When I was sworn in as Canada’s deputy minister of finance on September 1, 1985, my colleagues threw a bombshell at me as soon as the words of the oath were out of my mouth. ”œDeputy,” they told me, ”œyou need to know that this morning we closed two banks.”
I was well aware of the problems that had beset the Canadian Commercial Bank in the fall of 1984 and the win- ter and spring of 1985. As chair of the Private Sector Advisory Committee for the National Economic Conference, which Prime Minister Mulroney had convened in Ottawa that spring, I had noticed the absence for pro- longed periods of time of senior Finance officials, and, at times, the minister himself, culminating in a support pack- age for the institution, which proved to be insufficient.
But I was not prepared for the fact that two Schedule ”œA” banks (Northland Bank was the second) ”” which funded themselves by raising wholesale deposits, mostly through brokers attracted by marginally higher interest paid to depos- itors ”” had not been able to sustain themselves and had been certified as not being viable by the Inspector General of Banks. Nor was anyone prepared for the consequences ”” a Royal Commission chaired by Mr. Justice Willard Z. Estey, recently retired from the Supreme Court of Canada, into the causes of the collapse, the payment by the government of uninsured deposits brought about by the ”œmoral hazard” of the inadequate rescue package, the subsequent run on deposits at other Canadian banks that did not have stable, retail based funding as a ”œflight to quality” raced through our banking system, and far-reaching reforms to our regulatory regime and our financial institutions policy.
Estey essentially found that the banks in question had compensated for having to pay more to attract deposits by taking on riskier loans in the expectation of higher returns, and that the risk-assessment systems at the banks were ineffective at controlling the portfolio imbalance that resulted. Sectoral and geographical concentra- tion of loans contributed to the deba- cle, because of inordinate reliance on clients in the energy business and inordinate exposure to industry cycles. The deposits in both banks had, of course, been insured by the Canada Deposit Insurance Corporation, but that insurance had a limit of $60,000 per account. Because Bank of Canada Governor Gerald Bouey had declared, at the time of the rescue package, that access to his lending window of last resort was limited by statute to solvent institutions, depositors concluded that CCB must be safe. As a result, the banks’ failures forced the government to introduce special legislation reim- bursing depositors for unrecoverable losses beyond the $60,000 limit.
The damage could not be limited to two banks. Because of their reliance on wholesale deposits, in short order the Bank of British Columbia was con- veyed to the Hong Kong Bank of Canada (as it was then known, now HSBC Bank Canada); Continental Bank was sold to Lloyd’s Bank, which in turn later left Canada, selling to HKBC; Mercantile Bank (the former subsidiary of First National City Bank of New York, which still held 25 per- cent at the time) was shored up by a loan package from the Big Six plus Citibank and then sold to National Bank of Canada; two small Western-based banks (Bank of Alberta and Western Pacific Bank) were merged as Canadian Western Bank, and Morguard Bank was sold.
The policy and regulatory frame- work that had been in place for these bank failures, the first since the 1920s, was subjected to a critical re- thinking. The Office of the Inspector General of Banks was combined with that of the Superintendent of Insurance to form the Office of the Superintendent of Financial Institutions. CDIC introduced pruden- tial standards of its own so as not to be obliged to rely solely on the superviso- ry expertise of the banking regulator.
A White Paper explored ways in which the financial sector might be modernized, both to replace the lost competition brought about by the dis- appearance of so many smaller institu- tions in such a short space of time, and to examine ways to prevent a repeti- tion of the events.
The conventional wisdom about what happened next is that Canada tried to emulate the 1986 development in Margaret Thatcher’s United Kingdom that has come to be known as the ”œBig Bang.” While there is an element of truth to this, Canada was actually driven more by its own domestic policy needs. The CEOs of the Big Six banks asked the minister of finance, Michael Wilson, for an emer- gency meeting, which was held at the ChaÌ‚teau Montebello, Quebec, site of the G7 summit in 1981.
