Blocking Consolidation in Canada

It had the look of an ideal marriage. Last summer, officials from the Bank of Montreal and Bank of Nova Scotia reportedly negotiated a merger that would have created Canada’s largest financial institution, while matching BMO’s Chicago stronghold, Harris Bancorp, with ScotiaBank’s growing Latin American business. Even better, bringing together the two smallest of Canada’s “Big Five” banks wouldn’t involve any messy disputes over who would run things: ScotiaBank’s CEO, Peter Godsoe, had already let it be known he’d retire this spring, leaving the path clear for BMO’s Tony Comper to take the reins.

Instead, it became déjà vu all over again. Four years earlier, BMO had sought to merge with rival Royal Bank of Canada, only to have the deal shot down by the nation’s finance minister after a year of planning. This time around, the banks thought they

had the political bases covered, with well-connected lobbyists on both sides. Despite the plotting, however, this merger, too, was nixed—reportedly by Prime Minister Jean Chretien himself.

All this has to be frustrating to the 57-year-old Comper. But he won’t let on, nor will he comment much on the entire affair. In Canada, the topic of domestic bank mergers is a political hot potato—so sensitive that most bank executives and even bank analysts decline to talk openly about the subject for fear of a backlash. One analyst reportedly lost his job after floating the idea of mergers in a research report.

For all that, Comper is willing to concede what has become almost painfully obvious: that, while mergers “are not about strategy,” he’d like to do one. “The fact of the matter is, you could execute your strategy at a much faster pace if you had the wider capital base that would come through a domestic merger.”

The Great Canadian Bank Merger Debate is both high-profile and politically charged—a clash that pits the banks’ global ambitions against customers’ desire to maintain the status quo. “It’s impossible to overstate how emotional and politically sensitive the issue is,” says Martin Glynn, CEO of HSBC Canada, the nation’s largest foreign-owned bank.

It’s also one that could ultimately play a significant role in the pace of Canadian institutions’ expansion plans in the States. Bankers, intent on growing south of the border, argue they need the larger capital bases that mergers would afford to keep pace with fast-growing global competitors and grow earnings. Without the ability to join forces, proponents say, Canada’s banks risk becoming irrelevant players on the global stage. “The case we’re making is that we need to develop more operating scale for the company, so we can be more of a competitive force in international markets,” says Peter Currie, Royal Bank’s CFO and vice chairman. Mergers “will serve the country—they’re something the government should actually be championing—because it will give Canada a channel into those markets and make us a leader, not a follower.”

Opponents, however, fret that mergers would result in heavy domestic job losses, higher prices and poorer service and access, especially in remote rural areas. In a recent poll by Maclean’s, a Canadian newsweekly, 76 percent of respondents said that allowing bank mergers would be bad for consumers. With elected officials getting the final say, it’s easy to understand why four proposed mergers have been brushed aside since 1997.

“There isn’t a political constituency for mergers,” says Ross Healy, CEO of Strategic Analysis, a Toronto investment advisor. A merger critic, he accuses Canadian bankers of having an “edifice complex,” rooted more in envy of American rivals’ size than any desire to improve shareholder returns, which, he notes, typically hover in the 15 percent to 20 percent range. “They’re already bloody profitable, so don’t give me any rubbish about how they need to merge.”

Now, the long-simmering issue appears headed for some kind of resolution. Or maybe not. In December, the Senate banking committee issued a report calling on the government to allow mergers on competitive grounds. “Within 10 years, I think [the banks] would be decimated” without mergers, committee chairman Leo Kolber told reporters.

The House of Commons is expected to issue its own report within the next month or two. This will be a tougher sell, because unlike the Senate, whose members are appointed, the 301 House members are elected and tilt strongly to the left. If it, too, sides with the banks, then it will be left up to the liberal Chretien government—or its successor—to decide whether or not to overhaul the process. If not, then it could be back to square one for the banks.

The debate highlights the stark differences between the Canadian and U.S. banking systems. While the U.S. has about 8,000 commercial banks, and none with a market share of even 10 percent, the Canadian banking sector is highly concentrated, with five large banks—BMO, Royal Bank, BankScotia, Canadian Imperial Bank of Commerce and TD Bank Financial Group—controlling nearly 80 percent of deposits. A handful of regional players, foreign banks and provincial credit unions take up most of the slack. “It’s a mature oligopoly,” similar to that enjoyed by Coke and Pepsi in softdrinks, says Robert Wessel, a banking analyst for National Bank Financial, a unit of the nation’s sixth-largest banking company. The Big Five are universal institutions, dominant in virtually all aspects of financial services. All boast national branch networks, and offer everything from investment banking, brokerage, asset management and insurance to retail and wholesale banking under one roof. “The Big Five thoroughly and utterly and completely dominate the Canadian market,” Wessel adds.

That pervasiveness has fostered a sort of love-hate relationship with Canadian consumers. The Big Five rank among the country’s largest and best employers, and sponsor community activities and pee-wee hockey teams across the country. They’re also seen as global standard bearers, and a source of pride, for a national economy that is relatively short on big corporations.

But the banks have been unable to translate that standing into political goodwill. Many Canadians resent the big profits banks produce, and feel they’re already being gouged by the banks—something they fear would only increase if mergers were allowed. “It would mean less competition, higher costs and lower levels of service,” says Catherine Swift, CEO of the Canadian Federation of Independent Business, a small-business trade group whose members are strongly opposed to mergers.

