This Selected Issues paper reviews empirical evidence on the main determinants of the real bilateral exchange rate between the Canadian and the U.S. dollars, with particular emphasis on the role played by cyclical and longer-term economic factors. The paper aims to identify the nature of the shocks that have contributed to the recent downward trend in the Canadian dollar. The analysis shows that fluctuations in the real bilateral exchange rate can be explained reasonably well by its long-term fundamentals. The paper also analyzes inflation and the natural rate of unemployment in Canada.

Abstract

This Selected Issues paper reviews empirical evidence on the main determinants of the real bilateral exchange rate between the Canadian and the U.S. dollars, with particular emphasis on the role played by cyclical and longer-term economic factors. The paper aims to identify the nature of the shocks that have contributed to the recent downward trend in the Canadian dollar. The analysis shows that fluctuations in the real bilateral exchange rate can be explained reasonably well by its long-term fundamentals. The paper also analyzes inflation and the natural rate of unemployment in Canada.

VII. CANADA’S FINANCIAL SYSTEM1

1. In January 1998, the Royal Bank of Canada and the Bank of Montreal announced their intention to merge. This was followed by a similar announcement by the Canadian Imperial Bank of Commerce and the Toronto-Dominion Bank in April 1998. Coming on the heels of the examination of financial services by the Task Force on the Future of the Canadian Financial Services Sector, these proposals prompted considerable debate and deliberation, culminating in the Minister of Finance’s decision in December 1998 not to allow the proposed mergers. This paper discusses the structure of the Canadian financial sector, the forces leading to the proposed bank mergers, and the potential implications of increased concentration in the banking sector in Canada. It also reviews the main recommendations by the Task Force on the Future of the Financial Services Sector in the area of enhancing financial sector competitiveness.

A. Structure of the Financial Sector

2. Historically, the Canadian financial system was based on five principal groups: chartered banks, trust and loan companies, the co-operative credit movement, insurance companies, and securities dealers. The functions of the different kinds of institutions were separated. Chartered banks are incorporated and supervised by the federal government and have been traditionally involved in personal, residential mortgage, and commercial lending. Trust and loan institutions tended to specialize in residential mortgage lending and in term deposits, and they were the only institutions permitted to offer fiduciary services. They can be either federally or provincially incorporated and supervised. The co-operative credit movement (credit unions and caisses populaires) operates almost entirely under provincial jurisdiction. Traditionally, these institutions invested in residential mortgages and personal loans. The majority of insurance companies are federally supervised, but some companies are provincially regulated. The securities dealers have traditionally operated under the supervision of the provincial governments. They have typically engaged in activities associated with the underwriting and selling of bond and stock issues, offering investment advice and trading of securities in the secondary markets.

3. The period since the late 1980s has seen sweeping change in the structure of the financial sector. These changes have been largely the result of legislative actions that have blurred the lines of separation between the different kinds of institutions. Particularly noteworthy are the legislative amendments introduced in 1987 that allowed links between banks and securities dealers. The large chartered banks responded by entering the securities business either by buying existing securities dealers, as most did, or by establishing new dealers. As a result, the largest securities dealers are now all part of broader financial services groups headed by banks.2

4. Legislation in 1992 eliminated most of the remaining distinctions between the different financial institutions, allowing them to compete directly with one another by expanding their business powers and by permitting cross-ownership. All the major banks acquired a trust subsidiary, reflecting in part the financial difficulties encountered by trust companies in the early 1990s.3 In contrast, while some banks have made inroads into the provision of insurance services, this business is still dominated by the old-line insurance companies.

5. Table 1 provides an overview of the current structure of the Canadian financial sector. Chartered banks account for over 50 percent of the total assets of the Canadian financial sector.4 At the end of 1997, 11 Canadian-owned chartered banks accounted for 93 percent of the total assets of the banking system, while 44 foreign-owned banks accounted for the remaining 7 percent (Table 2).5 The largest six domestic banks account for 92 percent of the total assets of the banking system.

Table 1.

Canada: Assets of Financial Institutions, 1997

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Source: Statistics Canada, Cat No. 61-008.
Table 2.

Canada: Bank Assets, 1997

(In millions of dollars)

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Source: Task Force on the Future of the Canadian Financial Services Sector.

