Merger Enforcement Guidelines (Banks) - Evaluative Criteria

Merger Enforcement Guidelines (Banks) - Evaluative Criteria

71. Several of the key evaluative criteria listed in Section 93 of the Act play a major role at the market definition stage. However, once the relevant markets have been defined and market shares have been determined, it is important to also assess these factors in relation to each of the relevant markets where the merged entity's market share exceeds either the 35% threshold or the four-firm concentration level exceeds the 65 % threshold and the merged firm holds more than 10%, to determine whether the merging parties can sustain price increases for more than two years.

Foreign Competition

72. The assessment of foreign competition (section 93(a)), particularly important in the context of the globalization of markets, involves a determination of the extent to which foreign products or foreign competitors provide or are likely to provide effective competition to the businesses of the merging parties. To determine the constraining influence of foreign competition, a number of factors are considered, including the extent to which the effectiveness of foreign competition is likely to be hindered or impeded by domestic ownership restrictions.

73. For example, current regulations restrict the entry of foreign banks by requiring that they establish bank subsidiaries rather than simply operate through branches within Canada. The 10% ownership rule also limits foreign entry, and while this rule is typically viewed as a constraining factor on domestic mergers, it also serves to restrict the ability of foreign companies from acquiring a significant interest in Canadian financial institutions. Moreover, the extent to which foreign entry has been facilitated by technological change, particularly through the feasibility of electronic banking, is another factor considered in determining the constraining influence of foreign competition.

The Availability of Acceptable Substitutes

74. In addition to identifying which products compete with the products of the merging parties and therefore warrant inclusion in the relevant market or in market share analysis, it is necessary to assess whether the supply of these products would likely increase or be made available within a two year period in response to an attempted exercise of market power (section 93(c)). In this regard, an assessment is made as to whether:

i ) competing sellers collectively have, or could easily add, sufficient capacity;

ii) it is likely that the total supply of acceptable substitutes in the market will increase sufficiently; and,

iii) buyers are likely to switch a sufficient quantity of their purchases to acceptable substitutes

to ensure that a material price increase cannot be profitably maintained in the relevant market post-merger.

75. For example, although telephone banking services are available to most retail customers, other electronic banking services requiring a computer are not readily available to many households and small businesses at this time. Although the number of electronic-based transactions has increased substantially in the last decade and new products are continuously being introduced, customer acceptance may take longer than two years. As a result, these alternative means of delivering banking products may not represent a sufficiently widely available, acceptable substitute to the provision of the same banking products through branches such that they may not constrain a potential exercise of market power by the merging banks. This will be an important component of the Bureau’s analysis of any bank merger.

Barriers to Entry

76. Section 93(d) draws attention to “any barriers to entry into a market, including:

i) tariff and non-tariff barriers to international trade;

ii) interprovincial barriers to trade; and,

iii) regulatory control over entry

and any effect of the merger or proposed merger on such barriers”.

77. Examination of this issue is directed toward determining whether entry by potential competitors would likely occur on a sufficient scale in response to a material price increase or other change in the relevant market brought about by the merger, to ensure that such a price increase could not be sustained for more than two years. This generally involves an examination of

whether entry is likely to be delayed or hindered by absolute cost differences or the need to make investments that are not likely to be recovered if entry is unsuccessful (referred to as sunk costs).

78. When assessing whether entry is likely, the Bureau will give primary consideration to the profitability of entry. This takes into account the barriers that must be overcome in order to enter the market, and the potential profit opportunities created by the merger. The analysis focuses on whether entry is profitable at prices that are below the postulated, elevated post-merger level. ⁽²⁷⁾ The profitability, and therefore the likelihood, of sustainable entry depends primarily upon absolute cost disadvantages faced by the entrant, the degree to which start-up costs associated with entry are sunk, and the probability that entry will be successful.

