Sumitomo Bank revived Mazda in the 1970s
- Reduces monitoring cost of Principal-Agent Problem
(Sun Bae Kim, Banking and Commerce: The Japanese
Case)
- Makes banks share ‘Upside Returns’ and ‘Calculated
Entrepreneurial Risk and Venture’
Cons:
- Stock Market Crash leads to Loss of Bank
Assets
- Moral Hazards: “Too Big to go bankrupt”