6. The Canadian banking system is one of the most concentrated in the industrial world (Figure 1). Although nonbank deposit-taking institutions (e.g., trust companies, caisses populaires, and credit unions) are significant players in the market for deposits, the largest six domestic banks account for about 70 percent of the total deposits held by all deposit-taking institutions (Figure 2). Foreign banks are small players in the retail deposit market.6 While Canadians have increasingly placed their savings in mutual funds instead of conventional deposits (Table 3), banks have recently entered into the mutual fund market in a significant way by offering a wide variety of bank-sponsored funds in their branches. Overall, the banks’ share of the mutual funds industry is around 25 percent.7

FIGURE 1
FIGURE 1

CANADA: BANKING CONCENTRATION RATIOS RELATIVE TO TOTAL BANKING SYSTEM ASSETS, 1997

(Percentage)

Citation: IMF Staff Country Reports 1999, 014; 10.5089/9781451806854.002.A007

Source: Task Force on the Canadian Financial Services Sector.
FIGURE 2
FIGURE 2

CANADA: DEPOSITS IN CANADA, 1997

$714 billion

Citation: IMF Staff Country Reports 1999, 014; 10.5089/9781451806854.002.A007

Source: Task Force on the Canadian Financial Services Sector.* Proposed mergers
Table 3.

Canada: Personal Savings by Type of Institution

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Sources: Bank of Canada; and Task Force on the Future of the Canadian Financial Services Sector.

7. The six largest Canadian banks also play a predominant role in the markets for consumer credit, residential mortgage credit, and the financing of small and medium-size corporations (Figures 3, 4, and 5). Larger Canadian corporate customers have increasingly tapped capital markets directly for their funding needs, moving away from borrowing from banks. After reaching a peak of over 50 percent in the early 1980s, the portion of business funding derived from bank loans has since declined to around 30 percent (Figure 6). The role of foreign banks in these various markets has been quite limited, accounting for about 7 percent of credit to large businesses and about 2 percent of credit extended to small and medium-sized businesses.8

FIGURE 3
FIGURE 3

CANADA: CONSUMER CREDIT IN CANADA, 1997

$138 billion

Citation: IMF Staff Country Reports 1999, 014; 10.5089/9781451806854.002.A007

Source: Task Force on the Canadian Financial Services Sector.* Proposed mergers
FIGURE 4
FIGURE 4

CANADA: RESIDENTIAL MORTGAGE CREDIT IN CANADA, 1997

$373 billion

Citation: IMF Staff Country Reports 1999, 014; 10.5089/9781451806854.002.A007

Source: Task Force on the Canadian Financial Services Sector.* Proposed mergers
FIGURE 5
FIGURE 5

CANADA: FINANCING OF SMALL AND MEDIUM SIZE CORPORATIONS IN CANADA, 1997

$110.9 billion

Citation: IMF Staff Country Reports 1999, 014; 10.5089/9781451806854.002.A007

Source: Task Force on the Canadian Financial Services Sector.* Proposed mergers
FIGURE 6
FIGURE 6

CANADA: BANK SHARE OF BUSINESS CREDIT MARKET

(Percentage)

Citation: IMF Staff Country Reports 1999, 014; 10.5089/9781451806854.002.A007

Sources: Statistics Canada; Fund staff estimates

8. Despite its current high degree of concentration, the Canadian financial market seems to function competitively.9 The moderate decline observed in recent years in the interest spreads charged by the six largest domestic banks suggests that concentration has not led to uncompetitive behavior by domestic banks (Figure 7).

FIGURE 7
FIGURE 7

CANADA: INTEREST RATE SPREADS OF SIX LARGEST BANKS

(Percentage of average assets)

Citation: IMF Staff Country Reports 1999, 014; 10.5089/9781451806854.002.A007

Source: Canadian Bankers Association.