79. The Bureau will conduct an analysis of entry conditions for each of the relevant markets in which it has been determined that, absent entry, competition would likely be lessened or prevented substantially as a result of the merger. When there are several such markets, as with a bank merger, entry may be more profitable, and therefore more likely, only when it is into several product or geographic markets. This may be the case if there are significant economies of scope that can be attained through the simultaneous offering of multiple products or through simultaneous entry into several geographic markets.

80. In assessing the extent to which future entry into banking markets would likely occur, the Bureau's analysis starts with an assessment of the likelihood of entry by banks, other deposit-taking institutions, and any other potential suppliers that appear to have an entry advantage. For example, when product markets are local, the likelihood that banks and other institutions that supply the relevant product in other geographic markets, or similar products in the same geographic market, will expand their supply of the relevant product in the relevant geographic market will be considered. Following this, the Bureau will turn to examining the likelihood by other potential entrants, such as non-financial institutions.

Absolute Cost Advantages

81. Incumbent firms can gain important cost advantages relative to potential entrants through a variety of sources. The Act highlights three sources of cost advantage that can present potential entrants with considerable, and in some cases insurmountable, barriers to entry. ⁽²⁸⁾ In the case of banking, there are several regulatory barriers to consider, including those pertaining to: other domestic financial institutions which are not Schedule I banks; domestic non-financial institutions; foreign banks; and other foreign financial institutions. The extent to which regulatory barriers to entry by foreign banks facilitate the exercise of market power in domestic markets is discussed in paragraphs 72 and 73.

82. Other potential cost advantages include control over access to scarce resources and influence over access to membership in cooperative ventures, such as Interac and the Canadian Payments Association.

Sunk Costs ⁽²⁹⁾

83. The term "sunk costs" refers to the proportion of the total entry costs which have continuing value if the firm stays in the market, but that are not recoverable if the firm exits the market. New entrants are often required to incur various start-up sunk costs, such as acquiring market information, developing and testing product designs, installing equipment, engaging new personnel and setting up distribution systems. In addition, sunk costs may be incurred by potential entrants when making investments in market specific assets and in learning how to optimize the use of these assets (these investments may include training personnel and obtaining information about local market conditions), overcoming reputation-related advantages enjoyed by incumbents, and/or overcoming disadvantages presented by the strategic behaviour of incumbents.

84. In the case of local banking markets, sunk costs may include establishing distribution facilities required for making loans or offering deposits and other banking products, and in establishing or expanding specialized computer systems, etc. In assessing the likelihood of entry, the Bureau will take into account developments in technology that may reduce sunk costs by allowing for the profitable use of a lower cost means of distribution that does not require a physical bricks and mortar presence. However, in keeping with the purpose of entry analysis, such prospective changes must be found to be both likely and sufficient to prevent post-merger material price increases. Where the available information suggests, for example, that a new entrant with a limited physical presence in the market is unlikely to gain acceptance by a significant number of consumers, such entry will not be considered to be sufficient to prevent a post-merger price increase.

85. In general, since entry decisions are typically made in an environment in which the probability of success is uncertain, the likelihood of significant future entry decreases as the proportion of total entry costs accounted for by sunk costs increases. The Bureau's assessment of sunk costs is focused upon whether the likely rewards of entry, the likely time required to become an effective competitor and the risk that entry will not ultimately be successful, taken together, justify making the sunk investments that are required.

86. Information about commitments that must be made and the time required to become an effective competitor can often be obtained by examining past entry attempts into the relevant market or other similar markets. However, evidence of past entry attempts will not, in itself, be taken to demonstrate that entry is likely to occur in the relevant market. Firms enter and leave markets for a number of reasons, and it will not be assumed that entry that may have occurred in response to changes in market conditions unrelated to the merger implies that entry sufficient to discipline a post-merger price increase will occur. The Bureau will generally conclude that a merger is not likely to prevent or lessen competition substantially where it can be established that, in response to the merger or to the exercise of increased market power resulting from the merger, sufficient entry into the relevant market would occur to ensure that a material price increase would not likely be sustained in a substantial part of the relevant market for more than two years.

