Competition In Canada's Financial Services Sector

Notes for Remarks by George N. Addy
Director Of Investigation and Research
Competition Bureau

To The Canadian Life Insurance Conference

May 22, 1996

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Introduction

I would like to thank the Institute for International Research for inviting me. It is a pleasure for me to participate in this very timely conference.

You are clearly in for two days of stimulating and vigorous discussion. The economic, regulatory and policy issues Canadian life insurers face are numerous and key among them are increasing technological change and consolidation.

Today, I'll share my perspective on the debate surrounding the 1997 review of financial institutions legislation.

I also want to say a few words on the role of the Competition Bureau in protecting and promoting competition, with particular reference to how competitive forces should be allowed to determine market outcomes in this sector.

The Competition Policy Message

I would like to begin by drawing to your attention a recent ad in the Wall Street Journal by AMD, an American computer chip manufacturer. While I am not here to earn commissions on the sales of computer chips, the message is most appropriate for my talk today. It reads "Competition is a lot like cod liver oil. First it makes you sick. Then it makes you better."

The first policy building block is: competitive market forces should act as the fundamental driving force in our economy.

Sectors of the economy in which regulation restricts competition should be the exception, not the norm. In a mixed economy such as ours, it is essential to constantly re-assess the continuing need for, and the costs associated with, sector-specific regulation.

Why do I strongly favour the elimination of regulation in favour of competition wherever possible?

First, competition is better than regulation at creating incentives for innovation. It is better at encouraging the development of new products, services, and methods of doing business. Competition is also better than regulation at forcing participants to minimize the costs of bringing products and services to consumers.

This is particularly true in industries where rapid technological innovation creates opportunities to offer new products and services or to exploit new channels for distribution.

Second, competitive market forces drive the prices of goods and services toward their relative costs of production. This minimizes the misallocation of resources in the economy which in turn enhances economic efficiency, generating overall benefits for the Canadian economy.

The Bureau has a long record of advocating increased reliance on market forces for the provision of goods and services. We have done so not only in the financial sector but also in other sectors of the economy. Sectors such as yours, have undergone, or are undergoing, significant changes as a result of globalization and the information revolution. Among them are the telecommunications, transportation, energy, agriculture and professional sectors.

The message that the Bureau has brought to the table in each of these areas is always the same: The ultimate objective in the review of any existing regulation should be to remove the restrictions on competition and to do so as soon as possible. Only in this way can one realize the full potential of competition in the market and thereby benefit all Canadians.

In advocating this position, we do not play favourites. We don't pick "winners" and "losers". When confronting the issues arising from the transition from regulation to competition, our perspective is of the marketplace as a whole, not that of the individual participants in the marketplace.

There will inevitably be winners and losers as individual participants come and go. That is what the competitive process is all about. Those who become complacent, fail to innovate, offer poor service or higher prices for similar products, or fail to continually earn their place in the marketplace, will simply not survive. Nor should they.

By rewarding the best, we ensure that Canadian consumers, Canadian businesses, and the Canadian economy are the ultimate winners. This must be a cornerstone of Canadian financial sector policy.

The Competition Act and the Role of the Director

Objectives and Structure of the Act

I would now like to take a moment to discuss the Competition Act and the role of the Director. The objective of the Competition Act is to foster competition and rivalry in the domestic marketplace. The Act does not see competition as an end in itself. Rather, competition is a means to achieve dynamic efficiencies in the economy, which in turn provides competitive prices and quality products and services to Canadian industry and consumers. A competitive market will ensure that companies become more efficient and better able to compete at home and abroad.

Canadian competition law is framework law. It is intended to outline the rules of the game and intervene only selectively in the marketplace. The Director does not regulate business conduct. Business decisions are left to market participants. The Act merely defines what is allowable behaviour within the market.

The approach taken when the legislation was amended in 1986 boils down to one single theme: action should be taken when firms are able to exercise market power in ways which have an adverse impact on economic welfare.

Let me take a moment here to tell you what is meant by the notion of "market power". The most commonly used measure of market power is price. Simply put: can a company unilaterally raise price without the threat of competitive reaction.

Other measures of market power exist and include the ability of a firm to profitably influence quality, variety, service, advertising and innovation in a market. If a firm is free to exercise market power in any of these ways, it is introducing inefficiencies to the market.

The Competition Act incorporates both criminal and civil law. Criminal law matters are unambiguous in the harm they do to a well functioning marketplace. The criminal prohibitions target activities such as bid rigging and conspiracies such as price fixing. The criminal provisions also target a variety of other activities such as price maintenance, misleading advertising and predatory pricing.

