2
The Canadian Securities Industry
CHAPTER OUTLINE
Overview of the Canadian Securities Industry The Role of Financial Intermediaries • Types of Firms • Organization Within Firms • How Securities Firms Are Financed • Dealer, Principal and Agency Functions • The Clearing System • Business Development Bank of Canada • Trends in the Securities Industry Banks as Financial Intermediaries • Schedule I Chartered Banks • Schedule II and Schedule III Banks • Trends in the Role of Banks Trust Companies, Credit Unions and Life Insurance Companies • Trust and Loan Companies • Credit Unions and Caisses Populaires • Insurance Companies • Trends in Insurance
LEARNING ObJEcTIVEs
By the end of this chapter, you should be able to: 1. Summarize the state of the Canadian securities industry today. 2. Distinguish among the three categories of securities firms,explain how they are organized,and compare and contrast dealer,principal and agency transactions. 3. Describe the roles of the chartered banks in the capital market. 4. Describe the roles of trust companies,credit unions and insurance companies in thecapital market. 5. Describe the roles of investment,savings,loan companies and pension plans in the capital market.
PARTIcIPANTs IN THE sEcURITIEs INDUsTRY
What do the following individuals have in common? A couple needs to borrow money to finance the purchase of a home. An entrepreneur needs to raise funds to help with financing the development of a new product. An investor would like to set up a regular savings program to save for her children’s education. The common strand is that all of these individuals require some form of intermediary to help meet their goals. Simply described, savers (lenders) give funds to a financial intermediary (such as a bank) that intern gives those funds to spenders (borrowers) in the form of loans or mortgages, among other products. Alternatively, the intermediary can play a direct role in bringing a new issue of securities to financial markets. More specifically for our purposes, a typical example occurs when a company needs money to operate or expand its business. One way to generate the necessary capital is by issuing securities, such as stocks and bonds. A financial intermediary, or investment dealer, can help the company issue the securities and sell them to investors. By buying the securities, the investors temporarily transfer their money to the company and, in return, receive securities representing claims on the company’s real assets.
If the firm does well, it earns a profit. Its securities may rise in value, yielding a profit for the investor when the security is sold in the marketplace. But investors are not the only ones to profit. Part of the money earned by the company may be reinvested in the firm, spurring further economic development. In the previous chapter, we learned about the various financial markets and instruments that have evolved
In the on-line to meet the expanding needs of financial consumers. The focus here is the role played by the financial Learning Guide intermediaries, the last piece of the capital transfer puzzle. Their role is important because they have for this module, established efficient and reliable methods of channelling funds between lenders and borrowers. complete the Getting Started activity.
KEY TERMS
Agent Canadian Depository for Securities (CDS) Closed-end funds Demutualization Market-out clause Open-end fund Primary distribution Principal Segregated funds Self-Regulatory Organizations (SROs) Underwriting
OVERVIEW OF THE CANADIAN SECURITIES INDUSTRY
In this, and subsequent sections, we turn our attention to the securities industry. The Canadian securities industry is a regulated industry. Provinces have the power to create and to enforce their own laws and regulations through securities commissions (also called securities administrators in some provinces). Securities commissions delegate some of their powers to self-regulatory organizations (SROs), which establish and enforce industry regulations to protect investors and to maintain fair, equitable, and ethical practices. In that capacity, SROs are responsible for setting rules governing many aspects of investment dealers’ operations, including sales, finance, and trading. The major participants in the industry and their relationships are illustrated in Chart 2.1. The chart highlights the workings of the industry by showing the major participants and their relationships with one another. Investors and users of capital trade financial instruments through the various financial markets (stock exchanges, money markets, etc.). Brokers and investment dealers act as intermediaries by matching investors with the users of capital and each side of a transaction will have their own broker or dealer who match the trades through the markets. Trades and other transactions are settled through organizations like CDS Clearing and Depository Services Inc. and banks. The SROs monitor the markets to ensure fairness and transparency, and they set and enforce rules that govern market activity. Organizations like the Canadian Investor Protection Fund (CIPF) provide insurance against insolvency while provincial regulators oversee the markets and the SROs. Organizations like CSI provide education for industry participants.
Self-Regulatory Organizations
Investment Industry Regulatory Organization of Canada Mutual Funds Dealers Association Bourse de Montréal The Toronto Stock Exchange TSX Venture Exchange
Markets
Clearing & Settlement
CSI Global Education Inc. (Industry Educator)
Canadian Investor Protection Fund
(Industry Insurance Fund)
Provincial Regulator
(Securities Commission)
Market Flow
Ancillary Services
Table 2.1 shows indicators for the securities industry for the past three years. The table shows that there were 203 firms in the securities industry that were members of the Investment Industry Regulatory Organization of Canada (IIROC). Total employment improved over the three-year period, and continues to surpass levels above those recorded in 2000, which represented a peak year in employment levels for the industry.
TABLE 2.1 SECURITIES INDUSTRY INDICATORS
Characteristic Number of Employees Number of Firms
2007 42,329 203
2006 41,985 198
2005 39,174 201
Source: Investment Industry Association of Canada website, March 2008.
Still, the industry is small compared to other segments of the financial services sector or even to some companies operating within competing segments. For instance, Canada’s largest bank, Royal Bank of Canada, employed over 70,000 people in 2007 and had total assets of $548 billion. The entire Canadian securities industry is likewise eclipsed in size by several individual U.S. and Japanese securities houses. In spite of its comparatively small size, the industry has provided Canada with a capital market that is one of the most sophisticated and efficient in the world. These qualities are measured in terms of the variety and size of new issues brought to the market and the depth and liquidity of secondary market trading. Table 2.2 shows that new issues brought to the Canadian market have increased over the last three years; while Table 2.3 illustrates that money market, bond and listed stock secondary trading reached $17,477 billion in 2007.
TABLE 2.2 summary of neW FINANCING THROUGH CANADIAN SECURITIES MARKETS (EXCLUDING TREASURY BILLS, SHORT-TERM PAPER AND Canada Savings BondS)
($ Millions) Government Federal Provincial Municipal Total Government Common Share IPOs Preferred Shares Non IPOs Total Equity
Today the industry is highly competitive and becoming increasingly so. It calls for a high degree of specialized knowledge about securities issuers, investors and constantly changing securities markets. An entrepreneurial spirit of innovation and calculated risk-taking are among its hallmarks. Change and volatility are frequently the norm.
