1

A Characterization of the Canadian Financial
System

• Lecturer
• Professor Gilles Bernier, Ph.D
• Industrial-Alliance Insurance Chairholder
• Department of Finance and Insurance, Laval
  University
• Participants
  
• Undergraduate students from
• Bellarmine U. and Western-Illinois U.

Quebec City, May 29, 2003
2
My Biography

• Professor of finance and insurance at Laval since
  1978
• Holder of the Industrial-Alliance Insurance Chair
  since 1999
• Education
• Post-doctoral studies in risk and insurance at
  the Wharton School, U of Pennsylvania, 1987-88
• Ph.D in finance, U of Toronto, 1984
• MBA-Finance, Laval University, 1978
• BBA, Laval University, 1976.
• Other responsibilities
• Ph.D program director in 1991-92
• Associate dean, Academic Affairs, 1992-96 (AACSB)
• Host of different U.S. schools Lynchburg College
  (Va) UNH

3
Part 1 Introductory Concepts

• Content
• Definition and Purposes of a FS
• Do FIs Add Value? An Example
• Governance of FIs Comparing Models
• Forces of Change Impacting FIs
• Why Regulate FIs?

4
1. Definition and Purposes of a Financial
System

• A combination of institutional structures and
  regulatory framework that facilitates the
  following
• Inter-temporal transfer of cash
• Inter-temporal transfer of risk
• Two basic/fundamental economic functions
• Facilitated by markets institutions
• Creates innovative financial instruments

5
Financial System A Schematic View
6
Financial vs. Market Intermediaries

• Financial Intermediaries
• Commercial banks other Near-banks
• Insurance firms (LH PC)
• Mutual funds
• Market Mediaries
• Investment banks
• Financial markets (TSX, NYSE, etc)

7
Financial Intermediation

• Asset transformation / Portfolio Intermediation
• Raising funds by issuing financial liabilities
• Secondary securities
• Financial claims on financial assets
• Bank deposits, Insurance policies and annuities,
  MF shares/units
• Investing in financial assets
• Primary securities
• Financial claims on real assets
• Bank loans, Corporate bonds equity

8
2. Do FIs Add Value? The Case of LH
Insurers

• LH Insurers create value by providing 3
  principal services
• 1. Risk-pooling and risk-bearing
• Risk reduction through a pooling mechanism
• Actuarial and underwriting activities are a major
  source of value added
• Risks are also borne by shareholders (stock co.)
  or by previous policyholders (mutual co.) or by
  other parties holding the debt of the insurer
  (for both types of firms)
• This creates value added by increasing economic
  security
• 2. Real financial services relating to insured
  losses
• Financial planning and counseling for individuals
  and administration of pension and benefit plans
  for businesses
• 3. Intermediation function
• Funds raised are invested until withdrawn or
  needed to pay claims
• The net interest margin (difference between rate
  earned on assets and rate credited on products)
  is the value added here

9
3. Governance of FIs
Comparing Models

• Anglo-American Framework
• Shareholder wealth maximization
• Separation between banking insurance
• Separation between commercial and investment
  banking
• Separation between the financial the real
  sector
• Euro-Japan Framework
• Stakeholder wealth maximization
• Japan Kieretsu network focuses on increasing
  market share
• Bancassurance
• Universal banking
• Cross-ownership between commercial financial
  firms

10
4. Forces of Change Impacting FIs

• Disintermediation
• Convergence
• Integration
• Consolidation
• Technological revolution
• Financial innovation
• Customer sophistication
• Globalization

11
Product Convergence

• Very significant within Canadas FS sector,
  resulting in large financial groups
• Banks in insurance, funds management
• LH Insurers in banking, funds management.
• Wide array of products being offered by those
  groups both directly and through subsidiaries.
• Emerging monoline companies focusing on one or
  a few business lines.

12
Convergence and Integration Strategies

• Distribution alliances
• Agreements w/r to production distribution
• Joint ventures
• Joint production distribution
• Mergers acquisitions
• Integration both within and between industries
• Greenfield / De novo entry
• Entry into a new industry

13
5. Why Regulate FIs?