The civil provisions of the Act, unlike criminal offences, address matters which may have different competitive impacts depending on the circumstances.

For example, mergers may be either neutral, good (pro-competitive) or bad (anti-competitive). They require a sophisticated consideration of their potential economic effects, a consideration which does not lend itself to the criminal process. The civil provisions address matters such as mergers, abuse of dominant position, exclusive dealing and tied selling.

The role of the Director

Investigative as well as enforcement responsibility is vested in the Director of Investigation and Research. The Director is an independent law enforcement official. The Director is responsible for both civil and criminal investigations. He and his officials investigate criminal matters and refer them to the Attorney General for prosecution. Civil matters are brought before the Competition Tribunal for adjudication. The Tribunal has the authority to order the divestiture of assets or shares or to order the prohibition of specific anti-competitive practices.

In addition to enforcement, the Director has a statutory right to intervene before federal regulatory boards, tribunals and other agencies to make presentations concerning competition. He may also apply to appear before provincial boards for the same purpose.

The Director also has an important policy role as advisor to the government on competition matters. The Director routinely provides his views to the government on the competition policy implications of proposed policy initiatives.

It is in this capacity that in February of this year I provided the Department of Finance with a confidential submission. In it, I set out my views on some of the competition issues arising from the current debate over the 1997 financial sector legislative review.

While the submission was confidential, you will gain an understanding of my views from my comments today. I fully expect to comment further on these issues when the White Paper is finally released. My core message will be that competition is the most effective form of consumer protection.

Financial Sector Regulation

The financial services sector plays a very important role in facilitating economic growth and prosperity by channelling funds from savers to investors. The more competitive and efficient is this intermediation process, the more likely it is that funds will be made available and allocated according to their highest valued uses.

It is important that government policy strive to establish a framework which fosters a dynamic, innovative and efficient financial system.

Stability of the financial system is generally recognized as the paramount goal of financial market regulation. It is recognized too that stability may come at the expense of some competition policy goals. Nevertheless, some regulatory changes can increase flexibility and facilitate competition without compromising the stability and solvency of the financial system.

There are three areas where reform would be important from a competition policy point of view: restrictions on the business powers of specific financial institutions, the payments system, and entry restrictions on foreign banks.

The 1992 amendment package went a great distance in removing the major regulatory restrictions that prevented cross pillar competition. The removal of most of the ownership restrictions among the financial pillars and the broadening of the business powers of certain institutions has opened the door for a more competitive and more efficient market. Regulatory barriers, however, continue to exist.

The general trend is clearly toward liberalization of financial sector regulations. This is the right direction to be moving in. From a competition policy perspective, entry by deposit taking institutions into direct personal property leasing and the retailing of insurance would be positive. Enhanced competition resulting from such entry would benefit consumers in both of these markets and promote greater efficiency. There is no competition policy rationale to support continued restrictions on leasing and retailing insurance by banks.

I can already see peoples' hands going up with questions, so let me try to address some of the concerns that have been raised by the insurance and leasing industries on this point. Both insurance agents and automobile dealers have unique advantages to offer consumers that will help them remain a viable competitive force in these markets.

One of the arguments frequently made is that bank entry into insurance will drive agents out of business. At the same time, the insurance industry argues that banks will not be able to provide customers with the level of service available from an agent. These statements are contradictory. Should consumers demand the level of service available from agents, it will be the banks, and not the agents, that will fail.

Also the traditional insurance companies that sell through agents are being threatened now by insurance companies that sell directly to the consumer. It seems to me, and I suspect many among you would agree, that the insurance industry has no choice but to adapt to new forms of competition whether from existing members of the industry or new entrants.

In my view, it is those companies that better meet the consumers' demand that will survive and prosper. It should be the market that decides, not a regulator.

Some also suggest that banks will buy a dominant market share and then use that position to give away services in a predatory fashion until they have captured all of the market. There are two points to make here.

For the banks to successfully act in a predatory fashion would require them to act in concert - a criminal offence under our legislation that carries a maximum fine of $10 million. Such co-ordination is necessary because predatory conduct requires that you be able to control the amount of supply of the product that you are discounting. Predation also requires significant barriers to entry for future entrants, otherwise you can't raise prices to recoup the losses incurred while predating. Unless you can be assured that no one will enter and force you to lower prices later, predation is irrational corporate behaviour.

