Banking
The chartered banks accept deposits from the public and extend loans for commercial, personal and other purposes. Other financial institutions, known as "near-banks," perform some of these functions, but banks are the only financial institutions that can increase or contract the basic money supply (see MONETARY POLICY). In addition to these traditional functions of the banking system, the banks have increasingly moved to provide a wider range of services such as investment banking, international banking services, information processing and real estate operations.
Total Profits of Canadian Banks
In billions of dollars (courtesy Maclean's).
History of Banking
In one of the earliest codes of law, compiled by Hammurabi, king of Babylon from 1792 to 1750 BC, several paragraphs were devoted to banking. By c 1000 BC in Babylon the transfer of bank deposits to a third party was common, and the palace or temple extended loans from its own assets. The Greeks established private banks, which accepted deposits and acted as agents in the settlement of debts. Pasion of Athens, a famous 4th-century BC banker, invested his own funds and those of his depositors in commercial ventures. Roman bankers acted as money changers, auctioneers, discounters and creditors; they formed a banking association and maintained something similar to a modern current accounts system.
"Bank" derives from the Italian word banco, the bench on which money changers sat to conduct their business, and from the 5th to the 11th century bankers acted primarily in this capacity. With the advent of the Crusades, the Lombards, northern Italian merchants, formed merchant guilds; they accepted deposits, granted advances and made payments, preferring to operate where they were not required to pay taxes. In the 12th century, the Lombards established themselves in London, and Lombard Street remains a symbol of financial power.
From the 14th to the 19th century various banks were established in countries such as Italy, Holland, Spain, France, Germany and England. The Bank of Amsterdam was established in 1609 and acted as a guarantor of coinage, since it would accept coins only at what it perceived as their real value. The Bank of Stockholm, founded at about the same time, issued receipts for deposits that were circulated for purchasing goods and as bills of exchange-in effect, the first bank notes. The Bank of England was established in 1694 as a private bank (remaining so until 1946) under a royal charter to raise money for war. Banking history in England is distinguished by the early development and use of the cheque; on the continent the limitations of the non-negotiable cheque precluded extensive use of deposit credit until well into the 19th century.
In the earliest days of French settlement, BARTER was generally the method of trade and there was no local currency. The coins and merchandise customarily sent from France returned there for the purchase of imports. One year, when a shipment did not arrive, Intendant François BIGOT issued signed playing cards, redeemable in coins and merchandise (when they arrived), and ordered the colonists to accept them as money. By 1760 the colony was 80 million livres in debt, much of it in worthless ordonnances issued by Bigot. After the CONQUEST the British used Mexican, Spanish, Portuguese, French and German coins to pay their troops, which, with trade goods, became the coin of the realm.
In 1792, 9 Montréal merchants formed the Canada Banking Company, but because it could not obtain permission to issue bank notes it failed, as did 2 other similar ventures in 1807 and 1808. During the War of 1812 the governor issued "army bills" that bore interest and could be exchanged for cash, government bills of exchange in London or more army bills. In 1817 the BANK OF MONTREAL (a joint-stock operation owned by 289 subscribers) opened its doors in Canada, but did not get approval of its charter until 1822. Two other banks also received their charters around this time - the Bank of New Brunswick (1820) and the BANK OF UPPER CANADA (1821). The Bank of Upper Canada was controlled by the FAMILY COMPACT, and the legislature of the time refused charters to any group unless some of its members belonged to the oligarchy.
Another bank, the Bank of the People, was established by the enterprising Francis HINCKS, who became prime minister of the Province of Canada and later John A. Macdonald's finance minister. He was responsible for ensuring the passage of Canada's first BANK ACT (1871) and was later named president of the Consolidated Bank. (He was also brought to trial on various offences and convicted of fraud, although the conviction was reversed on appeal.)
Many of Canada's first bankers, eg, Samuel Zimmerman, who was involved in the Great Southern Railway swindle, were not examples of probity, and until the 1920s banks in Canada were generally unstable. Between 1867 and 1914 the failure rate of Canadian banks was 36% as opposed to 22.5% in the US, costing Canadian shareholders 31.2 times more than was lost to American shareholders; of the 26 failures in this period, 19 resulted in criminal charges against bank officers or employees. Improved bank regulation reversed these failure rates and Canada has had only 2 bank failures since 1923 while the US has had over 17 000. The structural organization of the Canadian banks followed the English model of allowing unlimited branches and, as one historian notes, "it was the model least suited to promoting industrial development in the colony." Regional growth suffered as well. For example, by 1912, in one area of the Maritimes, only 5 cents of every dollar deposited in the bank were loaned locally and 95 cents were transferred to central Canada.