TABLE 2.3 SECONDARY MARKET TRADING IN CANADA
($ Billions)
2007
2006
2005
Debt Securities Money Market Bond Market Total Debt 8,475 7,260 15,735 8,225 7,231 15,456 7,538 6,371 13,909
Equities Stock Market Total
Source: Investment Industry Association of Canada.
1,742 17,477
1,449 16,905
1,090 14,999
THE ROLE OF FINANCIAL INTERMEDIARIES
Intermediaries are a key component of the financial system . The term “intermediary” is used to describe any organization that facilitates the trading or movement of the financial instruments that transfer capital between suppliers and users. We will discuss intermediaries such as banks and trust companies, which concentrate on gathering funds from suppliers in the form of saving deposits or GICs and transferring them to users in the form of mortgages, car loans and other lending instruments. Other intermediaries, such as insurance companies and pension funds, collect funds and then invest them in bonds, equities, real estate, etc., to meet their customers’ needs for financial security. Investment dealers serve a number of functions, sometimes acting on their clients’ behalf as agents in the transfer of instruments between different investors, at other times acting as principals. Investment dealers sometimes are known by other names, such as brokerage firms or securities houses. Investment dealers play a significant role in the securities industry’s two main functions. First, investment dealers help to transfer capital from savers to users through the underwriting and distribution of new securities. This takes place in the primary market. Second, investment dealers maintain secondary markets in which previously issued or outstanding securities can be traded. Investors’ confidence in Canadian financial institutions is high. It is based upon a long record of integrity and financial soundness reinforced by a legislative framework that provides close supervision of their basic activities. It is not surprising that deposit-taking and savings institutions have experienced strong growth, as Table 2.4 illustrates.
In today’s financial environment, most banks own a number of other corporations, such as investment dealers and trust companies, as well as operating in the insurance market through subsidiaries. These activities are becoming more and more integrated. An investor, for example, can walk into a bank today and receive advice on purchasing mutual funds and other securities. In the same visit, a mortgage can be arranged. A life insurance salesperson will often sell mutual funds and segregated funds.
TABLE 2.4 ASSET GROWTH OF SELECTED CANADIAN FINANCIAL INSTITUTIONS
($ Millions) Assets Financial Intermediaries Chartered Banks Trust Companies (Unaffiliated) Life Insurance Companies including Segregated Funds Credit Unions and Caisse Populaires Investment Funds Sales Finance and Consumer Loan Companies Totals
*Excludes bank trust and mortgage subsidiaries. Source: Bank of Canada website, Banking and Financial Statistics, March 2008.
Table 2.4 also highlights growth rates between different types of financial institutions. Assets of the chartered banks have increased the most in dollar terms, while those of investment funds have recorded the highest percentage growth. The decline in the total assets of trust companies is caused primarily by the disappearance of independent trust companies as they are bought by chartered banks. The expansion of chartered bank assets has been facilitated by several factors. These include: • much greater international activity • changes in the Bank Act permitting the banks to compete vigorously in new sectors of the financial services industry • the creation of more banks, notably the foreign-owned Schedule II and Schedule III banks • the purchase of many major trust companies by banks
Types of Firms
Three categories of firms make up the Canadian securities industry: integrated firms, institutional firms and retail firms. Integrated firms offer products and services that cover all aspects of the industry, including full participation in both the institutional and the retail markets. The seven largest of these firms, including the securities dealer affiliates of the major domestic banks and one major U.S. dealer, generate about 70% of total industry revenues. Most underwrite all types of federal, provincial, municipal and corporate debt and corporate equity issues, actively trade in secondary markets including the money market, trade on all Canadian and some foreign stock exchanges, and
provide many ancillary services to securities issuers and large and small investors. Such services include economic, industry, corporate and securities research and advice, portfolio evaluation and management, merger and acquisition advice, tax counselling, loans to investors with margin accounts and safekeeping of clients’ securities. Many smaller securities dealers or “investment boutiques” specialize in such areas as stock trading, bond trading, research on particular industries, trading only with institutional clients, unlisted stock trading, arbitrage, portfolio management, underwriting of junior mines, oils and industrials, mutual funds distribution, and tax-shelter sales. Some 50 foreign and domestic institutional firms serve institutional clients exclusively. Foreign firms account for about one-third of total institutional firms and include affiliates of many of the major U.S. and European securities dealers. Retail firms account for the remainder of the industry. Retail firms include full-service firms and discount brokers. Full-service retail firms offer a wide variety of products and services for the retail investor. Discount brokers execute trades for clients at reduced rates but do not provide advice. Discount brokers are more popular with those investors who are willing to research individual companies themselves in exchange for lower commission rates.
Organization Within Firms
The operational structure of securities firms varies widely in the industry, depending on size of capitalization, number and location of employees and branch offices, business mix and degree of specialization. Some of the bank-owned firms have integrated the functions of the banking side of their business with the securities side. A typical configuration divides the company into wealth management (which focuses on the retail client and small businesses, both from a banking perspective and a securities perspective) and global capital markets (which concentrates on the trading, investment banking and institutional sales).
MANAGEMENT
A key element in the success of any securities firm is the depth and quality of senior personnel. A firm’s success will depend on how well these key people are able to respond to change, seize new business opportunities, penetrate existing markets, maximize the use of available capital and create a responsive and enthusiastic team effort among all employees. Senior officers usually include a chairman, a president, an executive vice-president, vicepresidents, some of whom are also directors, and other directors, including, in a few firms, directors from outside the securities industry. Most senior officers work at head office, but some may be in charge of regional branch offices in Canada or abroad. Securities firms may be very different in the way management functions are performed. For example, in some firms, the chairman of the board is the chief executive officer and plays a dominant role in the firm’s management; in others, the chairman is more of a consultant who can draw on extensive business contacts and many years of experience. Regardless of a firm’s size, decision and policy making usually rest with the chairman, president, executive vice-president and senior vice-presidents who comprise the Executive Committee. While the organization structure is flexible, a larger, integrated firm might be organized into the following departments.
