Banks: The home game

Playing safe is certainly good for bank profits. But does it hurt everyone else?

It’s seven o’clock on a monsoon-like Wednesday morning in New York, but the early wake-up doesn’t faze Christiane Bergevin. She’s used to making the most of her time. Bergevin is the president of SNC-Lavalin Capital Inc., a subsidiary of the Montreal-based engineering-construction group that in 2005 ranked among the world’s Top 10 global bookrunners for project finance bonds. Her team chases deals in infrastructure, issuing privately placed bonds for financing bridges, roads and other projects — and competing head to head with Lehman Brothers, Citigroup and other powerhouse investment banks.

SNC-Lavalin Capital grabbed attention in this niche back in 1999, when it helped finance the acquisition of the 407 toll road in Ontario. Since then, it has arranged financing for the Ankara subway in Turkey, and advised on many infrastructure projects in energy, including a dam in Algeria. In this hyper-competitive world, snagging a top spot on an international league table is a coveted prize. “What I can’t quite understand,” Bergevin says with a mischievous glint in her eye, “is why the capital financing arm of an engineering firm made these rankings” — before the Canadian banks got a look in.

Infrastructure financing is hot; developing economies are even hotter. Morningstar expects 30% of Citigroup’s income growth to come from operations in emerging economies, which are projected to expand at double the pace of mature markets over the next 10 years.

The CEO of Royal Bank of Canada isn’t blind to the opportunities Bergevin is chasing. Comfortably seated in a stuffed armchair in his corner office overlooking Bay and Front streets in Toronto, Gordon Nixon is explaining why North America’s sixth-largest bank is targeting infrastructure projects — just not those in developing markets. “Growth in those markets is going to be higher and faster than it will be in Canada, the U.S. and Europe. We want to be in new markets,” he says, “but we want to do it in a way that is smart. It’s not something we are going to independently pursue aggressively.”

One of the world’s top banks, RBC is no slouch when it comes to competing. In August, its capital market division made Infrastructure Journal’s global league table for deal activity in 2007. But for Nixon, chasing the really high-growth business — in places where the locals are more likely to eat rice than Rice Krispies for breakfast — is not yet “a strategic priority.”

Such a note of caution echoes right across Canadian banking. Excepting Scotiabank (and perhaps due to CIBC’s unfortunate recent history in the United States), Canada’s banks demonstrate an aversion to risk, particularly overseas, that is disproportionate to their strength and size. Be it financing expansions in emerging markets, startups at home or lucrative opportunities in small business and export financing, Canadian banks consistently default to the safe-and-sure path.

To a country with a conservative business culture, safe-and-sure sounds good — particularly when debt markets are imploding and investors are running for cover. But in today’s economy, safe-and-sure can also lead just as surely to global irrelevance. Deborah Wince-Smith, president of the Washington, D.C.–based Council on Competitiveness, a think-tank that monitors American competitiveness, says that outside Canada, Canadian banks simply don’t play a significant role. “They just aren’t seen as a threat,” she says. “They have no profile.”

That Canada’s banks, which rank among our largest corporations by assets and market capitalization, barely register as players overseas comes at an interesting time for the economy. In report after report, economists bemoan Canada’s poor record on productivity. Concerns about foreign takeovers continue, with some captains of industry calling for policies to help promote Canadian global champions. In July, federal Finance Minister Jim Flaherty and then–industry minister Maxime Bernier named a panel to rethink the Competition Act and examine the regulatory structure underpinning key sectors, including financial services. It’s an opportunity to ask why Canadian banks prioritize such caution over playing in the big leagues — and suggest ways to change the status quo.

Last quarter, RBC reported earnings of $1,279 million. The other big banks also reported healthy profits, as they have been doing for years. Between them, the Big Six (RBC, Bank of Montreal, CIBC, TD Canada Trust, Scotiabank and National Bank) command 90% of the domestic retail market. There’s no question they are top performers, at least when it comes to generating yield for shareholders. Whether the banks are directing capital to where it will have the most impact is another matter.

Maintaining a lock on the domestic market gives the banks access to enormous pools of capital. In RBC’s case, it can draw from $376 billion in deposits alone, for a total asset count of $605 billion. Such reserves rival the capacities of smaller, more internationally aggressive investment banks such as Macquarie of Australia (total assets: US$136 billion) or Lehman Brothers of Wall Street (assets: US$503.5 billion). While it’s true retail banks labour under tighter capital reserve requirements than their investment banking counterparts, the comparison is worth noting.

