Mini-Review 85-14E

CHANGING REGULATORY ENVIRONMENT FORCANADIAN FINANCIAL INSTITUTIONS:A CONFERENCEREPORT

RandallChanEconomicsDivision

10 September1985

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CHANGINGREGULATORYENVIRONMENTFOR CANADIAN FINANCIAL INSTITUTIONS:

A CONFERENCEREPORT

I NTRODUCTION

In view of the recent federal discussion paper Regulation of

Canadian Financial Institutions, the Conference on the Changing Regulatory

Environment for Canadian Financial Institutions organized jointly by the

Faculty of Law, University of Toronto and the Ontario Economic Council on

May 22 and 23 in Toronto was timely. The panels of speakers were composed

of academics, lawyers from financial institutions and representatives of

industry. The Conference addressed five themes: functions of regulation,

internationalization and integration of markets, federal—provincial

relations, insolvencies and deposit insurance, and consequences of

deregulation. This paper summarizes the main issues raised on each of these

five themes.

FUNCTIONS OF REGULATION

The failure of one financial institution can cause the public

to lose confidence in others and thereby diminish the stability of the

entire system. For this reason, the regulation of financial institutions

differs from that of other industries in that solvency is a major public

policy objective. Other objectives include promoting competition among

different institutions providing similar services, enhancing efficiency in

terms of allocating resources and minimizing cost, and assuring some degree

of Canadian ownership in the financial sector.

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A variety of measures can be used to achieve these goals.

Ownership restrictions similar to those under the Bank Act can ensure

predominantly Canadian ownership. Separation of financial functions

(commercial lending, insurance, fiduciary activity and investment

underwriting) tends to minimize potential conflicts of interest and hence

enhances solvency of the system as would prohibition on self-dealing and

conflict of interest guidelines. In contrast, allowing full integration of

functions within a single financial institution would promote competition

across the entire financial sector for all services. Potential conflicts of

interest can be minimized with the use of “Chinese walls”. These are

essentially codes of conduct for employees within a financial institution

and are designed to prohibit employees of different divisions from passing

client information to each other.

In regulating financial institutions, one ought to distin-

guish between remedial and preventive measures. Remedial measures are

policing procedures whereas preventive measures are intended to preempt

undesired consequences. Because financial institutions are entrusted with

public funds and are highly leveraged, the benefits of preventive regulationare generally considered to be greater than its costs which may entail

higher operational expenses or reduced competition.

INTERNATIONALIZATION AND INTEGRATION OF MARKETS

Developments in the financial services industry in the U.S.

can be characterized by four major trends. The first is integration or

homogenization. For example, the insurance industry is offering more and

more equity based financial instruments and securities firms are providing

money market funds and banking services. The second trend is towards

amalgamation as when insurance companies merge with mutual funds or

with securities firms. Thirdly, we have geographical expansion, such as the

use of bank holding companies to enter into interstate banking. The fourth

trend is international, as shown by the growing presence of foreign banks

and the increasing importance of foreign denominated assets in domestic

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institutions. In sum, these trends represent conglomerization in the

context of expansion.

Many of the underlying causes of deregulation in the U.S.

are not, however, applicable to Canada. Canada has never suffered from the

distortions resulting from U.S. regulations such as Regulation Q and

restriction on inter-state banking.

In the trend towards deregulation, several issues are

considered to be of major importance. How should deposit insurance be

determined so that market discipline can be brought to bear on deposit

institutions? Industrial corporations can now enter into financial services

without restrictions, though not vice versa. How can conflict of interest

and self-dealing be effectively controlled without creating inefficiency and

reducing competition? What is the proper trade-off between solvency and

competiti on?

FEDERAL-PROVINCIAL RELATIONS

With the exception of property and civil rights which fall

under provincial jurisdiction, the Constitution provides the federal

authority with the power to regulate trade, commerce, banking, inter-

provincial trade, peace and order, and bankruptcy and insolvency. Some

observers believe that federal power is sufficiently pervasive for it to

regulate virtually all activities of financial institutions.

