Bank Mergers – The Left was Right

My personal theory as to why the Canadian banking system survived the great global financial crisis relatively unscathed is that calls by the big Canadian banks in the late 1990s to allow mergers were successfully resisted. Had the big banks been allowed to merge to pursue their global ambitions, they would have ramped up their US and high risk foreign operations considerably, and the cozy, profitable, risk-averse Canadian banking oligopoly would have been broken up by the quid pro quo for mergers – allowing foreign takeovers of Canadian banks. The Liberal Government decision to effectively prohibit bank mergers – despite massive pressure from the big banks – effectively maintained a national financial system under widespread Canadian ownership, and thus subject to national regulatory oversight and control. Much of the credit goes to the popular movements which fought for bank regulation, not to the government regulators who largely bought into the financial sector arguments for deregulation.

I’ve pasted in below the November, 1998 submission by the Canadian Labour Congress to the House of Commons Standign Commitee on Finance Hearings on the Report of the Task Force of the Canadian Financial Services Sector.

Personally, I think the line of argument has been pretty well vindicated by recent events.

“The Canadian Labour Congress (CLC), as the voice for Canadian workers, has two central concerns regarding the future evolution and restructuring of the financial sector. First and foremost, we are concerned with the impact of any major changes such as bank mergers or greater entry by foreign banks upon jobs and incomes in the Canadian economy as a whole. The financial sector and the “real economy” are closely related, and it is a profound mistake to look at financial sector issues in isolation from broad economic issues of concern to workers. Second, we are concerned about the potential direct impacts of financial sector restructuring, particularly bank mergers, upon jobs and communities. These concerns lead us to support closer regulation of the financial sector in the public interest. We believe that the banks will continue to be an “oligopoly” and that limited competition generates abuses which must be responded to through enhanced regulation.

Despite some rhetoric in the Report on the need for more competition, the Task Force clearly opens the door to mergers of the large banks which would greatly hinder competition and, indeed, set the stage for the most concentrated banking system in the advanced industrial world. The Task Force speaks of the “forces of change” leading to merger proposals as if these could not possibly be resisted, even though the extent to which the Canadian banks are exposed to foreign competition is clearly limited by public policy. New technology is certainly reshaping the system, but there is nothing about electronic banking or large computer systems which make mergers necessary or desirable. (The banks have co-operated to develop technology in areas where economies of scale can indeed be obtained, and most experts agree that the big Canadian banks do not have to be bigger in order to be more efficient.) The banks speak of the need for mergers if they are to compete internationally, but some of the large banks are already major international players and there is little or no evidence that size is needed to succeed in international markets, as argued in a major Bank of Canada background study. Further, it is unclear why we would even want Canadian banks to be major players internationally, given the precarious situation of many large international banks and the role they have recently played in setting the stage for global economic disorder. In short, bank mergers may make short-term sense for the shareholders and senior corporate executives who will benefit from stock gains and from increased concentration in the domestic market, but the public policy case for mergers and mega banks is, at best, dubious.

While we welcome the Task Force recommendations for a detailed public interest review of large bank mergers over and above review by the Competition Bureau, and note that the Task Force supports the possible imposition of major conditions by the Minister of Finance, the Task Force should have concluded that the current policy that “big shall not buy big” should remain in place. The basic case against the mega mergers is clear. They would result in the loss of up to 40,000 jobs, many held by women in smaller communities. They would lead to closure of bank branches in many communities, and likely to complete loss of service in some. They would lead to an unprecedented concentration of market power in financial services, setting the stage for an increase in already high profit margins at the expense of consumers and businesses. They would likely lead to an outward flow of Canadian savings to foreign investments and risky activity on international financial markets, and they would lead to the possible exposure of taxpayers to large bailout losses, since the merged banks would be “too big to fail.” Unfortunately, the Task Force failed to deal with these substantive issues, limiting itself to issues of process.

The Report of the Task Force argues in favour of a more competitive financial sector, and makes proposals which are intended to foster more competition through the creation of new deposit accepting institutions and greater entry by foreign banks. (Specifically, the Task Force proposes access to the payments systems by mutual funds, life insurance companies and investment dealers which would allow them to act more like banks; proposes easier access to the Canadian market for foreign banks; and proposes broader ownership and holding company rules which might encourage retail chains and other large companies to start banking operations.)

Most experts are highly sceptical that changes such as those proposed would, in fact, lead to a significant increase in competition given the highly entrenched and dominant position of the large chartered banks which control some two-thirds of the capital and assets of the financial sector as a whole. The big banks completely dominate retail financial services, having taken over most of the trusts which provided limited competition earlier, and barriers to entry by rivals in this sector are huge given the very large “bricks and mortar” cost of establishing rival branch systems. The banks also have become the major players in the securities industry, adding to their traditional role in investment banking. It is true that the big banks have faced increased competition in wealth management services from non-bank mutual funds and have lost some of their traditional corporate finance business to issuers of corporate bonds. But marginal changes to the rules of the game will likely not spell an end to the very high level of concentration in Canada’s financial services sector.