Although trading is the core function of investment dealers, they perform many other services. The success of a securities firm rests largely on profits generated by its sales department, which is usually the largest and most geographically dispersed unit in a firm. Typically, the sales department is divided into institutional and retail divisions. Institutional salespeople deal mainly with traders at major financial institutions and larger nonfinancial companies. Working with their firm’s underwriting department, they help sell new securities issues to institutional accounts. In co-operation with the firm’s trading department, they help generate day-to-day trading in outstanding securities with such accounts. They are normally located at head and major branch offices and are in constant telephone communication with major accounts throughout the country and abroad. Some larger firms also maintain separately managed portfolio departments, which advise larger clients on their investment portfolios on a fee basis or manage in-house pooled or mutual funds. The retail sales force serves individual investors and smaller business accounts and usually comprises the largest single group of a firm’s employees. The activities of retail Investment Advisors (IAs) are extremely diverse, reflecting the spectrum of investor types and needs. To sell securities to the public, a salesperson (called an investment advisor or IA) must be registered with the provincial securities commission, be of legal age, have passed the CSC and the Conduct and Practices Handbook exam, and participate in a 90-day training program. IAs must also complete the Wealth Management Essentials Course within 30 months of their registration. The duties of an investment advisor include developing a list of clients, meeting with them to determine their financial position and goals, providing them with investment information and advice (often based on the investment dealer’s in-house research), and processing their orders for securities. In performing these tasks, the investment advisor must follow the industry’s guidelines for ensuring that clients’ investment decisions are appropriate given their characteristics and objectives. Supporting the work of the sales and trading staff are personnel who work in areas such as administration, research, operations, finance and compliance.
UNDERWRITING/FINANCING DEPARTMENT
The underwriting/financing department works with individual companies or governments that are interested in raising capital or bringing new issues of securities to the marketplace. The underwriting department will negotiate with a company on the type of security, price, interest or dividend rate, special features and protective provisions that are needed to market a new issue successfully in an ever-changing market. The underwriting/financing process is described in Chapter 11.
TRADING DEPARTMENT
Traders work in close co-operation with a firm’s underwriting and sales departments. The trading department is often divided into bond, stock and specialized product divisions: • Bond: Typically traded in and out of a firm’s own inventory or from the inventories at other firms specializing in particular issues. Traders tend to specialize in government and corporate money market instruments, medium and long-term Government of Canada bonds, provincial bonds and guarantees, municipal debentures, and corporate bonds and debentures.
• Stocks: Except for unlisteds, stocks normally trade on stock exchanges rather than from a firm’s own inventory. A separate division staffed by block stock traders and phone and order clerks is maintained to link buy and sell orders flowing in from institutional and retail sales staff with traders and market makers on the exchanges. • Specialized instruments: Some firms employ mutual fund specialists. Many also have trading specialists to handle exchange-traded options and commodity and financial futures contracts. More information on commodities and futures is provided in the material on derivative products.
RESEARCH DEPARTMENT
The research department in a larger securities firm will often consist of an economist, a technical analyst and several research analysts, each of whom covers one or more industries (e.g. mining, retail, primary industry, oil and gas, etc.). Each analyst is responsible for studying conditions within his or her industry and the current operations and future prospects of many Canadian and some foreign companies in that industry, and for co-ordinating such data with economic and market trends. Research reports with specific investment recommendations are produced, often with extensive analytical coverage for institutional investors and shorter summaries for retail clients. Research facilities may be divided into retail and institutional sections to service each type of client better. The retail side is geared to handle questions about companies and their securities that IAs receive from their clients and to help IAs evaluate and make proposals for client portfolios. The institutional side may assist institutional salespersons and traders in making investment proposals to institutional accounts and help underwriting and corporate finance department personnel in special studies involving new issues, takeovers, mergers, etc. In recent years, there has been a great deal of controversy concerning the potential for conflict of interest between the underwriting departments and the research departments. It is felt that it is difficult for a research analyst to be unbiased about a security that has been underwritten by the same firm. Responding to this concern, the industry is in the process of developing and improving financial analysts’ standards.
ADMINISTRATION DEPARTMENT
This key department enables all other departments to function smoothly. The more important administrative areas include: • Operations: This section is primarily responsible for the recording and accounting of all trades made by the firm on its own behalf and for its clients. Incoming and outgoing cash, cheques and securities must be balanced; securities must be checked to meet proper registration and good delivery requirements; and client accounts must be credited with interest and dividend payments paid on securities that are held in safekeeping by the firm. • Credit and compliance: The focus here is on clients’ accounts. Cash accounts must be checked to see that incoming payments or securities are received by regular delivery dates or, if overdue, are debited or restricted according to industry requirements and in-house policies and controls. Margin accounts must similarly be monitored to ensure that they conform to initial and maintenance margin requirements of the industry and the firm.
• Financial: This area includes payroll, budgeting, financial reports and statements, and financial controls. Regulatory bodies require firms to maintain at all times adequate minimum levels of capital which vary according to the volume and type of business being done. Capital requirements must therefore be calculated frequently and capital allocations must be shifted between various departments of a firm to reflect changing business circumstances. For example, a new underwriting commitment will mean that additional funds may have to be transferred to that department until the issue has been sold. Those funds can then be re-allocated to other departments.
How Securities Firms are Financed
Like other businesses, securities firms are financed by capital originally subscribed by their owner shareholders, by year-to-year net earnings retained in the business and by loans. The industry is highly leveraged. Firms depend on borrowed money to a significant extent to finance their securities inventories, underwriting activity (including bought deals), trading commitments and client margin accounts. Commissions generated from agency transactions are the chief source of revenue for most investment houses, on average making up about 35% of the total. Earnings arising from fixedincome trading activities (5%) and from underwriting (24%) are other significant revenue sources. Interest makes up 7% of revenue and includes interest earned on debt securities held in inventory and interest paid by clients on margin loans. It is partially offset by interest paid by a firm for short and longer-term financing, including that paid to clients who have cash balances in their accounts. The past few years has seen a shift from commission-based accounts (where the IA charges on a per-transaction basis) to fee-based accounts (where the IA charges an annual fee, typically based on assets under management). Fee revenues from products such as wrap accounts, managed accounts and fee-based accounts are becoming more significant. Returns in the securities business tend to be high in bull markets, reflecting the risks and volatility inherent in the industry. However, with their heavy exposure to loss in trading and underwriting and their costly and extensive staff and communication networks, securities firms are especially vulnerable to: • cyclical business swings; • dramatic and unpredictable ebbs and surges in bond and stock trading volumes; and • securities price and interest rate gyrations not only in Canada but also throughout the world.