Given such a position of strength, and buoyed by the high Canadian dollar, the banks should be powering forth into high-growth markets. Sure enough, RBC is growing its U.K. operations to chase infrastructure deals in Europe. The bank is also expanding its reach in the U.S. market. On Sept. 6, it announced a $1.6-billion acquisition in Alabama, its largest in six years.

RBC isn’t the only Canadian bank expanding overseas. TD Banknorth continues to grow its business in the Northeast United States. Meanwhile, Morningstar analyst Michael Kon praises Scotiabank in particular for its growth strategy in emerging markets. Kon is less bullish on BMO’s acquisition of Chicago’s Harris Bank in 1984: “A 10% return on a $700-million investment isn’t much to get excited about.” As for CIBC, with reports of exposure to the subprime mortgage market this summer and the US$2.4-billion payout to Enron shareholders still a recent memory, the less said the better.

Our banks’ variable performance overseas is prompting economists to ask critical questions about how well the financial services sector is serving businesses in a global economy. In June, economists Thorsten Koeppl and James MacGee of the C. D. Howe Institute published a report that urged the government to allow banks to merge to compete globally, while opening the market to foreign competition at home. Glen Hodgson, senior economist and vice-president at the Conference Board of Canada, believes a serious debate on financial services is overdue. “Are we competitive? Can we go out and play in global markets?” he asks. “Are our companies getting access to the credit they need? In many cases, the answer is no.”

A study published last winter by Harvard Business School’s William Kerr and MIT’s Ramana Nanda offers clues as to how (and why) policy-makers need to wake up the sector. In Banking Deregulation, Financing Constraints and Entrepreneurship, Kerr and Nanda examine what happened when the U.S. banking sector deregulated between 1970 and 1994. Large national banks merged and grew, smaller banks were allowed to compete across state lines, and the number of businesses able to access financing to incorporate and expand grew significantly.

In Canada, by comparison, banks are not allowed to merge. The domestic market remains largely barred to foreign competitors. And with record profits available at home, there’s no real incentive for the banks to go after hot growth opportunities overseas in a comprehensive way — so they don’t.

Historically, Canada’s financial services sector has been one of the most protected in the world. But changes to the Bank Act in 1999 and 2002 mean that, in theory, any foreign bank can now set up shop here. In practice, the barriers to entry are still steep. Foreign banks must hire Canadians in key roles. They can’t offer domestic retail services — any deposits a foreign bank based in Canada accepts must be a minimum of $150,000. And no one entity can own more than 20% of a large Canadian bank’s voting shares, effectively preventing a foreign competitor from buying its way into the system. In such an environment, real competition in banking remains a pipe dream. “Effectively, the Canadian market is an oligopoly,” says Kon, “from which the Big Six banks make great returns.”

The impact of all that protection and consolidation is far-reaching. A report put out this March by the Institute for Competitiveness and Prosperity, a Toronto-based think-tank, finds the Canadian economy isn’t keeping pace with its U.S. counterpart. In 2006, Canadians earned $9,200 per capita less than Americans. That “prosperity gap” is set to widen to $17,400 by 2020. What’s more, the OECD’s latest country report on Canada puts it woefully behind its counterparts when it comes to productivity. In 2004, productivity grew at a pathetic 0.4%; in 2005, it inched up to 2.2%. One main reason for this sluggish performance is Canada’s marginal effective tax rate on capital, which at 38% is the highest in the OECD. But Hodgson thinks other factors — including lack of competition in the financial services sector — play a critical role. “Financial services is the lifeblood of any economy,” he says. “But Canadians don’t think of the financial services sector as a service provider to business, and that’s a problem.”

What’s the link between low productivity and access to financing? The OECD’s Canada 2006 report puts low productivity down to businesses’ lack of investment in IT, research and development. But to make such investments, companies need ready access to affordable financing. And for many Canadian businesses, finding money on decent terms has been a challenge.

Consider: the U.S. economy boasts just over 8,000 banks, competing for every niche, from lines of credits for small businesses to financing overseas expansion. Canada’s domestic market consists of six large banks, 16 smaller niche players, 48 trusts and 24 foreign players, including HSBC and ING Direct Canada. As any classically trained economist would expect, such lack of choice means financial services in Canada are more expensive than they would be in a more competitive market.