In addition, the number of banks in Canada was restricted by high capital requirements and vested interests allied to the legislators. Attempts by Westerners to form their own bank were vetoed by the Canadian Bankers' Association, officially incorporated in 1901. As a result the Canadian banking system became characterized by the creation of a few dominant banks with many branches, compared to the American practice of encouraging many unit banks and restricting or prohibiting branches.
Bank charters were issued by Upper Canada and Québec until 1867 and subsequently by the federal government. Thirty-eight banks were chartered by 1886 and this number changed little until World War I, when it declined sharply, and only 8 remained, of which 5 were nationally significant. Legislative changes and the economic expansion of the West reversed this trend. There are now 53 banks operating in Canada.
Banking practices and financial institutions changed and evolved as the economy developed in the 19th century. At this time, the banks issued their own notes, which were used as money, but gradually governments supplanted this privilege until finally only the Bank of Canada could issue legal tender. Lending practices evolved from the primary banking function of making commercial loans that were self-liquidating within a year to making loans on grain secured by warehouse receipts, on proven reserves of oil in the ground and in the form of mortgages on real estate.
Other financial institutions providing some of these banking functions also began appearing early in Canadian history. Mortgage loan companies patterned after building societies in the UK opened in the 1840s and they evolved into "permanent" companies, eg, the Canada Permanent Mortgage Company, selling debentures and investing in mortgages. TRUST COMPANIES were also formed during this time to act as trustees and professionally manage estates and trusts; they gradually assumed banking functions, eg, providing savings and chequing accounts, and became major participants in the mortgage market. Most of these financial institutions have been absorbed into the banking system in recent years through mergers and acquisitions as a result of legislative changes, financial problems created by heavy loan losses and because of a lack of economies of scale.
The other major type of near-bank is the savings and credit co-operative, called a CREDIT UNION in most of Canada and a CAISSE POPULAIRE in some areas. After a slow start in the first half of the 20th century, credit unions grew rapidly by using deposits to extend loans to their members.
Role of Banks
As is true with all financial institutions, the basic function of banks is to channel funds from individuals, organizations and governments with surplus funds to those wishing to use those funds, which is why they are called financial intermediaries. But banks also have a premiere position in this financial intermediation because of their role in providing the payment system while acting as the vehicle for Canadian monetary policy and as the federal government's instrument for some social and political policies. Consequently the actions of the banks have a major impact on the efficiency with which the country's resources are allocated.
In addition to these wider roles, the banks also have an obligation to their shareholders to earn an adequate return on their equity and pay sufficient dividends. If these goals are neglected, investors will withdraw their capital from the banking system and force either a contraction of the money supply or government ownership.
The experience of the early 1980s reveals the conflict that can arise among these purposes and goals in the Canadian banking system. The federal government encouraged the banks to extend huge loans to Canadian companies that wished to take over subsidiaries of foreign companies, especially in the oil and gas industry. This was sometimes in defiance of sound banking practice, and it had wider economic implications, such as the misallocation of credit resources, pressure on the Canadian dollar and an inflationary expansion of the money supply. As a result, the domestic loan portfolio of the banks began deteriorating sharply in 1982 to what was certainly its worst condition in the postwar period.
Loans to the highly cyclical real estate industry accounted for about 120% of bank capital; loans to oil and gas companies such as DOME, Sulpetro and Turbo, to forest product companies and to MASSEY-FERGUSON and International Harvester also imperilled the financial strength of the banks.
International lending practices of Canadian banks were equally disastrous. Brisk demand and wide profit margins encouraged the larger Canadian banks to pursue international borrowers vigorously with the result that their foreign assets increased from $21.7 billion in 1973 to $156.7 billion in 1983. Many of these loans were made to governments or government-guaranteed borrowers on the theory, which any student of history knows is incorrect, that governments do not default on loans.
By the summer of 1983, over 40 countries had agreed to or had applied for rescheduling of their debt or had accumulated substantial arrears in interest payments. Furthermore, banks began extending new credits to foreign lenders to enable them to pay interest on older loans. This sleight of hand was good for the reported earnings of the banks but did little or nothing to resolve the serious problem of international debt.