• Safety Soundness
• Supervision examination of solvency
• Transparency disclosure
• Market power, concentration competition
• Level playing field
• Fair pricing
• Contagion effects
• Conflict of interest Tied-selling
• Consumer protection

14
Part 2 An Overview of Canadas Economy

• Content
• 1. A Few General
• Statistics
• 2. The Relative
• Importance of the
• Financial Services
• Sector in the
• Economy

15
1. A Few General Statistics

• As of 2001 (Swiss Re, Sigma No. 6 / 2002)
• Population of Canada 31 million
• GDP 705 billion USD
• Smaller Economy Among G7 Countries With Currently
  Best Real Growth
• Inflation Rate 2,5 (vs 2,8 for the US)
• Exchange Rate 1,376 per USD ( 5/22/2003)

16
2. The Relative Importance of the Financial
Services Sector in the Economy

• As of 2001
• Significant contributor to Canadas economic
  growth
• Number of employees Over 500 000 people
• Yearly Payroll About 24 Billion CDN
• Sector represented over 5 of GDP.
• Sector contributed approximately 9 billion CDN
  in taxes to all levels of government.

17
Part 3 Tracking the Evolution of Canadas
Financial System

• Content
• 1. Canadas FS
• Before 1990
• 2. Canadas FS
• After 1990
• 3. Assessment of
• Canadas FS
• 4. Analysis of the Difference
• in Solvency Experience of U.S
• and Canadian LH Insurers

18
1. Canadas FS Before 1990

• Four pillars
• Banks, trust companies, investment firms,
  insurance firms
• Two bank failures in mid-eighties
• Deregulation in mid-eighties
• Banks take over securities firms (1987)
• Banks take over trusts companies (1990)
• Banks gain limited entry into insurance, and
  vice-versa (1992)
• Strong growth of the mutual funds industry during
  the 90s

19
2. Canadas FS After 1990

• 3 LH failures in early 90s
• Major demutualization wave (n 5) in the LH
  sector (1999-2000)
• Two recent mergers in the LH sector
• Sun Life Clarica in 2002
• Great-West Canada Life in 2003
• Two large pillars
• Domestic Chartered Banks and L H Insurers
• Other smaller players
• Property Casualty Insurers
• Credit Unions and Caisses Populaires, Savings
  Loans Companies
• Foreign Banks

20
3. Assessment of Canadas FS

• In 2000, the IMF undertook  The Financial Sector
  Stability Assessment  and concluded that
  Canadas FS is
• stable and highly advanced
• and,
• among the soundest in the world.

21
4. Analysis of the Difference in Solvency
Experience of U.S and Canadian LH Insurers

• Kleffner Jorgensen (1997) did compare this
  sector in both countries over the period 1976-91.
• They conclude that both industries are
• Similar in many ways
• Shifting from protection-type to
  accumulation-type product
• Intensely regulated and very competitive.
• On critical area where Canada did perform better
  over this period Insolvency (2 vs 12)
• Main reason given federal regulation of
  insurers in Canada is more consistent than
  regulation of insurers on a state by state basis
  in the U.S.. Canadian regulation also appears to
  have been more timely and proactive than in the
  U.S., particularly with respect to risk based
  capital standards 

22
Part 4 A Quick Glance at Canadas Banking Sector

• Content
• Number of banks
• The Six Largest Domestic Banks
• Banking Concentration and Profitability
• Canadian Banks Abroad
• Delivery Mechanisms Used by Canadian Banks
• Is Size Important for Canadian Banks?
• Should Banks Be Allowed to Merge?

23
1. Number of Banks (OFSI)

• Banks (69)
• Domestic Banks (16)
• Foreign Banks (32)
• Foreign Bank Branches- Full Service (17)
• Foreign Bank Branches-Lending (4)

24
2. The Six Largest Domestic Banks (by asset size
in decreasing order)

• Royal Bank of Canada
• Canadian Imperial Bank of Commerce
• Bank of Nova Scotia
• Bank of Montreal
• National Bank of Canada
• Laurentian Bank of Canada
• Note No Canadian banks appear among the Top
  25 Worlwide
• (Source The Banker, July 2002)

25
3. Banking Concentration and Profitability

• Banks account for over 70 per cent of the total
  assets of the Canadian Financial Services Sector.
• The six largest domestic banks account for over
  90 per cent of the assets of the
  banking industry.
• Typically, the largest banks target ROEs of
  about 17. Realized ROEs have been lower in 2001
  and 2002 (range of 14-16)