In fact, however, the federal government has acquiesced for

about 100 years in the granting of licences by provincial governments to

bank-like institutions and provincial government regulation of banking—type

activities. The courts have also tended to rule in favour of provincial

governments over the years.It can be argued that the proposal of the federal discussion

paper to relate commercial lending power exclusively to institutions

chartered under the Bank Act is an attempt to consolidate federal juris-

diction over most deposit institutions. There are three possible outcomes

of this latent federal-provincial jurisdictional dispute: no coordination

between the two levels of governments, constitutional amendment for the

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division of power, or judicial determination of the scope of federal

jurisdiction over financial institutions.

INSOLVENCIES AND DEPOSIT INSURANCE

The recent rash of insolvencies in financial institutions and

their attendant claims have raised some fundamental questions about thefunction of deposit insurance and the impact of the existing system on

competition, efficiency and market discipline.

Under the present system of a flat rate premium structure,deposit insurance can only succeed only if the probability of insolvency is

low and the chances of loss are small. Proponents of this system point tothe ease with which it can be administered, particularly if separation of

function is enforced. Risk-related premium is not considered practical

because of the disparity in size of existing deposit institutions. To

improve prudential supervision and enhance the solvency objective, these

observers prefer to render existing regulations more stringent to include

more information disclosure, greater capital requirement and stricter

eligibility conditions for chartering. They also suggest that the

introduction of some form of co-insurance would instill an element of

discipline on depositors as well as management.

Critics of the present system contend that deposit insurance

as it is now operated does not constitute an insurance contract against

defined hazards. Owing to the authorities’ concern for public confidence,

deposit insurance has become in effect a financial guarantee for the deposit

institution’s liability. This results in an unequal sharing of risks and

rewards because earnings are retained by the institution but losses are

borne by the guarantor. The flat-rate premium structure also means that

prudently managed institutions subsidize those which accept unreasonable

risks. If reform is not carried out, delays in short-run adjustment will

ultimately undermine the system. Proposed reforms include market value

accounting, increased capital requirement, greater information disclosure,

greater enforcement power for supervisory authority, recalibrated insurance

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coverage, risk- related premiums, reinsurance for larger risks and statutory

limitation on bailouts. It was pointed out that the U.S. experience with

failures and market adjustments has been one of consolidation and

conglomeration; yet the federal discussion paper seems to halt the growth of

Canada’s large banks.

CONSEQUENCES OF DEREGULATION

The pursuit of several public policy objectives inevitably

results in trade-offs. Such is the case with the promotion of competition

and efficiency on the one hand and the preservation of stability, confidence

and solvency on the other. Public policy must therefore seek to bring about

the regulation of markets and functions so as to restrict as little as

possible the efficient operations of the institutions, while ensuring their

solvency. Guidelines on conflict of interest and the ban on self-dealing as

outlined in the federal discussion paper are considered by many observers as

a reflection of the federal government’s overriding concern with solvency.

Most argue that for these cases the costs of regulation would far exceed the

potential benefits. After all, regulation cannot guarantee honesty and

integrity. Perhaps some degree of self-regulation may be appropriate.

Some industry representatives claim that the proposed

creation of ‘C’ banks would not meet the needs of small trust companies

seeking greater commercial lending power because most such companies are not

in a position to establish a financial holding company in order to

incorporate a ‘C’ bank. For them, greater commercial lending power under

appropriate provincial legislation would be more realistic.

Other representatives criticized the federal government for

paying only “lip service” to competition because foreign competition would

still be restricted in the future. Domestically, the future scope of

operations of those institutions that can most likely unleash competitive

forces in a deregulated environment has been frozen by the discussion paper.

Conglomerations are not in themselves bad. The role of competition is to

promote countervailing powers. If the market is sufficiently open,

contestability of markets and market discipline will impose themselves upon

financial institutions.