Dealer, Principal and Agency Functions
Like other intermediaries, one important role of investment dealers is to bring together those who have surplus capital to invest and governments and companies who need investment capital. This function is performed on the primary or new issue market, and these transactions are achieved through the underwriting and distribution to investors of new issues of securities. Investment dealers often function as principals in this role. When acting as a principal, the securities firm owns securities as part of its own inventory at some stage in its buying and selling transactions with investors. The difference between buying and selling prices is the dealer’s gross profit or loss.
A second role of investment dealers is to facilitate active and liquid secondary markets for the transfer of existing or already outstanding securities from one owner to another. As described below, investment dealers may function as principals or as agents in this role. When acting as an agent, the broker acts for or on behalf of a buyer or a seller but does not itself own title to the securities at any time during the transactions. The broker’s profit is the agent’s commission charged for each transaction. Earlier in the century, the securities business was composed of investment dealers on the one hand and stockbrokers on the other. The difference was largely perceived as a bond business for dealers and a stock business for brokers, but this distinction was only a part of the story. The essential difference was that dealers acted as principals in securities transactions while brokers acted as agents. Today, this sharp distinction has all but disappeared as most firms act as both principal and agents in both bond and equities markets. Few securities firms today conduct solely a bond business or a stock business, and few act only as principals or agents. Most firms today deal in both bonds and stocks and act as both principals and agents.
UNDERWRITING/FINANCING SECURITIES
The term underwriting originated in Lloyd’s Coffee House in London. It was the practice of merchants who gathered there to sign their names under or at the end of documents when they agreed to assume jointly a portion of the risks of marine and other dangerous business enterprises. Their early joint ventures led to the establishment of Lloyd’s of London, internationally known today for its insurance syndicates. In the securities business, underwriting or financing has come to mean the purchase from a government body or a company of a new issue of securities on a given date at a specified price. The dealers act as principals, using their own capital to buy the issue in anticipation of being able to make a profit when later selling it to others. The dealers also accept a risk since market prices may fall during the time the securities remain in their inventory. The issuer normally incurs no liability or responsibility in the sale of its own securities since payment is guaranteed by the underwriter regardless of its success in selling the securities to investors. Dealers underwrite both stock and bond issues, and the range of types available, special features and protective provisions is very broad. The selection of the specific kind of security to be underwritten and its price are determined only after extensive negotiations with the issuer. In the selection process, the dealer advises the issuer on current market conditions and the type of security most likely to be well received by investors. The dealer’s expertise in this area is gained through its activities as a securities trader in secondary markets. The underwriting process is covered more fully in Chapter 11.
PRINCIPAL TRADING
Dealers also act as principals in secondary markets (i.e., after primary distribution has been completed) by maintaining an inventory of already issued, outstanding securities. Here the dealer buys securities in the open market, holds them in inventory for varying periods of time, and subsequently sells them. Generally, most secondary trading of non-equity securities is conducted with the securities firm acting as principal, though occasional agency trades take place. For new money market issues, for instance, a dealer may sell the securities as an agent or, alternatively, take them into inventory as principal for later resale.
There is no central marketplace for most principal or dealer market activities. Instead, transactions are routinely conducted on the over-the-counter market (described earlier) by means of computer systems of inter-dealer brokers which link dealers and large institutions. By maintaining an inventory of outstanding securities, the dealer provides several useful services. Its knowledge of current conditions in secondary markets tempers the advice it gives about terms and features that should be built into a new issue in the primary market. Yields prevailing on outstanding bonds, for example, provide a benchmark when the yield on a new bond issue is determined in a primary distribution. The dealer may also complete a separate buy or a separate sell transaction from its own inventory. There is no need to wait for simultaneous, matching buy-sell orders from other investors to complete an order. The relative speed and ease with which purchases or sales may be made from inventory greatly adds to the liquidity of already issued securities (i.e., the size of an order that can be quickly absorbed without undue price fluctuation). This liquidity also enhances the primary market since it helps assure buyers of new securities that they will be able to sell their holdings, if needed, at reasonable prevailing prices. Stock exchange trades may involve the securities house only as agent, but in many cases the involvement is as principal. Trades done as principal occur when exchanges appoint some registered traders or market makers who have the responsibility of taking positions in some listed stocks for their own firm’s accounts in order to enhance market liquidity and smooth out undue price distortions. In recent years, some firms have also bought listed stocks as principals in order to accumulate blocks of shares of sufficient size to permit them to be more competitive in serving their larger institutional clients. As well, firms trade for their own account with the intent of making a profit.
BROKER OR AGENCY TRANSACTIONS
When acting as a broker, a securities firm is an agent or an intermediary in a secondary securities transaction. The broker’s clients who buy and sell securities are, in fact, the principals or owners of the securities, and the broker acts only as an agent, never actually owning them itself. Both the broker acting for the seller and the broker acting for the buyer charge their respective clients a commission for executing a trade. Commission rates were fixed by stock exchanges until the mid1980s, but are now negotiated between clients and their brokers.
The Clearing System
In Canada securities are cleared through, CDS Clearing and Depository Services Inc. (CDS). Marketplaces (exchanges such as the TSX and TSX Venture) and alternative trading systems (ATSs) report trades to CDS’s clearing and settlement system, CDSX. Over-the-counter trades are also reported to CDS by participants in the system. Participants with access to the clearing and settlement system primarily include banks, investment dealers and trust companies. During a trading day, an exchange member will be both buyer and seller of many listed stocks. Instead of each member making a separate settlement with another member, a designated central clearing system handles the daily settlement process between members.
By using a central clearing system, the number of securities and the amount of cash that has to change hands among the various members each day is substantially reduced through a process called netting. The clearing system establishes and confirms a credit or debit cash or security position balance for each member firm, compiles their clearing settlement sheets and informs each member of the securities or funds it must deliver to balance its account. CDS is a founding member of the Canadian Capital Markets Association, which is promoting a change in settlement date for equities and other securities to one day after the date of a trade from the current three days.