There was no one present other than the six CEOs, the minister, me as his deputy, and Don McCutchan, a trusted advisor in the minister’s office. The bankers made a plea to be allowed to enter the securities business, which had been denied them for decades so as to minimize the risk to bank capital resulting from securities market volatil- ity. Their thesis was that lending had become securitized: the banks’ best cus- tomers could finance themselves directly in the London Interbank Market, in essence in competition with the banks themselves, by issuing Eurodollar securities, leaving to the banks the worst credits, on which spreads could be as little as 3/8 percent. Dick Thomson of the Toronto- Dominion Bank, speaking for the group, pointed out that while we were still dealing with the fright- ening implications of the recent run on virtually all of the country’s smaller banks, the government needed to consider the possibility of failures among the Big Six.
The representations were persuasive: not only were market standards changing so that CEOs of borrowers were increasingly indiffer- ent to whether a bank funded itself as a principal, added a spread and made a loan to the client, or designed a piece of paper that the client signed and the banker then sold to the street; but there was a policy inclination among the minister and his officials to ques- tion the validity of the ”œfour pillars” tradition of financial institutions regu- lation, which saw banks, insurance companies, trust and loan companies and securities dealers all relegated to their respective regimes of operation and supervision.
The Glass-Steagall mentality that produced the separation of the pillars was now increasingly subject to serious questioning. One-stop finan- cial supermarket shopping was coming into vogue as a model for growing and consolidating financial institutions. The public policy imperative was to generate new kinds of competition, and the creative juices that would be unleashed by combining commercial and investment banking was seen as a highly desirable outcome.
It should be remembered that no one expected the single model of bank-owned investment dealers, which eventually emerged to be the sole and solitary solution. At first, it seemed as if the hoped-for diversity of bank/dealer combinations would come to fruition. Wood Gundy made a deal with First Chicago (a deal that foundered after the stock market melt- down of October 19, 1987, when the Dow lost 23 percent of its value in a single session: Wood Gundy was near- ly itself a fatal victim because of a huge bet the firm had made on the privati- zation of BP, following which Wood Gundy was ”œrescued” by CIBC with the help of Jack Cockwell’s Brascan).
Burns Fry sold a minority interest to Security Pacific, before undoing that arrangement and merging with Nesbitt Thomson in 1994. Bank of Montreal had acquired Nesbitt in 1987, just as Bank of Nova Scotia had purchased McLeod Young Weir, and Royal Bank of Canada had acquired Dominion Securities. National Bank of Canada bought the venerable Quebec-based house of Lévesque Beaubien. Only Toronto Dominion Bank opted to build instead of buying their securities dealer arm, although even they even- tually went on to purchase several top quality boutiques in subsequent years to round out their offering.
So Canada’s ”œLittle Bang” (or, more pejoratively, ”œwhimper”) was born of a philosophical view favouring cross- pillar pollination through competition in each other’s previously watertight compartments. As we will see, this approach has become mired in a new but equally stultifying batch of regula- tory restrictions since the events that originally produced this policy shift, which has led to an unfortunate loss of momentum and opportunity.
The advent of bank-owned securi- ties dealers raised the inevitable constitutional issue: which level of government would regulate what? Banking is a federal matter under sec- tion 91 of the Constitution Act, whereas securities regulation has been charac- terized as a matter of property and civil rights in the various provinces. This being Canada, the most vigorous debate was reserved not for the under- lying policy, but for the dispute over powers and jurisdiction. While the dis- cussions involved the ministers responsible from every province, they ultimately resulted in the so-called Hockin-Kwinter Accord, between then minister of state for financial institu- tions in the federal government, Tom Hockin, and Monte Kwinter, his Ontario counterpart.
The accord listed which securities activities could be carried on in banks, while all other securities-related func- tions were reserved for the provincially licensed securities dealers. This was the first of the sclerotic limitations placed on cross-pillar competition by governments, which never quite permitted financial markets to capitalize on the original rea- son for breaking down the pillars.
Ironically, within the newly integrat- ed institutions resulting from the ”œLittle Bang,” the bright line between functions has been steadily and inex- orably erased. This corresponds with reality: financing with the optimal mix and the lowest cost of capital often involves a combination of bank debt, capital markets debt and equity, and it is finding the right mix, not the right pil- lar, that the corporate world cares about.
But while Canada was still in the process of unleashing the competitive forces that would spur variety in prod- uct offerings and multiply the sources of capital, the negotiations for the Free Trade Agreement with the United States became a major preoccupation for the government. Simon Reisman, our forceful and effective chief nego- tiator, and Gordon Ritchie, his deputy, developed a sectoral approach to the bargaining, which was essential to ensure the necessary domestic consul- tation and the expertise to negotiate the best arrangements possible. The very able Bill Hood, one of my prede- cessors as deputy of finance, headed the financial sector working group.