26
4. Canadian Banks Abroad

• The six major domestic banks also have a
  significant presence outside Canada, in areas
  such as the United States, Latin America, the
  Caribbean and Asia.
• International operations accounted for
  approximately 33 of their gross revenues
  in 2001.
• BMO, Scotia CIBC were (in 2000) among the Top
  30 worldwide w/r to the relative importance of
  their international activities (The Banker, 2001)

27
5. Delivery Mechanisms Used by Canadian Banks

• Banks with significant branch networks rely on
  the  Bricks and Clicks  strategy
• Increasing use of technology to handle low-margin
  acounts
• Focus on advisory services and sale of
  high-value products.
• Use of branches and e-networks to sell products
  of 3rd-party producers (best price/service)
• Use of excess capacity in distribution channels
• Realized savings from not developing and market
  own products (e.g., mutual funds, term
  deposits).

28
5. Delivery Mechanisms (cont)

• Banks are also developing Web sites to facilitate
  access by their customers to a wide variety of
  products and services. For example
• Web auction facilities for small-business
  financing
• B2B Web sites to facilitate purchase of supplies
• Credit scoring techniques more widespread which
  make standard loans less costly.

29
6. Is Size Important for Canadian Banks?

• Recent banking literature seems to suggest that
  SE in a number of business lines extend further
  than previous empirical work had indicated.
• The prevalent view here is that even the largest
  Canadian banks need to be North Amerian entities
  in order to operate at an efficient scale in
  certain lines of business (See Freedman Goodlet
  pp.12-13 for examples) 

30
7. Should Banks Be Allowed to Merge?

• Major deals were announced back in 1998
• Royal Bank and Bank of Montreal
• CIBC and TD Bank
• As Professor L. Booth of U of T said at the time
  
• What the government has to decide is whether
  allowing the banks to merge will generate gains
  in highly competitive markets, like international
  and coporate lending and investment banking, that
  more than outweigh the losses caused by less
  competition in the areas that matter most to
  Canadians, namely retail and commercial
  lending .
• Both deals were rejected by the Federal
  Government in 1999.
• Recently, Manulife announced a plan to acquire
  CIBC. The Federal government has put the question
  to a Senate Committee which will review such an
  option in the Fall. 

31
Part 5 A Quick Glance at Canadas Insurance
Sector

• Content
• A Few Macro Comparative Statistics
• The Canadian LH Market
• The Canadian PC Market
• Current Issues in the Canadian Insurance Industry

32
1. A Few Macro Comparative Statistics

• As of 2001 (Source Swiss Re, Sigma No. 6 /
  2002)
• Total premium volume (in USD)
• Canada 45.3 billion USA
  904.021 billion
• Overall weighted share of world insurance market
  
• Canada 1.88 (8th) USA
  37.54 (1st)
• Insurance density (total business per capita in
  USD)
• Canada 1460 (17th) USA 3266
  (4th)
• Insurance penetration ( of GDP for total
  business)
• Canada 6.42 (9th) USA 8.97
  (10th)

33
2. The Canadian L/H Market

• 1.46 of the world market (9th)
• Currently, 110 companies are monitored for
  financial soundness by OSFI (49 Canadian, 61
  Foreign).
• Increasing concentration due to consolidation
  (MS of Top 5 68 in 2002 vs. 47 in 1994).
• The market is dominated by 5 large stock groups
• Great-West / London / Canada Life, Sun
  Life/Clarica, Manulife, Desjardins Financial
  Security and the Industrial-Alliance Group
• Market is shifting away from exclusive sales
  forces (45) towards independent producers (55).

34
Demutualization in the Canadian L/H Insurance
Industry

• Major wave in 1999-2000 (largest wealth transfer
  in Canadian history)
• Insurer
  IPO Date
• Clarica
  July 21, 1999
• Manulife
  Sept. 30, 1999
• Canada Life
  Nov. 5, 1999
• Industrial-Alliance
  Feb. 10, 2000
• Sun Life
  March 23, 2000

35
IPO PERFORMANCE ANALYSIS

• Evidence of significant underpricing of L/H IPOs
• Offer-to-close 9 on average.
• Most short-run returns achieved during first day
  of trading.
• Evidence of strong returns even if first day
  excluded.
• Evidence that a secondary market investor holding
  those shares would have outperformed the market