Time

87. An important aspect of the assessment of entry conditions involves determining the time that it would take for a potential competitor to become an effective competitor in response to a material price increase or other change in the market brought about by a merger. In general, the longer the time required for potential entrants to become effective competitors, the less likely it is that incumbent firms will be deterred from exercising market power by the threat of future entry in the first place and the longer any market power that is exercised can be maintained. Account is also taken of whether the delay and losses that potential entrants expect to encounter before becoming effective competitors will likely increase the sunk costs, risk or uncertainty perceived to be associated with such entry, and thereby reduce the likelihood that entry will occur.

Effective Remaining Competition

88. Effective remaining competition is a broad concept that refers to the collective constraining influence of all sources of competition in a market, including those afforded by individual competitors, as well as foreign competition, available and acceptable substitutes, new entry and innovation. In this regard, an assessment is made of the nature and extent of forms of rivalry such as discounting and other aggressive pricing strategies, innovative distribution and marketing methods, product and packaging innovation, and aggressive service offerings that have been evident in the relevant markets. These and other forms of competition give rise to a competitive environment that contrasts sharply with markets where competitors accept stability or are content to follow attempts at price leadership or other initiatives of existing or aspiring market leaders. An assessment is also made of how existing competitors will likely respond to a merger, particularly in relation to their vigor and effectiveness in the marketplace. This analysis will take into account any proposed or likely mergers among remaining competitors, and how such transactions, if not challenged, would affect competition remaining in the relevant markets.

89. Where it is clear that the level of effective competition remaining in the relevant market is not likely to be reduced as a result of the merger, this alone will generally justify a conclusion not to challenge the merger on the basis that the merger will enhance the ability of the merging firms to unilaterally exercise market power. This is so whether the absolute level of effective competition in the market in question appears to be high or low.

Removal of a Vigorous and Effective Competitor

90. By assessing the competitive attributes of the acquired firm, more direct attention is drawn to what is likely to be lost as a result of the merger. A wide variety of factors can indicate whether the acquiree, either large or small, is or has been a vigorous and effective competitor, including its level of innovation, its role in the marketplace as price leader or price follower, its use of discounting or other aggressive pricing strategies, its role as a disruptive force in a market that appears to be otherwise susceptible to interdependent behaviour, its role in providing unique service to the market, or in helping to ensure that similar benefits offered by other competitors are not reduced.

91. Although competition is prevented or lessened to some degree when a vigorous and effective firm is eliminated from the relevant market through a merger, the removal of such a competitor is not generally sufficient, in and of itself, to warrant enforcement action under the Act. It must also be established that prices will be materially higher than in absence of the merger; i.e., there must also be findings unfavourable to the merger in terms of other factors, in particular, effective remaining competition and future entry.

Change and Innovation

92. Although already incorporated to some extent in evaluating the impact of the other section 93 factors, an analysis of change and innovation includes general dynamic developments in products, distribution, service, sales, marketing, buyer preferences, firm structure, the regulatory environment and the economy as a whole. The pressures imposed on remaining competitors in a market by the nature and extent of dynamic developments in any of these areas may be such as to ensure that a material price increase is unlikely to occur or will not be sustainable. The stage of market growth is also considered.

93. Although traditional banking is typically viewed as a mature industry, new developments in distribution and buyer sophistication have prompted changes to the way the financial sector operates. For example, the rising importance of electronic delivery of banking services may reduce the importance of a bank’s local branch presence, since buyers may readily access the services of more distant suppliers of financial services through electronic means. Electronically delivering traditional banking services is also a considerably less expensive means of distribution, and may allow for greater entry opportunities for firms not currently involved in Canadian financial services. In addition, with the evolution of leasing and financing companies, disintermediation may be displacing the traditional role of banks as the intermediary between the needs of lenders and borrowers. This and other trends are critical elements in determining the ability of the merging parties to exercise market power.

94. When a merger is likely to enhance or facilitate the maintenance of existing market power, representations regarding how the merger may be likely to give rise to innovation-related synergies and other efficiencies will be considered pursuant to section 96.