B. Potential Implications of Bank Mergers

9. After reviewing reports from the Competition Bureau with respect to competition concerns, from the Office of the Superintendent of Financial Institutions with respect to prudential issues, and from several parliamentary committees, the Minister of Finance announced on December 14, 1998 that the proposed bank mergers would not be considered until new legislation is in place to enhance competition in the sector and increase consumer protection. The Minister was of the view that the proposed mergers would lead to an unacceptable concentration of economic power in the hands of fewer, very large banks; a significant reduction of competition; and reduced policy flexibility of the regulatory authorities to address potential future prudential concerns arising from having fewer, very large banks. The Minister emphasized that priority would be given to establishing an appropriate policy framework for the financial sector and that, for that purpose, he would review the recommendations set forth by the Task Force on the Future of the Canadian Financial Services Sector (discussed below) and by parliamentary reports. The objectives of the policy framework will include putting in place a new review process to assess major bank merger proposals, promote competition by allowing the entry of new players (foreign and domestic), enable the financial sector to be at the leading edge of technological innovation, allow for strong Canadian institutions with a solid international presence, and protect consumers. The government would not consider any merger among major banks until the new policy framework is in place. Even then, new merger proposals will need to demonstrate, in light of the circumstances of the day, that they do not unduly concentrate economic power, significantly reduce competition, or restrict the government’s flexibility to address prudential concerns.

10. The proposed mergers between the Royal Bank and the Bank of Montreal and the Canadian Imperial Bank of Commerce and the Toronto-Dominion Bank would have further increased concentration in the Canadian financial sector. Post-merger, Canada would effectively have had two mega-banks, one relatively large domestic bank, a few other smaller domestic banks, and several small foreign banks. Even when measured against the full financial industry in which other nonbank financial institutions compete in providing some of the same financial services, the two resulting mega-banks would have constituted a significant force in the overall financial market. The two new mega-banks would have accounted for more than 50 percent of total consumer credit (see Figure 3) and over 40 percent of total residential mortgage credits (see Figure 4) extended in the overall financial sector. The two newly formed banks would have accounted for more than 70 percent of the total assets, loans, and deposits in the banking system.

11. The case for bank mergers is based on the assumption that financial institutions need to be large and diverse to prosper in financial markets that are becoming increasingly globalized. This view rests on the assessment that, given technological requirements, it would be extremely expensive to maintain a competitive infrastructure for delivering financial services efficiently unless an institution is sufficiently large to manage these costs. In particular, economies of scale could be realized only by large financial firms. In addition, a successful financial institution would have to be large enough to take advantage of economies of scope, which may arise when it is more cost effective to produce two or more products jointly in a single production unit than to produce the products in separate specializing firms. Scope economies can arise from the spread of fixed costs over an expanded product base, or from cost complementarities in producing the different products.10 In international markets, it is also often asserted that it is essential for banks to be large to compete outside the domestic market.11

12. Most of the studies on economies of scale and economies of scope are based on the experience of U.S. banks.12 This literature has provided little evidence that a bank needs to be a mega-institution to exploit economies of scale. In particular, several studies suggest that only small banks have the potential for scale efficiency gains and that the measured economies are usually relatively small.13 The fact that the U.S. financial system is much less concentrated than in Canada, and that the proposed mergers were between relatively large Canadian banks, would suggest that there was less likely to be substantial scale economies arising from the proposed mergers.

13. The computation of scope economies is based on comparing the predicted costs of producing a given bundle of financial products by two or more specialized firms with the costs of joint production by a single firm. Because of estimation problems and data availability, it is difficult to draw firm conclusions regarding the existence of scope economies and their potential magnitude. Studies on U.S. banks suggest that the synergies of producing joint products in banking may not be large; however, significant gains are possible in some cases.14

C. Task Force on the Future of the Canadian Financial Services Sector

14. In 1996, a Task Force on the Future of the Canadian Financial Services Sector was established, and the Task Force report was released in September 1998. Table 4 summarizes the report’s main recommendations with regard to enhancing competition in the financial sector.15

Table 4.

Canada: Task Force on the Future of the Canadian Financial Services Sector Main Recommendations in Regard to Enhancing Competitiveness

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15. The Task Force views the establishment and growth of new financial institutions as a critical element in enhancing competition. In particular, it recommends that the criteria for incorporation of financial institutions should be revised to facilitate that process. For example, foreign banks should be able to carry on any banking business in Canada, other than receiving retail deposits (i.e., of less than $150,000), through branches of the foreign parent bank. Foreign banks that wish to take retail deposits in Canada would continue to be required to establish subsidiaries. The Task Force also recommends avenues to expand the powers of all financial institutions, including by extending access to the payments system to nonbanks, by allowing the retail sale of insurance in bank branches and by permitting banks and insurance companies to lease light vehicles.