RBC’s Nixon counters that in the aggregate, Canadian credit spreads are competitive internationally. And he’s right, in part: OECD statistics for 2007 peg Canadian short-term interest rates at 4.67% for July, slightly lower than the U.S. figure of 5.32% but higher than either China’s (3.14%) or the eurozone’s (4.22%). These trends have been roughly consistent since 2000. But drill down into key areas of the economy, and it becomes clear that lack of choice means financial services are often more expensive or less accessible than they would be in a less protected market.

Take consumer banking. Canadians pay $1.50 each time they use a competing bank’s ATM machine. When Matthew Barrett, the former Bank of Montreal chief executive who left BMO for Barclays in 1999, tried to introduce similar fees into the U.K. market, public outcry forced him to back down. In Canada, it’s another story. Duff Conacher of Democracy Watch, a left-leaning think-tank, pegs average total ATM fees paid by Canadians at $817 million a year between 2000 and 2005. (The CBA strongly disagrees with this assessment. Spokesperson Melanie Minos would not, however, provide any official CBA figures for how much Canadians spent on ATM fees between 2000 and 2005.) Why do Canadians support such fees, when the British do not? Simple. Little real choice.

ING Direct Canada is one bank that’s merrily capitalizing on that lack of choice. It entered the Canadian market in 1997, offering attractive interest rates on a limited range of financial products at the retail level. ING Direct’s president, Johanne Brossard, describes how, prior to setting up shop, her team looked at an OECD study of the comparative cost of financial services. It found Canadians were paying the highest fees on savings accounts in the OECD — $13 a month. “So we offered new customers $13 just to open a savings account with us, at 5% interest,” she says. ING Direct Canada’s business went ballistic, enjoying annual growth rates of up to 85% in its first few years. It now commands a total of 3.3% of the domestic market in savings, and 3.6% in mortgages.

But such dramatic growth aside, ING’s market share remains a footnote to the dominant position the Big Six enjoys.

That’s too bad for those hoping to finance and grow innovation in this country. In such a conservative environment, innovative companies often find it necessary to go outside Canada for capital and credit. In the past two years, six solar energy companies in the Cleantech Network have gone public. Though the Cleantech Network was founded by a Canadian and maintains an office in Toronto, none of the solar plays went public on a Canadian exchange, and none featured a Canadian bank as lead underwriter — not even the patriotically named Canadian Solar Inc., which listed on the Nasdaq and was underwritten by Deutsche Bank and Lehman Brothers. (CIBC played a subsidiary role.) “There’s a gross lack of financing,” says Nicholas Parker, chairman and co-founder of the Cleantech Network. “So many of these companies find they are not getting funded by domestic capital. When it comes to recognizing and capitalizing on new technologies, the Canadian financial services sector is asleep at the switch.”

The prize may be considerable. An energy finance study put out in October 2006 by Zouk, a venture-capital firm based in Berlin, shows the average return on clean-tech investments in Europe alone between 1999 and 2006 was 87.6%. And in 2006, clean tech moved into third place behind software and biotech in terms of amounts of capital raised worldwide.

Of course, from a Canadian banker’s perspective, underwriting companies hoping to tap capital markets in new sectors where investors barely understand the innovation in question, let alone its market potential, is a risky proposition. Why take a gamble, when record profits are to be had from safer paths like domestic retail and resource plays?

Shift the analysis to a much more down-to-earth realm — small and medium-size businesses, which comprise 90% of the Canadian economy — and the story remains the same: caution before growth. According to Bank of Canada data, the number of loans made that are valued at under $200,000 has remained virtually flat since 1989.

Garth Whyte, executive vice-president of the Canadian Federation of Independent Business, says the plateau in small loans is not due to lower demand. It happens because businesses are getting less access. In its most recent survey of small-business owners, one in four cites affordable access to credit as a barrier to growth. Another issue is access to financial advice — with managers constantly being switched between branches, entrepreneurs find themselves making the same pitch for financing several times over. Then there’s securing loans and lines of credit on decent terms, which tend to be above prime for startups. “Canadians are turning to personal lines of credit and credit cards to finance startups instead,” says Whyte. “We all know how expensive those sources of financing can be.”