Predictably, the results of both domestic and international lending policies were huge losses for the banks and intensified malaise and costs for Canadians. In an effort to combat the impact on bank earnings, and to make adequate provision for loan losses, the margin or difference between the prime rate and the cost of funds in savings acccounts was pushed to a very high level. In 1980 the banks' prime rate was 15.5% and the rate on bank savings deposits was 12.5%, a "spread" of 3%. Two years later, the prime rate was unchanged while the savings rate had dropped 12% to 11%, a spread of 4.5%. Borrowers were therefore paying a higher than normal price for money while savings received less than a normal return. In addition to these penalties, the high proportion of bank assets tied up in nonproductive loans restricted the banks' flexibility in accommodating credit-worthy borrowers.
In the very low interest rate environment of early 1997, the prime rate dropped to 4.75% and the savings rate to one half of 1%, leaving the spread basically unchanged. During the following year interest rates rose and the prime rate was raised to 7.5% while the rate on savings accounts increased to 7.5%. Using the banks' measure of interest spreads (interest income minus interest expense as a percentage of average assets), there was a decline in the spread from 2.9% in 1991 to 2.8% in 1997.
Banking Structure
The Canadian banking system is generally highly competitive with over 3000 companies offering a wide variety of services. Some are highly specialized and operate in niche markets such as credit cards or home mortgages, and others, such as the major banks, compete in the markets. There are 6 large banks holding 46.4% of the assets of the financial system. Of the balance, 5.06% is held by 50 trust companies, 3.6% by property and casualty insurers, 12.8% by 150 life insurance companies and 9.6% by 2500 credit unions and caisse populaires. The rest of the market is shared among 80 mutual fund companies, 28 auto leasers, 18 credit card companies, 50 Schedule II banks, consumer finance companies and various government agencies.
Despite this wide choice in financial intermediaries, the banking system remains basically a banking oligopoly dominated by the "Big Five" (see BUSINESS ELITES), who have 43% of the total assets of the major classes of consumer credit-granting and deposit-taking financial intermediaries in Canada. These 5 banks were once considered big by international standards and the 2 largest were among the top 20 in the world in the 1970s as measured in asset size. Today none are in the top 60 and the combined assets of the 6 largest banks are equal to only 77% of the assets of the largest Japanese bank. This calculation is, however, somewhat misleading because the Japanese banks have major loan losses and non-performing loans which have not been accounted for. As a result, market capitalization is now used more frequently to rate the size of banks. Nevertheless, Canadian banks have declined in relative international standing and this is leading to pressure to allow mergers of the largest banks to increase their international competitiveness.
Incorporation of a Bank
The term "bank" can only be used in Canada if the organization has been approved by the Minister of Finance. The initial shareholders' investment must be at least $10 million dollars.
There are 2 types of banks incorporated in Canada. A Schedule I bank has wide public ownership; only 10% of its shares can be owned by a single foreign or domestic investor and only 25% can be owned by all foreign investors. At least 75% of the board of directors must be Canadian residents. A Schedule II bank is a closely held Canadian bank or the subsidiary of a foreign bank. Its activities are more restricted. It can add branches only with ministerial approval, and the total Canadian assets that all foreign banks may hold is limited to 12% of total Canadian banking assets. There are 7 Schedule I banks and 46 active Schedule II banks.
Source of Assets and Liabilities
When a bank or other financial institution is incorporated, it begins operations by selling shares to investors, and the funds raised in this manner become the shareholders' equity. The bank will then try to attract deposits from the public in the form of demand deposits, which can be withdrawn by cheque at any time and which normally pay no interest; savings accounts, which pay a variable rate of interest and have restrictions on their withdrawal; and deposits with a fixed term of a few days to 5 years, paying a fixed rate of interest. In 1998 the banks held $53 billion in demand deposits, $54.5 billion in chequable savings accounts, $38.1 billion in non-chequable savings accounts; and $332.7 billion in term deposits. All of this deposit money is a liability or debt of the bank, used to acquire assets that can generate profits and pay the interest and operating costs.
To meet public demand, the banks keep some of their assets in the form of cash and investments, eg, treasury bills, which can be quickly converted into cash. Most of the remaining financial resources are invested in securities such as bonds and term-preferred shares and in loans and mortgages. In 1998 Canadian banks held $98.4 billion in cash and short-term securities, $52.2 billion in securities, $299.1 billion in Canadian loans, $546.6 billion in mortgages and $31.5 billion in foreign currency loans.
