One of the unique and unusual features of the Canadian bank regulatory system is that Canada regulates financial entities based on what they are rather than what they do. As a result, you can have two entities carrying on the exact same line of business and one will be highly regulated and the other will have very little regulation. The difference is the nature of the entities.
If the entity carrying on a financial services activity is Canadian, then it will be subject to bank-like regulation which will include capital ratios, concentration ratios, AML/ATF requirements and governance requirements. On the other hand, subject to my comments below regarding foreign banks, an entity that is not a Canadian bank, will not be subject to any regulation at this time.
The fundamental question is how do you differentiate a bank from a non-bank and the answer is surprisingly simple – an entity that is incorporated under the Bank Act is a bank and an entity that is not incorporated under the Bank Act is not a bank. There is no functional test, just an incorporation test.
This distinction is important with respect to two significant financial needs of Canadians. Namely, to obtain operating lease financing and to obtain uninsured high loan to value mortgages. Canadian banks are prohibited from carrying-on an operating lease business or an uninsured high loan to value mortgage business. Generally speaking, an operating lease is a lease where the collateral at the end of the lease term has a residual value greater than 25% of its cost of acquisition or a lease which imposes on the lessor owner-like responsibilities such as for maintenance, repair and insurance.
The second restricted business line is a high loan to value mortgage business. Generally speaking, unless mortgage insurance is in place, a Canadian bank cannot lend on the security of a residential property an amount greater than 80% of the value of the property.
As a result of these two prohibitions, Canadian banks have not been able to provide competitive operating leases or non-insured high loan to value mortgage lending.
Canadian bank regulation has a “level playing field” principle to the effect that, if a Canadian bank is prohibited from carrying on certain activities in Canada, then non-Canadian banks are also prohibited from carrying on those same activities in Canada.
As a result of the level playing field principle, a non-Canadian bank that carries on business in Canada is also prohibited from carrying on an operating lease business and an uninsured high loan to value mortgage business.
The level playing field rules also apply to “foreign bank groups” that carry-on business in Canada. As a general rule, a group will be considered to be a foreign bank group if more than 35% of its consolidated assets or 35% of its consolidated revenues relate to, or are derived from, entities that are real banks.
As a result of this 35% rule, financial entities that have banks in their families, but whose consolidated assets and revenues do not exceed the 35% threshold, are able to carry-on business in Canada without regard to the level playing field principles.
One foreign financial institution that has amassed significant portfolios in Canada consisting of what would be impermissible assets for banks is GE Capital. GE Capital has made a very substantial contribution to providing competitive financing in Canada to Canadians through lines of businesses that cannot be carried on by banks.
As it has been widely reported in the media, GE Capital has made a decision to divest itself of most of its financial assets and businesses. In Canada, banks, both Canadian and foreign, are acquiring some of these assets and businesses. However, the difficult legal issue for these banks in purchasing some of the assets is to find a way to purchase and maintain the assets and businesses which, although they were permissible assets or businesses for a non-bank entity like GE Capital, are not permissible assets for bank entities.
Each potential acquisition of these assets by banks face the same question – given the level playing rules, how can a bank acquire these impermissible assets?
Fortunately, a Canadian policy objective has come to the aid of the banks. Given the prominence which GE Capital had with these impermissible assets and businesses, the Federal Government appreciates that there would be a significant lack of competition in the market for Canadians who need to replace the operating lease financing and uninsured high loan to value mortgage financing which they have previously obtained from GE Capital. As a result, although it is unlikely that there will be any permanent and unconditional consents from the Department of Finance that would allow banks to maintain the impermissible assets or businesses for an indefinite period of time, there does seem to be a willingness to allow the banks to acquire and hold the assets or businesses for a limited period of time during which, hopefully, the banks can restructure the assets so that they are permissible for the banks and they will be able to continue to carry-on similar businesses to those which were carried-on by GE Capital. Certainly, Canadians need to have a continuation in this kind of financing.