Business Development Bank of Canada
The predecessor body of this federal agency was founded in 1944 to provide fixed-term loans to businesses, especially smaller enterprises, if such businesses are unable to obtain funds on reasonable terms and conditions from other lenders. Over the years similar business development agencies have been operated by many of the provinces.
Trends in the Securities Industry
The Canadian securities industry continues to realign and reorganize to better position itself to compete globally. Future trends in the Canadian marketplace may include: • Continued mergers and alliances between Canadian and global brokerage houses to improve access to capital and global trading. • Continued debate over the harmonization of securities laws across Canada and the call for a national securities regulator. • A continuation of the trend away from commission-based accounts to fee-based accounts. Over the last 20 years, retail investors in Canada moved from individual ownership of securities to an increase in the purchase of managed products, particularly mutual funds. • The creation of an ever-expanding array of innovative financial products to meet market demand and investor needs.
Complete the on-line activity associated with this section.
BANKS AS FINANCIAL INTERMEDIARIES
Banks operate under the Bank Act, which has been regularly updated, usually through revisions every ten years. The Act sets out specifically what a bank may do and provides operating rules enabling it to function within the regulatory framework. At the end of 2007, Canada had 72 banks, made up of 22 domestic banks, 24 foreign bank subsidiaries and 26 foreign bank branches. The largest six domestic banks control more than 90% of the approximately $2.5 trillion in assets. The Canadian banking industry employs close to 249,000 people, making it one of Canada’s largest industries. However, as a result of international consolidation, the largest Canadian banks are becoming relatively smaller when judged against their international competitors. RBC Royal Bank, Scotiabank and TD Canada Trust are in the list of top 50 banks worldwide, when ranked by market capitalization.
Regulations on Canadian bank ownership are designed to protect the Canadian banking system from foreign competition. Recent criticisms that the current structure does not permit Canadian banks to remain competitive in the face of global industry consolidation are now being addressed with a new policy framework for Canadian financial institutions. Banks are designated as Schedule I, Schedule II or Schedule III. Each designation has unique rules and regulations surrounding the banks’ activities. Most Canadian-owned banks are designated as Schedule I banks and the foreign-owned banks are either Schedule II or Schedule III banks. Currently, voting shares of large Schedule I banks must be widely held, subject to rules that restrict the control of any individual or group and non-NAFTA shareholders to no more than 20 per cent. In contrast, a single shareholder, including a company, can control a medium-sized bank (shareholder equity of less than $5 billion) by owning up to 65% of the voting shares, provided that the remaining shares remain publicly traded. A small bank (shareholder equity of less than $1 billion) can be owned by one individual or organization. Table 2.5 shows the major Canadian dollar assets of the chartered banks. As Table 2.5 demonstrates, by far the largest portion of the banks’ assets (about 72 %) are loans to corporate and individual clients (non-mortgage loans) and mortgages (both residential and non-residential). Most of the major Canadian chartered banks also participate in the mortgage loan market through separate subsidiary companies.
TABLE 2.5 MAJOR CANADIAN DOLLAR ASSETS OF THE CHARTERED BANKS (AS AT END OF DECEMBER 2007)
$ Per Cent of Millions Major Canadian Assets
Liquid Assets Held with Bank of Canada Call and Short-term Loans Treasury Bills Government of Canada Bonds Other Short-Term Assets Total Liquid Assets 5,795 3,509 24,536 99,945 67,073 200,858 0.39 0.24 1.65 6.73 4.52 13.53
Less-Liquid Assets Non-Mortgage Loans Residential Mortgages Non-residential Mortgages Canadian Securities Total Canadian Dollar Assets 581,965 460,784 21,637 219,434 1,484,678 39.20 31.04 1.45 14.78 100.00
Source: Bank of Canada website, Banking and Financial Statistics, March 2008.
Schedule I Chartered Banks
Schedule I banks are the giants of Canada’s capital market. There are 19 Schedule I banks, with six (RBC Royal Bank, CIBC, BMO Bank of Montreal, Scotiabank, TD Bank Financial Group and National Bank of Canada) far out-distancing the asset size of other Canadian-owned banks and most other non-bank financial institutions. The major banks have achieved their present asset size largely by establishing a network of more than 9,000 retail branches throughout Canada, augmented in recent years with over 48,000 automated banking machines (ABMs), thus attracting and centralizing the savings of Canadians. They have also become major participants in the international banking scene. Most Schedule I banks are expanding their international operations through acquisitions of, or investments in, U.S. and other international financial institutions. Banking has undergone tremendous change in the past decade. While traditional banking such as retail, commercial and corporate banking services still exist, banks today provide a variety of services through investment dealer, insurance, mortgage, trust, mutual fund and international subsidiaries. In addition, banks have expanded their core services to respond to the increasing demand for wealth management services. Canadian banks offer consumer and commercial banking products and services, including mortgages and loans, bank accounts and investments. Banks also offer financial planning, cash management and wealth management services, some directly and some through subsidiaries. In addition, the banks, through subsidiaries, offer a wide range of products that include segregated funds and life insurance products, trust services, leasing, mutual funds, credit card and investment dealer services. Wealth management products and services, including mutual funds and financial planning services, have been a growing part of banking business in recent years, as demographics in Canada provide record numbers of investors as potential clients. Banks have become more dominant players in this field. The largest banks have all purchased investment firms to expand their capital and client base. Services such as investment dealer activities, discount brokerage accounts, and the sale of insurance products are handled by subsidiaries within the banking group. While banks are permitted under current legislation to take part in diverse sectors of the financial services industry, there are controls on how they do so and on the sharing of customer information between subsidiaries. The controls that inhibit information sharing between various businesses and business units are commonly known as “Chinese walls.” For example, a bank may offer chequing accounts and mortgages through a local branch. If a customer wants a discount brokerage account, the customer would be directed to deal with the investment dealer subsidiary and would receive all further related correspondence from that subsidiary. The bank branch would not have access to information about the customer’s brokerage account or trades, and the investment dealer subsidiary would not have access to the customer’s bank account or loan balances. In this way, the operations of different businesses within the same banking group are kept quite separate. Building on an acceptance of new technologies and an efficient payment system in Canada, significant inroads to electronic (Internet) and telephone banking have been made. The move to Internet delivery of financial services, such as electronic bill payment, is occurring quickly. Canadian banks are leaders in the development and promotion of products and services utilizing technology, such as debit cards and telephone and Internet banking. A 2006 report by the Bank
for International Settlements (BIS) ranked Canada the highest per capita users worldwide of both automatic banking machines (ABMs) and debit cards, with just over 1,500 ABMs terminals per one million inhabitants. According to a recent survey, more than 85% of retail banking transactions in Canada are conducted electronically through use of debit cards, telephone banking, online banking and hand-held wireless devices. A major activity of the banks is to loan funds to businesses and consumers at interest rates higher than the rates they must pay in interest on deposits and other borrowings. The spread between the two sets of interest rates covers the banks’ operating costs (rent, salaries, administration, appropriations for loan losses, etc.), as well as providing a margin for the banks’ profits.