For these reasons, it is exceptional to find examples of successful predatory practices anywhere in the economy. Even the courts have recognised that what many people call predatory behaviour is really aggressive competition.

I strongly favour increased competition in the traditional markets of the deposit-taking institutions. I also believe that the insurance industry is well placed to provide some of this competition. I strongly favour reducing the barriers which currently make it difficult for insurance companies to compete on a cost-effective basis with banks.

This leads me to the payments system. In a sense, the payments system is the nerve centre of the Canadian financial sector.

Providing market-based incentives for the efficient evolution of the system to better manage risks and, where appropriate, implement new technologies, is a key challenge for policy makers. Direct access to the system is increasingly seen as a strategic tool and as a source of competitive advantage in the marketing of a wide range of financial services.

The structure and governance of the payments system need to be reviewed, bearing in mind the following objectives:

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1)promoting competition in the provision of payment services

2)expanding access to the system by firms other than deposit-taking institutions

3)putting in place mechanisms to ensure the optimal evolution of the system.

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Our experience in the Interac matter has highlighted the importance of access to the payments system as a strategic factor affecting competition throughout the financial sector.

In addition to accessing shared electronic network services used for financial services transactions, access to clearing and settlement functions is of critical importance. In fact, during the Interac hearings I acknowledged that dealing with the Canadian Payments Association is fundamental.

In this regard, I welcome the opportunity the present legislative review offersto study how best to effect the needed payments system reforms. I look forward to participating in this review to address the three objectives I just identified.

Lastly, restrictions on foreign banks is an area where, although much progress has already been made, there is still room to move further. Relaxation of remaining restrictions on the entry of foreign banks into the Canadian market would strengthen competition and facilitate access to capital by Canadian businesses.

So much for my views on reforming financial institutions legislation. Now I would like to comment on what others have had to say about a subject that relates directly to our work: concentration and dominance.

Throughout the years of debate on reforming financial institutions legislation, recurring observations and predictions have been made about the state of competition, concentration, and dominance in the financial services sector. Much of this commentary has focused on the impact that the reforms will have on bank dominance in the financial services industry.

Two issues are continually raised in the debate.

The first is the notion of size - for example, much has been made of the major banks' share of the Canadian financial industry's total assets, especially when compared to the share accounted for by others, such as the major life insurance companies.

The second issue is the question of concentration - there are only six large banks as compared to 100 plus life insurance companies.

From a competition policy perspective, these are not issues that we should be concerned about and by continuing to focus on them, we only serve to confuse matters further.

Let me return to some first principles. For a long time, there was a widespread concern about the level of corporate concentration, especially in the Canadian economy. The theory was that high levels of concentration would result in a lessening of competition as the markets became controlled by only a few players. Over the last ten to fifteen years, these theories have lost their favour.

It is now recognized that there are other elements of competition that exist and that these can successfully promote competition within a concentrated market. Aggressive new entrants are able to succeed over older established players by offering innovative products or marketing styles. This forces the incumbents to re-examine their approach as market shares crumble and corporate heads roll.

This explains why anti-trust officials around the world now focus on the ability of a party to exercise market power within a specific product market when trying to determine the state of competition.

In an effort to highlight this, the merger provisions of the Competition Act were amended in 1986 to include a specific reference to the fact that a merger will not be found to prevent or lessen competition substantially based solely on evidence of market share or concentration. Other elements of competition must also be taken into consideration, such as the existence of entry barriers, the role of foreign competition and the availability of substitutes.

The importance of these factors, and particularly the role of entry barriers, stems from a concern that the ability to exercise market power in a concentrated market is intensified as entry barriers increase and as the availability of close substitute products diminishes.

If entry barriers are low, even dominant firms will have to price at competitive levels and be dynamic and innovative. If they are not, new firms will enter and undercut their prices and fill product or quality gaps.

If customers have easy access to close substitutes, firms in concentrated markets will have to behave competitively, even in the short-run, if they are to avoid losing their market to these substitutes. These are the types of competitive pressures that keep the market honest.

From an economic perspective, concentration remains an issue only as it relates to concentration in specific product markets. Why? Because product market concentration makes it easier to co-ordinate behaviour in order to exercise market power.

Similarly, absolute size is not an issue except as it may relate to entry barriers - more specifically, the types of sunk costs a new entrant may face when trying to enter to compete with a large incumbent.

Nevertheless, these two arguments continue to be raised in the debate over financial sector reform in Canada. As a result, the evidence that has been put on the table in support of various positions has been equally muddy. For example, in my view, the use of aggregate industry assets does not provide any useful measure of the market power of the banks in the financial services sector.