Unfortunately for us, the US had not yet come around to the deregulation that both the UK and Canada had already completed, and so, in offering us ”œnational treatment,” as we were offer- ing them, there was precious little of interest they could concede. We had to content ourselves with a promise that, if the Glass-Steagall restrictions ever went away and the lines between banking and securities were erased, Canadian institu- tions could benefit from that liberaliza- tion regardless of what the institutions from any other country could do. The same was true for a contemplated future removal of the restrictions on inter-state bank branching. We also obtained some easing of the ability of our bank-owned dealers to participate in government debt offerings, which would not other- wise have then been available to any dealer with bank ownership.
When the legislation governing banks, insurance companies and trust and loan companies was revised by Parliament in 1992, it was disappointing to see that, while banks were allowed to own insurance companies, they could not offer their own products over the counter in their branches (other than creditor life insurance on such products as mortgages and car loans, which had long been legal). This was the result of a fierce lobby from the insurance industry. The owners of insurance companies feared that their franchises would be stolen by the banks (staying just clear of prohibitions in the Competition Act against tied selling) by making the bor- rower believe that the bank would be suf- ficiently gratified if the house insurer were used that the loan might be more likely to be forthcoming. The prohibition against in-branch insurance sales was ini- tially intended to be temporary, until insurance shareholders had an opportu- nity to monetize their investments.
Then there were the agents and brokers. Mostly self-employed, or at least masters of their own hours of work, and representing an element of society that was well-educated, finan- cially comfortable and politically involved, it would be fair to say that every candidate for the two leading national parties had and has a cadre of insurance industry personnel on his or her campaign team. These agents and brokers feared the commoditization of their product if sold by bank personnel over the counter in bank branches and made their opposition known.
This was another lost opportunity to open our financial markets to challenge from competitive forces. The truth is that plain vanilla insurance would be appropriate to sell in bank branches, while the more complex and rewarding cases involving estate plan- ning, business succession and buy-sell arrangements will always be sold in living rooms or offices after multiple meetings. The bifurcation of the mar- ket between commodity products and highly individualized ones might actu- ally help the most skilled professional agents and brokers
Having given away the ”œ10/25” rule, (by virtue of which individual for- eign owners were restricted to 10 per- cent of a financial institution, and foreign ownership collectively was limit- ed to 25 percent) in the FTA negotia- tions, Canada attempted to preclude foreign banks seeking to buy our previ- ously protected institutions, as well as to prevent further domestic consolidation. ”œNational treatment” meant no share- holder, Canadian or foreign, could hold more than 10 percent of a large financial institution (now moving to 20 percent), and the government declared that ”œbig shall not buy big.” This and other policy enunciations were also aimed at cross- pillar combinations between banks and insurance companies.
The government has permitted four large insurance companies to demutualize, and, based on size, the two smaller ones to be purchased by two larger companies. The banks have absorbed the trust companies; most, though not all, were bought in cir- cumstances that qualified as acquisi- tions of ”œfailing firms.” In the latest version of the Bank Act, smaller banks qualify as targets to the extent of 100 percent or 65 percent, based on size.
The United States has now caught up in the modernization of financial institutions regulation. Not only has the separation between commercial and investment banking been repealed, but laws now accommodate the ”œban- cassurance” model, where banks and insurance companies co-exist in the same corporate structure. Canada’s government, on the other hand, has unfortunately, lost sight of the prom- ise, and the purpose, of dismantling the four pillars, and progress is stalled in liberalizing our financial system.
We are still waiting for the final word on whether the current govern- ment will permit bank mergers and/or cross-pillar mergers. It would be the ulti- mate reversal of the thrust toward open- ness, begun in harsh circumstances in 1985, if the MacKay Committee report, the ensuing White Paper, the Bank Act amendments permitting bank mergers, the Kolber Report of the Senate Banking Committee, the regulations, and the long-awaited public interest guidelines amounted to a Potemkin village, offer- ing the illusion of policy development, but masking the reality of a reluctance to permit the changes that would allow us to reap the benefits of really mattering in the world.