Wealth Relative Index Ritter (1991)
Day 1 to 6 months 1.31
Day 1 to 1 year 1.33
Day 1 to 2 years 1.55
Here, the market is proxied by the TSE
Financial Services Sub-Index.
Source Babin Bernier, 2001, Assurances
36
3. The Canadian P/C Market

• 2.51 of the world market (7th)
• Currently, 198 companies are monitored for
  financial soundness by OSFI (93 Canadian, 105
  Foreign).
• P/C is a less concentrated market than L/H
• Specific regional markets or specific product
  lines.
• Top 5 MS in 2002 36 (CGU Group Canada, ING
  Canada, Co-operators Group, Royal Sun Alliance,
  Economical Ins.Group)
• Broker Cos still have a dominant MS of 67 (24
  for Direct Writers and 9 for Reinsurers only)

37
4. Current Issues in the Canadian Insurance
Industry

• In the L/H market
• Aging of population and increase in life
  expectancy
• Shift from life insurance products to savings
  products (e.g. Segregated funds) and health
  products (e.g. Dread disease insurance).
• LTC and LTC / DI hybrids are also starting to
  appear in the Canadian L/H market.
• A.M.Best expects that the major Canadian life
  stock insurers will seek to expand in the USA.

Sources Journal de lassurance and A.M.Best
Report, 7/17/2002
38
4. Current Issues (contd)

• In the Canadian P/C market (Similarities with
  USA)
• All time low industry profits in 2001 (Avg. ROE lt
  3)
• High Auto bodily injury claims mostly in Ontario
  Atlantic Provinces
• Low investment returns and excessive capital
• Lack of support by provincial governments for
  auto insurance reform. Québec wants to review its
  No-fault System.
• Slightly improving operating results since
  2002-Q1 and also in 2003
• Increased prices and tighter underwriting terms
• Significant Shortage of Management Talent
• Great opportunities for business university
  graduates.

Source IBC, Canadian Underwriter and Canadian
Insurance
39
Part 6 A Quick Glance at Canadas Securities
Industry

• Content
• Our Stock Markets
• Our Mutual Funds Industry
• The Regulation of our Securities Markets
• Governance of Publicly-Traded Companies in Canada

40
1. Our Stock Markets

• Since 2000, Canada has 3  specialized 
  exchanges
• The Toronto Stock Exhange (TSX) where
  securitities issued by more  senior  companies
  (n1,500) are being traded (e.g. large cap
  stocks)
• The TSX Venture Exchange where securities of more
   junior  firms are being traded. Born after the
  1999 merger of the Alberta Vancouver Stock
  exhanges, it is owned by the TSX but operates out
  of Vancouver.
• The Montreal Exchange trades mostly Options
  Futures contracts, and stocks of small
  Quebec-based public companies.

41
2. Our Mutual Funds Industry

• Palltrack (a MF tracking service) lists about
  6,000 funds for Canada compared to 15,000 in the
  US
• Crowded out market
• Choosing among competing funds is an increasingly
  challenging exercice for consumers.
• The Investments Funds Institute of Canada (IFIC)
  is the self-regulatory body overlooking the
  practices of the MF industry (www.ific.ca)

42
3. The Regulation of our Securities Markets

• In Canada, the regulation of the securities
  industry is under 10 provincial securities
  commissions (versus only one in the US, the SEC).
  
• The 2 most important commissions in Canada are
  the OSC and QSC.
• The provincial commissions also collaborate with
  self-regulatory bodies such as IFIC and the
  Investors Dealer Association (IDA).

43
4. Governance of Publicly-Traded Companies in
Canada

• Currently, the TSX has the power to set corporate
  governance standards for public companies
• Voluntary guidelines but no mandatory rules.
• Strong lobby by the new  Canadian Coalition for
  Good Governance  to sort things out in this
  area.
•  Enforcement should be expressed in legislation,
  and carried out by securities regulators  C.
  Lamoureux, CEO, Ontario Teachers Pension Plan,
  May 22, 2003.
• Mr Lamoureux feels that Canada is no different
  from the US. We need to adopt the same standards
  that were included in the U.S. Sarbanes-Oxley Act
  following the major financial scandals (Enron,
  WorldCom. etc.,).