No matter how compelling the business proposal, the next Magna isn’t likely to be bootstrapped on the back of a credit card charging 21% interest.

Nancy Hughes Anthony, the newly minted president of the Canadian Bankers Association, doesn’t agree that the banking sector is too protected and concentrated to be competitive, and she questions Whyte’s analysis. She says the Canadian market for small business financing is very competitive, as does Nixon, who cites the popularity of credit unions, among other entities, as evidence.

It is true Canada boasts the world’s highest credit union membership — 10 million, or almost one in three people belong to one of 1,200 credit unions and caisses populaires. But credit unions are limited. As provincially regulated bodies, they cannot offer nationwide retail banking services. In most cases, they are also limited by the size of their retail deposits. According to Ian Warner, chief operating officer of Vancouver-based Vancity, his credit union charges interest rates as rich as any bank’s — between 10% and 20% — on financing for high-risk propositions such as startups. Vancity will continue to do so as long as the market supports such pricing.

In some regional centres, one of the biggest commercial financing games in town is the government — in the form of the Business Development Bank of Canada. But financing from a government agency doesn’t come cheap. “It’s 2% above prime or more, depending on the nature of the venture,” says Whyte. Yet there’s an enthusiastic market for the expensive financing BDC offers. Last year, the Bank reported net income of $138 million, sending dividends totalling $21.5 million back to BDC’s sole shareholder, the Government of Canada. Since 1997, BDC has declared $140.2 million in dividends. And in 2007, total loans outstanding are $9.1 billion.

Back in his corner office, RBC’s Nixon says it’s “tough to comment” on why BDC has become so dominant in certain regions. “The government identified a niche, and stepped in to fill it,” he says. Whether BDC’s success bodes well for Canadian entrepreneurialism is another question.

The story is the same at Export Development Canada, an arm’s-length export credit agency set up back in 1944 to help Canadian companies fund export strategies. In 2006, EDC made net income of $1.22 billion and helped to facilitate $66.1 billion in transactions to promote export initiatives. That’s a staggering amount of business going to yet another government agency — particularly considering this country derives 30% of its GDP from trade.

It is curious that two government agencies exist, let alone thrive, to finance risk markets in two such critical sectors of the economy. Why don’t the Big Six go after either niche more aggressively? Simple. They don’t have to.

To the Conference Board’s Hodgson, the way to wake up financial services in this country is clear. “We need to be more open to banks merging for scale, but also to letting in international competition,” he says. SNC-Lavalin Capital’s Bergevin agrees. “It’s time to free the market,” she says. “I don’t always believe free markets are the solution, but in this instance that’s what’s required.” Gord Nixon concurs. “Most economists would argue that consolidation should be allowed to occur,” he says, “but the flip side would be more openness with respect to the ability of foreign companies to play in this realm.” One federal Ministry of Finance economist who worked on the last merger file in 1998 offered a smart suggestion. “Flaherty should allow bank mergers,” he said. “But a condition of merging should be that each bank sell off a portion of assets to foreign competitors.” That way our banks could better compete abroad, while giving foreign competitors smoother entry to the domestic market.

So answers are out there. But the political climate isn’t even close to allowing deregulation of this kind. Finance Minister Flaherty made it clear, in the last round of revisions to the Bank Act this April, that he’s not interested in reopening the merger file. There’s been little serious discussion of freeing the market, either. However, judging by the concern over the economy’s performance generally and financial services in particular, some kind of comprehensive rethink is in order. And it may beforthcoming, once Bernier and Flaherty’s competitiveness panel tables its report next June.

In the interim, the status quo obtains. Despite impressive assets, Canada’s once mighty financial institutions will continue to position themselves as mid-size on Wall Street. (At present, they lag ING Group, ABN AMRO, Royal Bank of Scotland, Deutsche Bank and Credit Suisse in revenue. Currently, RBC’s nearest competitor by revenue size is the Bank of China.) And the public hand-wringing about the lack of Canadian global champions will also likely continue.

Venture capitalist Nicholas Parker likes to use a hockey analogy to describe the Canadian economy’s current malaise. “Someone once asked Wayne Gretzky why he was such a good player. He said, ‘I don’t look where the puck goes — I look for where it is going to go,’” Parker says. “That’s what Canada needs to do more of, and we aren’t doing it. We aren’t anticipating where the puck is going to be.”