U.S. and Canadian Financial System:“Tales of Two Countries”

I. American Banking System

Summary

Commercial Banking Investment Banking

U.S. 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 forcesregions, 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 AmericanScarecrow -Western FarmerTin Woodman- Unemployed Industrial WorkersCowardly Lion -“William Jennings Bryan”

versus

Wicked Witch of the East- Eastern Business and Financial InterestsMunchkins -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 withMonetary 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 ActIn 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.

• 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.

0

2000

4000

6000

8000

10000

12000

14000

16000

'75 '80 '85 '90 '95 '00

# of Banks

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 betweenCommercial 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)

Full Service BankingTowards

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 IssuesThen, 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”