16. With regard to ownership rules, the Task Force recommends that the widely held ownership policy should remain applicable to the largest financial institutions, permitting in some cases ownership positions in excess of 10 percent and up to 20 percent of equity. Smaller institutions, however, would be subject to a more flexible ownership rule to encourage entry and competition. With regard to the foreign acquisition of widely held large Canadian banks, the report proposes that in “exceptional” cases the Government should have discretion to approve such acquisitions, free from the impact of the widely held rules.16

17. The Task Force provides no direct recommendation regarding domestic bank mergers and acquisitions of large Canadian banks, other than to suggest the process and criteria that should be used to assess the mergers. However, it proposes that there should not be a general policy that would prevent large institutions from entering into business combinations with other large institutions whether by amalgamation, acquisition, or other means. Mergers of large financial institutions could be permitted as long as the Minister of Finance is of the opinion that markets will remain competitive, that there are no material safety and soundness concerns, and that the transaction is in the public interest. The relevant public interest considerations would include: the cost and benefits to individual customers and small and medium-sized business; regional impacts; international competitiveness; employment; the adoption of innovative technologies; and the extent to which the approval may create a precedent.

18. The recommendations of the Task Force, as well as suggestions made by other interested groups on the future of the financial services sector, will be reviewed by the Minister of Finance before new financial sector legislation is introduced.

List of References

  • Bank of Montreal, 1998, Information on Merger Issues, Toronto, Canada, September.

  • Baumol, W. J., 1982, “An Uprising in the Theory of Industry Structure,American Economic Review, March.

  • Berger, A. N., D. Hancock, and D.B. Humphrey, 1993, “Bank Efficiency Derived from the Profit Function,Journal of Banking and Finance, April.

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  • Berger, A. N., and D. B. Humphrey, 1994, “Bank Scale Economies, Mergers, Concentration, and Efficiency: The U.S. Experience,Finance and Economics Discussion Series, 94-23, Federal Reserve Board, Washington D.C., August.

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  • Berger, A. N., W. C. Hunter, and S.G. Timme, 1993, “The Efficiency of Financial Institutions: A Review and Preview of Research Past, Present, and Future,Journal of Banking and Finance, April.

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  • Booth, Laurence, 1996, “Competition and Profitability in the Financial Services Industry,” in Putting Consumers First: Reforming the Canadian Financial Services Industry, edited by Jack Mintz and James Pesando, C.D. Howe Institute, Policy Study 27, Toronto, Canada.

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  • Clark, J., 1988, “Economies of Scale and Scope at Depository Financial Institutions: A Review of the Literature,Federal Reserve Bank of Kansas City Economic Review, 73, September/October.

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  • Freedman, Charles, 1998, The Canadian Banking System, Bank of Canada Technical Report, March.

  • Freedman, Charles, and Clyde Goodlet, 1998, The Financial Services Sector: Past Changes and Future Prospects, Bank of Canada Technical Report, March.

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  • Mathewson, Frank, and Neil Quigley, 1998, “Canadian Bank Mergers: Efficiency and Consumer Gain versus Market Power,” C.D. Howe Institute, June.

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  • Mester, L. J., 1987, “A Multiproduct Cost Study of Savings and Loans,Journal of Finance.

  • Nathan, A., and E. Neave, 1989, “Competition and Contestability in Canada’s Financial System: Empirical Results,Canadian Journal of Economics, August.

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  • National Caucus Task Force, 1998, A Balance of Interests, November.

  • Pulley, L., A.N. Berger, and D. B. Humphrey, 1993, “The Other Side of the Coin: Bank Scope Economies from a Revenue Function,Finance and Economics Discussion Series (FEDS), Board of Governors of the Federal Reserve System, August.

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  • Pulley, L., and D.B. Humphrey, 1993, “The Role of Fixed Costs and Cost Complementarities in Determining Scope Economies and the Cost of Narrow Banking Proposals,Journal of Business, July.

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  • Shaffer, S., 1993, “A Test of Competition in Canadian Banking,Journal of Money, Credit and Banking.

  • Task Force on the Future of the Canadian Financial Services Sector, 1998, Report of the Task Force, September.

1

Prepared by Brenda González-Hermosillo.