This all plays out in a highly politicized merger process. As in the States, regulators—the Office of the Superintendent of Financial Institutions and the Competition Bureau—must first sign off on any proposed merger. From there, parliamentary hearings on the “public interest” are mandated for any large bank merger. Those recommendations are then forwarded to the finance minister, who is supposed to make the final call.

This is all part of a new, more streamlined process, meant to provide a roadmap following 1998, when two bank mergers were vetoed. But as last fall’s scuttled BMO-BankScotia deal illustrates, it can be short-circuited at any step of the way. “We’re seeking clear rules for the road,” Currie says. “Tell us what the public interest is, and we’ll be glad to have a discussion about it. That’s been ambiguous to this point.”

Tony Ianno, a liberal member of parliament from Toronto and head of a committee that reviewed the two proposed 1998 mergers, says the public interest is clear: “Competition, access to capital, service levels and the ability for rural communities to sustain themselves,” he says.

Many small towns only have one or two institutions, Swift says, and the banks are burdened by “complacency and a lack of innovation” when it comes to forging attractive products. She notes that when Wells Fargo entered the market a few years back with a competitive small-business lending product, the Canadian banks quickly duplicated it. “They needed competition to introduce it,” she says.

Bankers counter that the present system serves customers well. Spreads and fees are both lower than in the States, they say, and a national clearing system allows for same-day check processing. A recent report by Standard & Poor’s called the system one of the world’s most efficient.

But while earnings for most of the banks have grown at double-digit rates, executives say growth prospects at home are slim. The Canadian economy is small, and the tendency of Canadians to stick with their financial institutions provides little chance for growing market share.

In response, they’ve been looking south, to the fragmented U.S. market. In just the past three years, the Big Five have made 22 acquisitions in the States. Today, according to a BMO analysis, all five rank among the top-18 foreign players in the U.S., controlling some $170 billion in combined assets.

BMO, which bought Harris in 1984, is the biggest, with $45.5 billion in U.S. assets, followed by CIBC and BankScotia. Royal Bank has been the most-aggressive of late, having made 14 acquisitions, including Rocky Mount, NC-based Centura Banks and securities firms Dain Rauscher and Tucker Anthony Sutro, since 1998. “The medium-term strategy is to increase our presence in the U.S. market,” Currie says, “to create a truly continental organization.”

This is the refrain heard from most Canadian bankers. Various tomes and speeches catalog a view of a broad “North American” marketplace that’s deemed essential to Canadian banks’ long-term prospects. “The expertise of Canadian banks is in running large national branch networks,” says James McIntosh, an economics professor at Montreal’s Concordia University. “The deregulation of the U.S. market makes it a natural for them.”

But this also is where their conundrum lies. In recent years, as large banks elsewhere have joined forces, Canadian banks have seen their relative standing shrivel. Royal Bank, the largest Canadian institution, has a market cap of about $25 billion – lower than the likes of Fifth Third, U.S. Bancorp and FleetBoston Financial—and ranks as just the world’s 53rd largest bank in terms of assets, compared to 23rd in 1975. As one pundit put it, the Big Five are “domestic whales, global minnows.”

Since Canadian law bans any shareholder from owning more than 20 percent of a bank—rendering a merger with a foreign institution impossible—domestic mergers are the only avenue for significantly boosting capital levels.

Even if parliament flinches in this latest go-around, Wessel believes it’s only a matter of time before mergers are allowed. He says that some “important members” of the government are sympathetic to the notion that Canada’s economy would benefit from having at least one “national champion” bank that’s big enough to compete globally, and pegs the odds of a merger being completed by the end of next year at 75 percent. “It’s inevitable,” agrees HSBC’s Glynn.

Others aren’t so sure. Ianno says that if banks really want more scale to compete internationally, then they’ll have to give up some of their domestic clout. “If you have competition in local markets, the merger issue will be dead. No one will care,” he says.

That’s easier said than done. Credit unions and smaller Canadian banks are bit players, and only about 45 foreign banks have Canadian operations. Some, such as HSBC, have found success on the retail end. But American banks have been mostly no-shows. According to the BMO analysis, total assets held by U.S. banks in Canada stand at about $30 billion—most of it in the wholesale or credit-card arenas—while no U.S. bank has a physical retail presence in the country.

Critics say there are still too many barriers to entry—regulatory and capital costs, and the sheer dominance of the Big Five—to attract foreign players. Ianno says he has suggested a competitive alternative: allow government-related entities, such as the Farm Credit Corp. and Postal Service, to take deposits and make loans. But banks have resisted such efforts.

HSBC’s Glynn says the competition issue is a moot point—there is no shortage of foreign and smaller local banks that would be willing to buy branches in the wake of a merger. HSBC has 120 branches in the country already, and would like to expand further. “We’ve made it clear to the politicians that, if they allow mergers [that require divestitures], then we will be happy to buy branches and fill the void,” he says. “We’d see it as an opportunity.”

Sitting in his Toronto office, Comper plays his cards close to the vest. Whether merged or not, he says, BMO and its counterparts will continue to pursue opportunities in the States, and do so successfully. “This isn’t about our being unable to be successful without a merger,” he says. “It’s about how fast we can execute our strategy.”

Spoken like a true politician.