Moreover, some proposed changes which might increase competition — such as allowing much greater access to our market on the part of foreign banks — would compromise other important objectives. Currently, foreign banks have been largely excluded from Canada, with the exception of some niche markets, because they have been required to establish branch networks, and have not been allowed to take over large Canadian banks. Greater foreign control of our banking system via major or even relatively modest adjustments to this system would lead to job losses and lost tax revenues as some head office and other operations were shifted out of Canada.

Furthermore, the ability of the government to regulate the financial sector in the public interest would likely be undercut by increased foreign control. Under the current system, the federal government and the Bank of Canada have the ability, in principle, to influence bank decision-making via moral suasion and other means, as an alternative to the blunt instruments of monetary policy. In our view, the authorities must retain the power to reduce excessive lending and speculation, or to increase the availability of credit to particular sectors, when necessary. For example, in the late 1980’s, the authorities could and should have stepped in to limit the over-extension of bank credit to real estate development and speculation, which was a factor behind increased inflation. Credit controls would have been greatly preferable to increased interest rates across the board. But such “micro” intervention could be compromised by foreign ownership given Canada’s existing obligations under NAFTA, the WTO, and the proposed MAI. Put another way, the current system represents an implicit compromise. The banks have been protected from foreign competition to a significant degree, and can legitimately be expected in return to assist the authorities in promoting public policy objectives. Within this context, we oppose greater entry by foreign banks to the Canadian market.

By contrast to the Task Force, we believe that regulation is likely to serve the public interest better than mergers or a more market-driven financial sector, and that more effective regulation of the current system is needed.

As the Task Force does recognize, a sound and well-regulated financial system is absolutely essential to the maintenance of a sound economy. Both the household and the corporate sector need access to credit, depositors need the assurance that their savings are safe, and financial services must be efficiently provided. History clearly demonstrates that a crisis in the financial system can quickly lead to wider economic crisis. This has underpinned the case for prudential regulation, and it is notable that highly regulated financial systems were established in Canada and elsewhere in the post-war years in response to the experience of the Great Depression which underscored the vulnerability of the real economy to financial crisis and turmoil.

Left to their own devices, banks are prone to make mistakes, and large banks are prone to making particularly large mistakes. Banks can and do become insolvent by extending capital to risky and speculative ventures, and banking crises can and do result in a restriction of credit in the wake of a crisis, depressing growth and often precipitating recessions. The current deepening global economic crisis was in large measure caused by the massive over-extension of credit to developing countries by major international banks, fueling speculative bubbles which have since burst, leading in turn to the collapse of real economies and a large scale withdrawal of credit. Literally, millions of workers in developing countries have lost their jobs and experienced huge reductions in real wages this year because of crises precipitated in large part by an unregulated international financial system.

The current crisis has also led to exposure of bank driven “casino capitalism” in the advanced industrial countries. The deepening global crisis is due not just to speculative bubbles in developing countries, but also to rampant speculation at home. We have learned that large European and U.S. banks made huge loans to purely speculative, highly leveraged hedge funds, and have themselves been deeply involved in speculative “off balance sheet” activities. It has become abundantly clear that large banks require close supervision if they are not to take huge risks, which can and do lead to the need for public support. In recent weeks, the U.S. Federal Reserve was forced to intervene to co-ordinate an aid package to prevent financial market collapse caused by the unwinding of hedge fund positions, and the Government of Japan has been obliged to put up close to $1 trillion to unwind the Japanese banking crisis.

What the Task Force does not sufficiently recognize is that a more “market driven” financial sector will tend to push institutions into taking greater and greater risks, since profit margins are likely to be reduced in “bread and butter” lines of business like retail banking. Indeed, the Canadian banks which have proposed mergers have done so precisely because, in their view, they must expand their international operations in order to reduce dependence upon domestic retail banking. The public policy case for expanding the international activities and exposure of the Canadian banks is dubious to say the least. It would require a remarkable leap of faith to believe that Canadian banks are not liable to make exactly the same huge mistakes which have led to huge losses and taxpayer bailouts of the large Japanese banks, and growing problems at large North American and European investment banks. Indeed, the Canadian banks incurred large losses in the past when they over extended credit, as in the commercial real estate meltdown of the early 1990’s.

There is a strong public interest in a more stable financial sector since, in the final analysis, the costs of financial sector mistakes are likely to fall on taxpayers and the general public. In the recent past, financial institution failures in other countries, notably the Savings and Loan debacle in the U.S. and the meltdown of the Japanese banking system, have imposed huge costs on taxpayers since the alternative of a wave of bankruptcies and a resulting credit crunch would have been so damaging to the real economy. Further, governments are more or less obliged to help large institutions work out their difficulties because of deposit insurance. Some would argue that a concentrated system is preferable because it is more stable, but as Arthur Donner and Doug Peters have noted, no Canadian government could possibly avoid a bail out of a failing bank in a highly concentrated system. Put simply, banks simply cannot be treated like any other business, subject only to “market discipline.”