Schedule II and Schedule III Banks
Schedule II banks are incorporated and operate in Canada as federally regulated foreign bank subsidiaries. These banks may accept deposits, which may be eligible for deposit insurance provided by the Canada Deposit and Insurance Corporation (CDIC). Examples of Schedule II banks in Canada include the AMEX Bank of Canada, Citibank Canada, and BNP Paribas. Schedule II banks have been able to open branches in Canada with restricted deposit taking since 1999. Schedule III banks are federally regulated foreign bank branches of foreign institutions that have been authorized under the Bank Act to do banking business in Canada. Examples of Schedule III banks in Canada include HSBC Bank USA, Comerica Bank and Mellon Bank, N.A. A Schedule II bank may engage in all types of business permitted to a Schedule I bank. In practice, most derive their greatest share of revenue from retail banking and electronic financial services. Schedule III banks, in contrast, tend to focus on corporate and institutional finance and investment banking. By allowing foreign banks to operate in Canada, the government has facilitated the expansion in the operations of Canadian-owned Schedule I banks abroad. The presence of foreign-owned banks in Canada also provides a conduit for investment of foreign capital in Canada as well as providing Canadian corporate borrowers with alternative sources of borrowed funds.
Trends in the Role of Banks
As mentioned, one of the most significant developments in Canada has been the move by the major Canadian banks into the securities business. Bank-owned investment dealers are an important part of the securities industry. More recently, they have begun to acquire U.S. investment dealers, primarily discount brokers, as well as investments in international banks. Another significant development is the expansion of powers given to the banks under revisions to the Bank Act. These changes now allow banks to offer non-banking financial services, such as insurance and trust activities, through subsidiaries, with the restriction that insurance products may not be “networked” through a bank’s branch operations. Banks now may hold a range of other types of corporations, including information services, e-commerce, real property holding and brokerage, and specialized financing corporations. Banks may also offer investment counselling and portfolio management services “in-house” rather than only through a subsidiary.
Many of the outstanding proposals for change that will allow banks to become more internationally competitive have been addressed. These are being accomplished through changes to bank ownership rules, the continued possibility of mergers and joint ventures, and by enabling the establishment of bank holding companies. Doing so will allow a bank to structure itself so that the more highly regulated banking services, such as deposit-taking, can be separated from the more lightly regulated services, such as credit card services. The objective of this initiative is to reduce the regulatory burden on a bank’s operations as a whole, which should allow them to become more competitive. This flexibility became necessary as the Bank Act now permits non-deposit-taking institutions, such as life insurance companies, securities dealers and money market mutual funds access to the payment system. (Access to the payments system was previously the exclusive domain of the chartered banks.) These institutions will now be able to offer their customers bank-like payment services such as chequing accounts and debit cards. As the wealth management sector grows, and in response to Canadian demographic trends, banks are actively developing products and services traditionally reserved for sophisticated and high-net worth individuals. Most banks now make available non-proprietary investment products, such as the mutual funds of competitors, in recognition of the importance of customer retention. Such broadening of the investment products offered by banks has resulted in the need for upgrading bank employee investment knowledge so that they can fulfill their fiduciary obligations to their clients.
TRUST COMPANIES, CREDIT UNIONS AND LIFE INSURANCE COMPANIES
Trust and Loan Companies
Federally and provincially incorporated trust companies offer a broad range of financial services, which in many cases overlap services provided by the chartered banks. For example, trust companies accept savings, issue term deposits, make personal and mortgage loans, and sell RRSPs and other tax-deferred plans. However, trust companies are the only corporations in Canada authorized to engage in a trust business (i.e., to act as a trustee in charge of corporate or individual assets such as property, stocks and bonds). They also offer estate planning and asset management. Most of the larger trust companies are now subsidiaries of the major banks. These institutions are regulated under the federal Trust and Loan Companies Act. These institutions are regulated by the Office of the Superintendent of Financial Institutions.
Credit Unions and Caisses Populaires
Early in the 1900s, many individual savers and borrowers felt that chartered banks were too profit oriented. This led to the establishment of many co-operative, member-owned credit unions in English-speaking communities in Canada (predominantly in Ontario, Saskatchewan and British Columbia), and the parallel caisses populaires (people’s banks) in Québec. Frequently,
credit unions seek member-savers from common interest groups such as those in the same neighbourhood, those with similar ethnic backgrounds and those from the same business or social group. Credit unions and caisses populaires offer diverse services such as business and consumer deposit taking and lending, mortgages, mutual funds, insurance, trust services, investment dealer services, and debit and credit cards. Local credit unions and caisses populaires belong to central provincial societies to further common interests. These societies provide broader services such as investment of surplus funds from member locals, lending them funds when required, and cheque clearing. Many are as small as one branch. Services and stability are provided by these provincial central credit unions and federations. The federal legislation governing credit unions is the Cooperative Credit Associations Act. The act generally limits activities of credit unions to providing financial services to their members, entities in which they have a substantial investment and certain types of co-operative institutions, and to providing administrative, educational and other services to cooperative credit societies. The act also contains a number of specific restrictions, such as those on in-house trust services and the retailing of insurance. The act requires associations to adhere to investment rules based on a “prudent portfolio approach” and prohibits associations from acquiring substantial investments in entities other than a list of authorized financial and quasi-financial entities. It also sets out a number of limits designed to restrict the exposure of associations to real property and equity securities.