Banks, trust companies and credit unions historically concentrated their assets and liabilities in different areas, but this has changed over the past 15 years as they competed more in the same markets. The banks monopolized the market for demand accounts at one time because they were the only deposit institution offering bank accounts with chequing privileges; they still control the huge corporate accounts, but the credit unions have been taking a slightly larger slice of the market for personal chequing accounts. Total deposits of the banking system indicated a slight growth in market share for the banks, from 80% in 1991 to 81.2% in 1995. On the liability side, the banks are still the predominant lenders to business and governments but have also grabbed a big share of the consumer credit and mortgage market.
Revenue
The principal source of revenue for a bank is the INTEREST earned on investments and loans, but they have increasingly added other sources such as service charges, fees and ancillary revenue-generating operations such as investment management and banking, MUTUAL FUNDS, stock brokerage and trust services (see STOCK AND BOND MARKETS). Innovations in lending and security markets have also led to a much wider range of services and products and to greater market risks, which in turn have led to sophisticated methods of managing risk through derivative securities and simulation-based risk evaluation models.
Profits
The profits of the banks are affected by their ability to develop new revenue sources, the direction of interest rates, the trend in non-performing loans and their success in controlling costs. The most important measures of profitability are the return on average assets and the return on shareholders' equity. The high volume and low margins characteristic of banking are indicated by the 0.56% average return on assets in 1997 and the wide swings in that ratio from a low of 0.3% in 1992 and a previous high of 0.7% in 1997. The return on shareholders' equity averaged 11.5% for the 6 biggest banks in 1997, well below the 14.2% average return of the 27 largest banks in the US.
Banking Operations
Canadian commercial banks, like other investor-owned organizations, are managed by a board of directors - headed by a chairman - which oversees a president and vice-presidents representing special areas of the bank. These boards of banks are considered the most prestigious appointments of all boards; they are large (35 to 50 members) and their members are generally also members of boards of other major companies who may be customers of the bank. These interlocking directorships and the number of directorships held by many of the members would seem to make it difficult for them to fulfil their responsibilities to the bank.
Regulation of Banking
According to the CONSTITUTION ACT 1867, banking is regulated by the federal government and property and civil rights are provincial responsibilities. The first BANK ACT, virtually drafted by the Bank of Montreal, put Maritime banks under the control of federal banks. In 1894 the Bankers Association (later the Canadian Bankers Association) was founded. A powerful lobby group, it was given the right to determine the fitness of bankers seeking charters, and under the regimes of both Sir John A. Macdonald and Sir Wilfrid LAURIER, bankers effectively chose the ministers of finance by threatening to excite financial crises if the candidates suggested by the prime ministers were approved.
In 1964 the Royal Commission on BANKING AND FINANCE (Porter Commission) recommended "a more open and competitive banking system,"and its suggestions led to major reforms and changes. The 1967 Bank Act revision lifted the 6% per annum interest-rate ceiling banks could charge on personal loans and allowed banks to enter the mortgage field. It also barred the previously legal practice of collective rate setting by banks and required banks to inform borrowers better about the real cost of loans.
In the same year, the federal government also passed an act to establish the Canada Deposit Insurance Corporation to provide $20 000 insurance for deposits in banks and federally chartered near-banks. Provincial near-banks were included in most provinces by relevant provincial legislation. The maximum insurance coverage was raised to $60 000 in 1983.
As a result of changes in the Bank Act of 1980, the Canadian Payments Association was established as the agency responsible for the cheque-clearing system; reserve requirements were reduced, which increased bank assets substantially; the minister of finance became the sole arbiter deciding which new banks could be established; foreign banks were allowed to establish themselves and required to keep reserves, but their growth was restricted in various ways; banks were allowed to become involved in the business of leasing large equipment; banks were allowed to become involved in factoring; and banks (but not their subsidiaries) were limited to a 10% holding of residential mortgages.
Subsequent revisions removed restrictions on mortgage lending, allowed the banks to buy and operate trust companies, securities dealers and insurance companies. However they are still forbidden from providing financing for auto leasing and from selling insurance in their branches. The 1991 revision defined the business of banking for the first time. New regulations have led to a much higher standard of disclosure to consumers regarding the various costs, rights and penalties involved in banking services.