Business Failure and Exit

95. Section 93(b) draws attention to the importance of assessing "whether the business, or a part of the business, of a party to the merger or proposed merger has failed or is likely to fail". The opening clause of section 93 makes it clear that this information is to be considered "in determining, for the purpose of section 92, whether or not a merger or proposed merger prevents or lessens, or is likely to prevent or lessen, competition substantially". The impact that a firm's exit can have in areas other than competition are generally beyond the scope of the Bureau’s assessment.

96. Probable failure of a party to a merger is not sufficient to warrant a conclusion that the merger is not likely to prevent or lessen competition substantially. An assessment must be made of whether acquisition of the failing firm by a third party, retrenchment by the failing firm, or liquidation, would likely result in a materially higher level of competition in the relevant market than if the merger proceeded. The Bureau applies the same rationale when analyzing situations where a firm wishes to exit a market for reasons other than failure, such as unsatisfactory profits, or a desire by a diversified firm to focus its efforts elsewhere. Similarly, these considerations are equally applicable to failure-related claims concerning a division or a wholly owned subsidiary of a larger enterprise. ⁽³⁰⁾

97. At the same time, the Bureau recognizes that its analysis should not be blind to the unique circumstances that arise in a failing firm situation. The MEGs acknowledge that there are factors that serve to constrain the competitive implications of a merger involving a failing firm. First, the loss of the competitive influence of a failing firm cannot be attributed to the merger if the firm would have exited the relevant market in any event. Second, the extent to which the acquisition of a failing firm can increase the market power of the acquiror is often reduced as the failure of the former becomes increasingly likely, and as its relative market position weakens. Third, the likelihood that any market power effects that will materialize subsequent to the merger can be avoided through retrenchment or liquidation is reduced as the failure of the firm in question becomes increasingly likely.

98. Following receipt of full information, the Bureau generally requires up to six weeks to assess the extent to which a firm is likely to fail if the merger does not proceed. The time required to make this assessment will vary from case to case. Parties intending to invoke the failing firm rationale and/or anticipate that they may be required to undertake a search for a competitively preferable purchaser are encouraged to make their submissions/search as early as possible. As soon as the absence of a competitive preferable alternative is established, the assessment of the likely effects of the merger on competition becomes moot.

99. These time requirements may be a significant factor in the financial services market where delays may raise uncertainty about the deposits of customers. The Bureau has reviewed transactions in this sector where firms are in financial difficulty and it was able to complete its review within the time frames of the merging parties. However, the Bureau cannot always guarantee this outcome and it would encourage all parties who find themselves in these circumstances to approach the Bureau at the earliest opportunity. Firms may wish to consider consulting the Bureau at the same time as they advise OSFI of their status and the efforts they are making to resolve their financial problems. It will be important for the Bureau to consult with the Minister of Finance in these situations since this is a possible scenario for the Minister to use the override authority set out in section 94 of the Act to allow a merger that the Bureau would otherwise challenge.

Additional Evaluative Criteria

100. Finally, section 93(h) recognizes that other factors relevant to competition in markets that are or would be affected by a merger may also be assessed to determine the likelihood that a merger will result in a substantial lessening or prevention of competition. The likelihood that firms in a market will employ practices such as exclusive contracts, tied selling, and price discrimination, that may be harmful to competition is considered at this stage.

---

⁽²⁷⁾ Entry prior to the merger may not have been profitable because such entry would have reduced prices to below pre-merger levels.

⁽²⁸⁾ These three sources are: i) tariff and non-tariff barriers to international trade; ii) interprovincial barriers to trade, and; iii) regulatory control over entry.

⁽²⁹⁾ Further background information about sunk costs is contained in Appendix I of the Director's Merger Enforcement Guidelines.

⁽³⁰⁾ In assessing submissions relating to the failure of a subsidiary or a division, attention will be paid to: transfer pricing within the larger enterprise, intra-corporate cost allocations, management fees, royalty fees, and other matters that may be particularly relevant in this context. These allocations will generally be assessed in relation to the values of equivalent arm's length transactions.