Insurance Companies
The Canadian insurance industry, including agents, appraisers and adjusters, employs more than 200,000 people, divided more or less evenly between the life insurance industry and the property and casualty insurance industry. Between the two industries, more than $400 billion in assets, either directly or indirectly, is managed on behalf of policyholders. Table 2.6 shows the composition of the assets of life insurance companies in Canada. At the end of 2007, the life insurance industry had total assets of $274 billion held in Canada on behalf of Canadian policyholders (excluding segregated funds). Segregated funds account for an additional $150 billion.
LIFE INSURERS’ ASSETS AT BOOK VALUE (AS AT THE END OF DECEMBER 2007)
Cash & Deposits Short-Term Paper & Bankers’ Acceptances Government of Canada Bonds Provincial & Municipal Bonds Canadian Corporate Bonds Corporate Shares Mortgages Real Estate Policy Loans Other Assets Total
Source: Bank of Canada website, Banking and Financial Statistics, March 2008.
The insurance industry has two main businesses: life insurance and property and casualty insurance. Life insurance and related products include insurance against loss of life, livelihood or health, such as health and disability insurance, term and whole life insurance, pension plans, registered retirement savings plans and annuities. The chief sources of a life insurance company’s funds are premiums on whole life, term and group insurance policies; premiums being paid for annuities, pensions, group medical and dental care programs; interest on policy loans and mortgages; and interest and dividends on securities and mortgages already owned. Life insurance products may be offered through either private or group insurance plans, often those sponsored by employers. Property and casualty insurance encompasses protection against loss of property, including home, auto and commercial business insurance. The largest aggregate premiums are generated by automobile insurance, followed by property insurance and liability insurance. The asset size of insurance companies operating in the property protection, automobile, health and accident fields is considerably smaller than that of the life insurance companies. Though their investment rules are also governed by the prudent portfolio approach as set out in the Insurance Companies Act, the property and casualty companies are considerably more interested in safe, short-term securities than are life companies. Casualty companies may be called upon to pay out substantial sums to claimants at short notice. Consequently, liquidity is a major consideration in their investment program. Life insurance companies act as trustees for the funds entrusted to them by policyholders and, therefore, they must exercise extreme caution in selecting their investments. Safety of principal is most important. Contractual obligations will have to be met in the future and certainty of
principal repayment is their first investment aim. Historically, life insurance companies have also tried, as far as market conditions permit, to invest as much as possible of their funds in high yielding, longer-term securities, since many of their contracts are long-term in nature, running for the lifetime of the insured. Life insurance companies, therefore, tend to be active in both mortgage and long-term bond markets. Underwriting operations are the most important aspect of the insurance business in Canada. Underwriting is the business of evaluating the risk an insurance company is willing to take from a client in exchange for insurance premiums, followed by the acceptance of the associated responsibility for fulfilling the terms of the insurance contract. The other significant aspect of the insurance business is acting as agent or broker for other underwriters. Such companies sell insurance policies underwritten by other firms. Reinsurance, the business of exchanging risk between insurance companies to facilitate better risk management, is a relatively small part of the Canadian insurance market, although it is an increasingly important business globally.
INSURANCE REGULATION
The key federal legislation governing insurance companies is the Insurance Companies Act. The bill establishing the Act was proclaimed June 1, 1992. The legislation permits life insurance companies to explicitly own trust and loan companies, and thus enter new financial businesses through subsidiaries. Similarly, widely held institutions such as mutual insurance companies would be permitted to own Schedule II banks. Insurance companies are also allowed to hold a range of other types of corporations. While companies will have enhanced powers to make consumer and corporate loans, the Act contains a number of restrictions on activities such as in-house trust services and deposit-taking. It also continues the practice of allowing only life companies to offer annuities and segregated funds. The Act also requires insurance companies to adhere to investment rules based on a “prudent portfolio approach” which replaces the “legal for life” rules. Companies are prohibited from acquiring substantial investments in entities other than a list of authorized financial and quasifinancial entities. The Act also sets out a number of portfolio limits designed to limit exposure to real property and equity securities. A number of insurance companies are wholly owned by the Canadian Schedule I banks. Although these large domestic banks have established their own insurance subsidiaries, the Bank Act does not permit the selling of insurance through their branch networks.
Trends in Insurance
Change is underway in the ownership structure of several large Canadian insurers as they continue to demutualize. Insurance companies in Canada are organized either as mutual companies, owned by policyholders, or as joint stock companies, owned by shareholders. Demutualization is a process by which insurance companies, owned by policyholders, reorganize into companies owned by shareholders. Policyholders, in effect, become shareholders in an insurance corporation. The significance of demutualization is that it provides insurance companies with access to capital markets, allowing them to acquire other companies with equity, rather than cash, making them better able to compete with other financial institutions such as banks.
Demutualization will likely lead to consolidation among insurance companies and the emergence of fewer, larger companies. Already the number of insurance companies in Canada is declining, while the size of the industry increases. Added to this environment of consolidation is an increased atmosphere of competitiveness due to new sources of competition, such as that from insurance subsidiaries of Canadian banks. The entrance of large banks into the insurance business reinforces trends found elsewhere in the financial services sector. These are trends primarily to increase competition and the potential rationalization of intermediaries such as agents and independent brokers. While Canadian banks are permitted to own insurance companies, they are still restricted as to the distribution of insurance products. Another trend is the development of innovative new products. The insurance industry continues to develop new markets in response to demand from policyholders, such as health and disability products for self-employed workers, critical illness insurance, and a wide variety of business liability insurance. Current financial reforms affect insurance companies as well as banks. Insurance companies will have access to the Payments System, allowing them to offer products such as chequing accounts and debit cards. The new flexibility with respect to creating holding companies will allow them to compete on an equal level with banks.
INVESTMENT FUNDS, SAVINGS BANKS, PENSION PLANS, SALES FINANCE AND CONSUMER LOAN COMPANIES
The institutions discussed in the above sections are among the major participants in Canada’s capital market. Banks, insurance companies, investment dealers and mutual fund companies are not the only distributors of financial products and services in Canada. Other distributors include credit unions, caisses populaires, non-bank-aligned trust companies, insurance brokers and financial planners. Some of these firms distribute their own products and services, while others distribute the products and services of other firms. Although these firms are often characterized by the products that they offer as distributors, they command a significant portion of the competitive Canadian financial services industry. These other financial intermediaries are described below.