2

For example, in the government securities market before the 1987 legislative changes, domestic banks had about 15 percent of treasury bill auction winnings and 19 percent of Canada bond auction winnings. In 1996, the comparable numbers for banks and their securities dealer subsidiaries combined were 62 percent and 50 percent, respectively. Banks and their subsidiaries also accounted for 82 percent of the turnover in the secondary market for treasury bills and for 59 percent of the turnover in the secondary market for bonds in 1996 (Freedman (1998)).

3

With their entry into the trust business, banks became important players in the market for assets under administration, with the six largest domestic banks representing about 80 percent of the total for this market (Freedman (1998)).

4

Chartered banks are either classified as Schedule I or II. Schedule I banks are domestically owned and are widely held. The widely held rule stipulates that no individual or individual group can own or control more than 10 percent of the bank’s equity. Foreign banks are Schedule II banks and are considered to be narrowly held even if they are widely held in their own jurisdiction.

5

The number of foreign banks in Canada has declined in recent years from a peak of 59 in 1987.

6

One notable exception is the Bank of Hong Kong.

7

The banks’ share of the mutual funds market varies among the different segments of that market. The banks’ highest market shares are in money market and mortgage mutual funds, where they accounted for 68 percent and 56 percent of the market, respectively, at the end of 1996 (Freedman (1998)).

9

Competition is not precluded in highly concentrated markets if they are contestable. Markets are said to be “contestable” if potential competitors have unrestricted access to the market. The notion of “contestable markets” was first explored in Baumol (1982) and studies applied to the Canadian financial sector include Nathan and Neave (1989) and Shaffer (1993).

10

Freedman and Goodlet (1998) discuss some of these propositions, noting that they are plausible on the surface but that they can be challenged to some degree. In particular, they stress that investment in expensive new technologies could be developed jointly, in the absence of mergers, through special arrangements among financial services providers.

11

Mergers can also potentially reduce costs through managerial efficiency which results when an efficient bank with superior management talent acquires a relatively inefficient bank. Such efficiency gains result from adopting “best practices” where cost is minimized for a given output bundle. For U.S. banks, studies suggest that some banks have costs that can be as much as 25 percent above those of the best-practice banks and, hence, these managerial efficiencies can be significant (see, for example, Berger, Hunter, and Timme (1993)).

12

Berger and Humphrey (1994) and Clark (1988) provide comprehensive surveys of this literature.

14

For example, Pulley and Humphrey (1993) found that large U.S. banks did not experience significant cost complementarities between deposit and loan products but did enjoy relatively small benefits of sharing fixed costs between these products. Using the profit function to evaluate optimal scope economies, Berger, Hancock, and Humphrey (1993) find that joint production is optimal for most U.S. banks, but that specialization is optimal for others.

15

Other areas of recommendations made by the Task Force include: (i) empowering consumers (e.g., through ensuring increased disclosure and transparency of services, privacy, elimination of tied selling of products, access to basic banking services, availability of microcredit, and financing of aboriginal business); and (ii) improving the regulatory framework (e.g., by reducing the regulatory overlap between different levels of government or agencies).

16

Such transactions would be subject to a similar process for domestic bank merger approvals. The buyer should be a widely held, regulated financial institution and the acquisition should be deemed to be in the interest of the Canadian public.

Canada: Selected Issues
Author: International Monetary Fund
  • View in gallery

    CANADA: BANKING CONCENTRATION RATIOS RELATIVE TO TOTAL BANKING SYSTEM ASSETS, 1997

    (Percentage)

  • View in gallery

    CANADA: DEPOSITS IN CANADA, 1997

    $714 billion

  • View in gallery

    CANADA: CONSUMER CREDIT IN CANADA, 1997

    $138 billion

  • View in gallery

    CANADA: RESIDENTIAL MORTGAGE CREDIT IN CANADA, 1997

    $373 billion

  • View in gallery

    CANADA: FINANCING OF SMALL AND MEDIUM SIZE CORPORATIONS IN CANADA, 1997

    $110.9 billion

  • View in gallery

    CANADA: BANK SHARE OF BUSINESS CREDIT MARKET

    (Percentage)

  • View in gallery

    CANADA: INTEREST RATE SPREADS OF SIX LARGEST BANKS

    (Percentage of average assets)