Canadians are fortunate to have had a reasonably stable financial system in recent decades, though it should be recalled that a number of smaller banks and trusts were liquidated or had to be taken over due to problems in the 1980’s, and that the large chartered banks incurred very large loses because of excessive lending to developing countries in the 1970’s and to commercial real estate development in the 1980’s. Regulation has not stopped banks from taking huge risks — for example, the large unsecured loans granted to Olympia and York real estate developments in the late 1980’s. It is disturbing that the Task Force proposed instructing the Office of the Superintendent of Financial Institutions to “balance competition considerations” and not just regulate so as to ensure safety and soundness. The Task Force also fails to discuss the need for increased scrutiny against the background of the acute financial fragility of the global economy. Strikingly, there are no calls in the Report for greater regulation and disclosure of “off balance sheet” risks to solvency, even though it is well-known that the Canadian banks have derived an increasing portion of their profits from trading on their own account in derivatives, foreign exchange futures and other highly risky instruments. The real risk of such instruments to the solvency of a bank is difficult to gauge, particularly if the bank position is not disclosed on the books. The role of the Canadian banks in speculation against the Canadian dollar this year remains unexplored, but it is likely that sharp swings in exchange rates may have exposed the banks to some of the same risks which have resulted in large losses by some hedge funds and investment banks.

The relative stability of the Canadian financial sector to date has above all been secured by effectively limiting the entry of foreign banks into retail banking and by insisting on broad ownership of the major chartered banks. Insistence on broad ownership has also limited the potential for self-dealing or “crony capitalism,” that is the extension of loans by banks to closely related companies. Separation between the banks and insurance companies has served the same purpose. The existing financial system is not only broadly stable, it is also relatively efficient. The payments system is among the most efficient in the world, interest rate spreads are quite low, and the cost of financial services to consumers is comparable or lower than in other countries. Of course, the chartered banks have been extremely profitable in the 1990’s, earning rates of return on capital which significantly exceed the industrial average. But excessive profit levels speak to the case for higher taxes on bank profits, not for radical changes to the existing structure. We emphatically reject the Task Force recommendation for lower bank taxes and tax holidays for new banks.

To summarize, Canada needs a stable financial system, subject to close supervision and control by the public authorities. The existing system is far from perfect, and very high rates of return suggest that the level of competition is quite limited. Given the significant protection from competition which the banks enjoy as a result of public policies intended to limit foreign ownership and to promote broad ownership, more should be asked of them not just in terms of tax revenues but also in terms of disclosure of information and audits of performance. We should, then, move in the direction of a much more closely regulated system.

Specifically, there should be much more public disclosure of bank lending, including disclosure of the level of loans to different kinds of businesses, and disclosure of lending to particular communities. The CLC supports proposals for Canadian legislation similar to the Community Reinvestment Act in the U.S. which has levered some additional lending to micro enterprises, minorities and depressed communities, and we note that the Task Force recommendation in favour of annual “Bank Accountability Statements” is much more limited. Beyond comprehensive disclosure of information on loan applications and approvals, we believe there is a strong public policy case for some public direction of bank lending in the interests of regional and community economic development. The CLC and our partners in the CCPA/CHO!CES Alternative Federal Budget project have called for compulsory bank deposits in public investment funds, beginning at a modest level. These funds could offer low cost credit to Community Development Corporations and sectoral and regional development banks as part of a comprehensive jobs strategy. The interests of Canadian workers lie in an expansion of real investment in the real economy, not in the expansion of a paper economy marked by speculation and other excesses which do not generate real wealth, and, indeed, imperil real wealth creation.

The banks should also be more closely regulated to defend consumer interests. Banks should be required to provide a minimal cost package of services to low income persons and households, and to cash cheques at low cost. It is scandalous that social assistance recipients and low wage workers are gouged by cheque cashing operators because the banks refuse to provide a basic service to all sectors of the public at reasonable cost. Regulators should also monitor the profit margins in specific areas of bank activity such as credit card operations, and mandate appropriate reductions in interest rates and service fees. Closure of bank branches should be subject to public justification and review, and should not be allowed if a community is deprived of needed levels of service. A bank ombudsman should be established, completely independent of the banks, to investigate consumer complaints and to make binding rulings. The Task Force does make modest recommendations in some of these areas, but the approach is very limited. Essentially, the banks are urged to disclose more information and to take their responsibilities to the public more seriously. But the Task Force refuses to accept that large financial institutions are analogous to public utilities — because competition is limited, there is a need for regulatory oversight and supervision.

To conclude, while the Task Force has made a number of useful suggestions and recommendations, we do not share their fundamental vision of the financial services sector. Finance is too important to be left to the market and to the market alone. The financial sector needs to be more closely regulated in the public interest, particularly given the high level of concentration in the Canadian banking system.”