From a competition policy perspective, the proper question is whether the banks, either individually or as a group, have market power in individual product markets and use it to suppress competition.

We can't begin to properly discuss concentration, dominance and competition until we properly define the relevant markets. From an economic perspective, this incorporates two dimensions - the relevant geographic market and the relevant product market. This is the starting point for much of the analysis we do under the Act.

It is a complicated procedure and I won't bore you with the mechanics of how we determine the boundaries for each market. Nonetheless, allow me to illustrate the differences between what I call the "corporate concentration" approach and the "competition" approach that the Bureau would take.

Using information from the Bank of Canada Review as the source, my staff prepared some rough estimates to try to portray the aggregate "business loans and financing market" in Canada.

Using November, 1995, as the basis, the banks had 67% of this market, other non-financial institutions had 13%, life insurers had 11%, finance companies had 5%, credit unions had 3% and trust and loans companies had 2%. But before using these numbers to determine whether the banks are dominant or have market power,let us consider the true nature of the market that we have tried to describe here.

The activity of business financing is a diversified one. Business financing can take the form of short-term demand and term loans, medium- and long-term debt financing and equity financing.

These products are available from various financial intermediaries including banks, trust companies, credit unions or insurance companies. They are also available through the securities industry in Canada and abroad. And this does not include any measure of the debt or equity markets.

If the market is broadened to include these sources of financing, the corporate debt and equity markets account for 50% and the banks drop to 34% of the market.

All this to say that not all measures are relevant or appropriate for competition analysis.

From this, it is obvious that the so-called "business loans and finance market" is, in reality, a spectrum of diversified markets. Each of these different markets can involve a different mix in terms of the size and types of buyers and sellers involved, their degree of participation and the variety of financial instruments which is made available to them. As a result, any assertions that the banks dominate the market must first be clarified by defining what market you are referring to.

Let me return to the question of concentration I raised earlier: how many firms in a market is enough. It is generally true that a high level of market concentration makes co-ordination of activities and therefore collusion relatively easier. But this does not change the fact that it should be left to market forces to determine the number of firms in a market, not regulators.

Throughout the debate on bank dominance, reference has been made to the dominance of "the banks". This suggests that the major banks co-ordinate their activities so that they act as one. I am not aware of any evidence to support this conclusion. Except for their actions in the Interac file, I have no basis for concluding that the banks are not acting independently and in competition with each other.

Nevertheless, I strongly support the removal of any artificial barriers that insulate the banks from competition, including access to the payments system. While 10 deposit taking institutions may be a nice number, in my view there is always room for improvement. At the same time, I see no reason on the life insurance side not to move from 110 suppliers to 115 or 120 suppliers.

This ishow, in my view, one should go about assessing the levels of concentration and dominance in specific markets.

As you can see, the issue is not as simple as some may suggest.

Furthermore, past discussions on this topic in the financial sector have been frustrated by the lack of relevant data. Although information on the assets or other size parameters of various financial institutions is readily available from public records, information on their individual lines of business is generally not available.

If we are to properly measure the degree of concentration and dominance in any market, it is essential that we have a sound analytic framework and relevant empirical data about the nature of the instruments and players in the various market segments.

In this regard, I was encouraged to learn that Senator Kirby, Chairman of the Senate Banking Committee, had asked the different parties to the current debate to collectively prepare a report summarizing the levels of concentration and a number of other factors affecting concentration in Canada and in other jurisdictions.

Unfortunately, I understand that certain participants in the proposed study lost interest following the announcement in the Budget Speech that retailing insurance through bank branches would not be allowed at this time. I believe this study should be continued as it will be a useful tool in the current and future rounds of this public debate.

Conclusions

The reform package in 1992 has gone a long way to removing the artificial barriers that had for too long existed between the different pillars of the financial community. Barriers continue, however, and I welcome the opportunity to review them in light of current economic thinking and the current market circumstances.

Regardless of the recent announcements by the government over its intentions on bank entry into insurance and the rumours over the car leasing issue, I suspect that the public debate on these issues will continue. I would urge the parties to the debate to renew their efforts to compile some meaningful data. Only in this way can the policy makers make an informed decision about the claims and counter claims that are being put forward by the different players in the industry.

As I noted at the outset, my intent today was to provide you with some insight into my views on the issues on the table. As the debate continues, let me leave you with one thought - while I may not be making a commission on the sale of computer chips, I might suggest that you consider investing in cod liver oil futures. Competition can improve your health.

Thank you.