The banks are also regulated by the Bank of Canada under the authority of the BANK OF CANADA ACT through its management of the government's monetary policy. The Canada Deposit Insurance Corporation and the Office of the Superintendent of Financial Institutions carefully monitor the banks for financial soundness and compliance.
Future of Banking
Technological advances in banking have led to major improvements in banking services. The Electronic Funds Transfer System (EFTS) that transfers funds through electronic messages instead of by cash or cheque enabled the banks to introduce multibranch banking, automatic bank machines (ABMs), more credit card services, debit cards, home banking, electronic data interchange, automated payments of regularly recurring expenses and direct deposits of government, payroll and other cheques. Canada now has over 17 000 ABMs, equivalent to 5.54 ABMs per 10 000 inhabitants, compared to 3.67 per 10 000 inhabitants in the USA.
On the horizon are smart cards incorporating a computer chip to store more information, perform more functions and be more secure than a credit card. ABMs may allow users to buy or sell mutual funds, make loan applications and even possibly provide other services currently available in some European countries such as buying bus tickets and postage stamps or changing foreign currency.
The enormous data banks created by these new systems have enabled the banks to assign costs more accurately to individual banking transactions and thereby charge fees for these services that reflect these costs. They have also raised privacy concerns because of the large amount of personal information accumulated about bank customers.
In preparation for the next revision of the Bank Act, the federal government is examining issues such as the protection of privacy with the use of the new technology. More controversially, it is also considering whether or not to allow banks to merge in order to meet the challenges of globalization. If approved, these changes would significantly alter the structure of the present financial system. The 1998 report of the federal task force headed by Harold McKay recommended that bank mergers be allowed, ownership restrictions on Schedule I banks be raised to 20%, and banks be allowed to sell life insurance and auto leases. The report also recommended that there be fewer restrictions on foreign-owned banks, that mutual fund and insurance companies be allowed to provide cheques and get access to ABMs, that there be greater consumer protection through tougher rules on tied selling access and use of consumer information and that credit unions be allowed to form co-operative banks. If implemented, the result would be a very different banking system. However, in January 1999 the government announced that the bank mergers would not be allowed to proceed.
Author ALIX GRANGER
Suggested Reading
H.H. Binhammer, Money, Banking and the Canadian Financial System, 6th ed (1993); Alix Granger, Don't Bank on It, 2nd ed (1986); T. Naylor, The History of Canadian Business, vol 1 (1975); M.H. Ogilvie, Bank and Customer Law in Canada (2007).
Links to Other Sites
Finance Glossary
An online glossary of finance terms from thestar.com website.
Canadian Bankers Association
The website for Canadian Bankers Association. Features a list of domestic and international banks operating in Canada, timeline of the banking industry, useful consumer information, a glossary, and related resources. CBA is the main representative body for banks in Canada and is the country’s oldest industry association.
TD Bank Financial Group
The website for TD Bank Financial Group. Features the latest news and information about personal, commercial and wholesale financial products and services, investor relations, current economic trends, and community relations.
BMO Financial Group
The BMO Financial Group website provides up to date information about their personal, commercial, corporate and institutional financial services in Canada and the US.
Canadian Imperial Bank of Commerce
The official website for CIBC (Canadian Imperial Bank of Commerce.)
RBC Financial Group
The website for the RBC Financial Group, a diversified financial services company. Offers information about products and services, investor relations, the RBC Financial Group Charitable Foundation and other company operations.
Scotiabank
The website for Scotiabank. Offers an online guide to products and services, current rates and other financial news.
Business News
Find the latest news and updates affecting the stock market, including new company releases and other listed company information.
Personal Investing
The lastest news on Canadian equity markets, personal investment plans, and more. From thestar.com.
Bank of Canada
The official website for the Bank of Canada. A great information source about monetary policy, the role of the Bank, the history of money, security features in Canadian bank notes, and much more. Check out the fact sheets, online glossary, and educational resources.
Global Competitiveness Index: Canada
A summary of key indicators related to Canada's status in the Global Competitiveness Index. From "The Global Competitiveness Report 2008-2009," World Economic Forum. A PDF file.
Canada rated world's soundest bank system: survey
A news article about Canada's banking system. From the Reuters website.
Office of the Superintendent of Financial Institutions
The website for OSFI, the primary regulator of banks and other federally incorporated financial institutions in Canada. Check out "About OSFI" for background information about this independent agency of the Government of Canada.
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