Investment Funds
Investment funds are companies or trusts that sell their shares to the public and invest the proceeds in a diverse securities portfolio. There are two types of investment funds: • Closed-End Funds: normally issue shares only at start-up or at other infrequent periods and reinvest the proceeds and borrowings in a portfolio of securities to produce income and capital gain.
• Open-End Funds (or mutual funds): continually issue shares to investors and redeem these shares on demand at their net asset or “break-up” value per share of the fund’s investment portfolio. Mutual funds range from those primarily seeking safety of principal and income through the purchase of mortgages, bonds and blue-chip preferred and common shares, to much more aggressive funds primarily seeking capital gain through trading common shares in growth industries. Of the two types of funds, mutual funds are much larger, accounting for close to 95% of aggregate funds invested. Table 2.7 shows the assets of mutual funds in Canada as at the end of December 2007.
TABLE 2.7 INVESTMENT FUND ASSETS AT COST (AS AT DECEMBER 2007)
Investment Fund Cash & Deposits Term Deposits Short-Term Paper & Bankers’ Acceptances Government of Canada Bonds Provincial & Municipal Bonds Canadian Corporate Bonds Foreign Securities Canadian Preferred & Common Mortgages Other Assets Total
Source: Bank of Canada website, Banking and Financial Statistics, March 2008.
Savings Banks
Two comparatively small savings banks operate in Ontario and Alberta. They are the Province of Ontario Savings Offices (which only accepts deposits and does not act as a lending agent) and the much larger Alberta Treasury Branches. Funds on deposit are 100% guaranteed by the respective province. The Alberta Treasury Branches were formed in 1938 when chartered banks pulled out their branches from many smaller towns. In some places, they are the only financial service provider in town.
Pension Plans
There has been a remarkable growth in the institutionalization of savings through pension plans during the past 55 years. This growth is partly the result of longer life expectancy, earlier retirement and the desire for financial independence during the now-longer period of retirement. Canada’s changing demographic landscape has also focused public attention on the future viability of the Canada Pension Plan (CPP) and Québec Pension Plans (QPP). Unions, employees and employers have therefore sought to provide additional retirement benefits through
pension plans. Favourable tax treatment in the form of tax deferral on pension premiums paid by employees and by self-employed individuals has also encouraged the rapid growth of pension assets in Canada. One or other of these plans is compulsory for virtually all employed persons and, in addition to minimum retirement benefits, both plans provide certain disability, death, widows’ and orphans’ benefits. Based on employee earnings with set maximums, both employee and employer contribute and both have cost-of-living adjustments on contributions and payouts. As with all pension plans, asset build-up tends to be heavy in the plans’ early years, maturing at a break-even point as payouts match contributions, and finally moving to a declining asset position unless contributions are raised or numbers of new workers exceed those retiring.
Review the on-line summary or checklist associated with this section.
Sales Finance and Consumer Loan Companies
Such companies make direct cash loans to consumers who usually repay principal and interest in instalments. They also purchase, at a discount, instalment sales contracts from retailers and dealers when such items as new automobiles, appliances or home improvements are bought on instalment plans
SUMMARY
After reading this chapter, you should be able to: 1. Summarize the state of the Canadian securities industry today. • Canadian capital markets are among the most sophisticated and efficient in the world. These qualities are measured in terms of the variety and size of new issues brought to the markets and the depth and liquidity of secondary market trading. New issues brought to Canadian markets have increased considerably over the past five years, while money market, bond and listed equity secondary trading has also risen significantly over this same period.
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2. Distinguish among the three categories of securities firms, explain how they are organized, and compare and contrast dealer, principal and agency transactions. • Firms in the Canadian securities industry are categorized as integrated, institutional and retail. Integrated firms account for about 70% of total industry revenue because they offer products and services that cover all aspects of the industry. Institutional firms primarily handle the trading activity of large clients such as pension funds and mutual funds. At the retail level, there are full-service firms that offer a wide variety of products and services, and discount brokers that provide reduced trading rates but do not provide advice. One main role of an investment dealer is to bring new issues of securities to the primary markets and facilitate trading in the secondary markets. The dealer can act as a principal or as an agent in either market.
When acting as a principal, the dealer owns securities as part of its inventory when conducting transactions with clients and investors. Profit is made on the spread between the original cost of the securities and what they eventually sell for. When acting as an agent, the dealer acts on behalf of a buyer or seller but does not itself own title to the securities at any time during the transaction. Profit is realized on the commission charged for each transaction.
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3. Describe the role of the chartered banks in the capital markets. • The Canadian chartered banks are the largest financial intermediaries in the country. They are designated as Schedule I, Schedule II or Schedule III banks. Each designation has different rules and regulations regarding ownership levels and the types of services that can be offered. Most Canadian-owned banks are designated as Schedule I banks. They are the dominant competitors in the industry both in terms of the wide-ranging services offered and their overall asset base. Schedule II banks are incorporated and operate in Canada as federally regulated foreign bank subsidiaries. These banks can engage in all the types of business that are permitted to Schedule I banks. Schedule III banks are federally regulated foreign bank branches of foreign institutions. Most operate as full-service branches able to accept deposits, though some are merely lending branches.
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4. Describe the roles of trust companies, credit unions and insurance companies in the capital markets. • These financial intermediaries offer a broad range of financial services that in many cases overlap with the services provided by chartered banks, including deposit-taking and lending, debit and credit cards, mortgages, and mutual funds.
5. Describe the roles of investment funds, savings banks, loan companies and pension plans in the capital markets. • • Investment funds sell their shares to the public, most often in the form of closed- or openend funds, and invest the proceeds in a diverse portfolio of securities. Loan companies make direct cash loans to consumers who typically use them to repay principal and interest on instalment loans. These intermediaries also purchase instalment sales contracts from retailers on such items as new automobiles, appliances, or home improvements that are purchased on instalment. Pension plans represent a type of institutionalized savings. Trusteed plans are offered to the employees of many companies, institutions and other organizations. One or the other of the government-related plans (the Canada Pension Plan and the parallel Québec Pension Plan) is compulsory for virtually all employed persons and, in addition to minimum retirement benefits, both plans provide certain disability, widows’ and orphans’ and death benefits.
Now that you’ve completed this chapter and the on-line activities, complete this post-test.