Rob Wessel is Managing Partner of Hamilton Capital, a Toronto-based fund manager specializing in financial services. An expanded version of this article can be found at www.hamilton-capital.com.
Canadian banks have been praised for avoiding the worst of the global financial crisis. This success is firmly rooted in public policy: For much of the past century, our policy makers have successfully – and deliberately – created a very powerful, domestically controlled banking system.
But the banks’ growing market dominance comes at a price. As policy makers around the world debate how to reform the banking sector – even former Citigroup Inc. CEO Sandy Weill is arguing for the breakup of U.S. megabanks – is it time for Canadians to ask whether the Big Five banks are becoming too powerful? The answer is yes.
To understand why, it is useful to review how Canada’s bank policy has evolved. The first phase took place throughout most of the 20th century, during which policy makers supported bank mergers with the objective of creating national banks that would be competitive. This process ended in the 1990s, when the banks acquired virtually the entire trust sector.
The second phase of this policy evolution, which began in the late 1980s, was a full embrace of the “universal bank” model that combines traditional lending with capital-markets activities. Canadian banks swept up the major investment dealers, including their retail brokerage networks, giving them a new source of profits.
Without a doubt, this created a very durable financial system less vulnerable to shocks like the one we saw in 2008. The policy was a huge success, pleasing both capitalists and economic nationalists.
But while the current system is excellent, this concentration of power is not entirely benign to either consumers or businesses. The biggest negative of the system is obvious. Because the banks enjoy de facto protection from foreign acquirers, large swaths of the wealth management and investment banking sectors have also become protected – creating what is now effectively a closed market. In fact, there is not a single business in which foreign competitors pose a serious threat to the Big Five.
Under the umbrella of this protection, the banks have used their overwhelming size and distribution power – including their huge branch networks – to dominate their smaller Canadian competitors.
There are no perfect solutions, but we believe there are some basic steps Ottawa should pursue to increase competition in financial services.
First, the government should introduce a market share limit for domestic retail banking that would effectively prohibit acquisitions within Canada once a bank achieves a certain size – say, once it has 10 per cent of bank deposits.
The objective of this policy, which exists in the U.S., would be to enhance competition. In a business where scale is critical, the Big Five banks now control approximately 70 per cent of retail banking deposits. The two largest banks represent more than 35 per cent.
This change would effectively mean that growth would have to be organic, and that, for example, none of the Big Five banks would be allowed to acquire HSBC’s Canadian unit, Laurentian Bank, or Canadian Western Bank, if they came up for sale. Therefore, should consolidation continue, this creates the opportunity for a larger competitor to form outside the existing oligopoly, potentially increasing access to credit – a positive for the system.
Second, ownership restrictions should be relaxed to allow foreign competitors to acquire 100 per cent of CIBC, National Bank, Canadian Western Bank and Laurentian Bank. This would allow these smaller players to take on a larger partner if they considered it strategically desirable. It would also leave the four largest banks as “national champions,” continuing to benefit from government protection.
This proposal has the potential to introduce additional competition to the system by strengthening the smallest banks. Does anyone not believe that competition would rise if Wells Fargo acquired CIBC?
Third, policy makers should require banks to offer other companies’ mutual funds – for a fee – in their retail branch networks. (Please note, my firm does not sell mutual funds.)
This change is important. Many of the big banks’ mutual fund lineups are terrible, but they grow nonetheless because the banks use their branches to sell them to customers who are less familiar with other investment options. Many observers consider the sale of exclusively proprietary financial products in bank branches a conflict of interest. Requiring the banks to open their retail branches to third-party funds would reduce this real or perceived conflict.
None of these recommendations would harm the Canadian banks as they are currently constituted. Nor do they cost taxpayers. But each of them would help create a more competitive Canadian financial system, which should ultimately benefit consumers and businesses.
Canadian banks are very well-run organizations. However, over the past several decades, the financial system has become increasingly organized to their benefit. The federal government can take steps to ensure the system evolves in a way that serves all Canadians, not just bank shareholders. The fact that virtually all bank investors believe these are “can’t lose” stocks says a lot.