On August 11, 2017, the Department of Finance Canada issued a second consultation document requesting input on the Federal financial sector. This is the second stage of a two-stage consultation process, and comments on this stage are to be provided by September 29, 2017.
Please refer to our Bulletin on the Department of Finance First Consultation Paper of August 26, 2016. Based on comments on the First Consultation Paper from a wide range of stakeholders, it was clear that greater access, choice, competition and innovation in financial services are desired.
By way of background, one of the unique features of the primary statutes governing Canada's federal financial institutions (Bank Act, Trust and Loan Companies Act, Insurance Companies Act and Cooperative Credit Associations Act) is that they all contain a "sunset clause" – a provision that permits these financial institutions to carry on business for only five years at a time. The rationale for this time horizon is that it forces Parliament to review the financial institution statutes at regular intervals. The most current sunset date is March 29, 2019.
The second consultation document is a significant 30-page document that is divided into five segments, each with a series of background comments, suggestions and request for further comments. What is interesting about the ambitious content in this document is that the Department does tamper expectations as it indicates in its Preface that it "is consulting on potential policy measures that could lead to consideration of legislation in Parliament prior to the statutory sunset date of March 29, 2019, or inform the Department's longer-term approaches to the financial sector". As will be seen below, this caveat is clearly appropriate given some of the significant and politically charged reforms for which comment is requested.
In particular, the Department seeks input for the 2019 update on clarifying the fintech business powers of financial institutions, facilitating fintech collaboration; and streamlining the bank entry and exit framework. The comments regarding earthquake risk are also notable given that a particular focus of comments on the First Consultation Paper was on the risk of a low probability, high severity earthquake and the consideration of what needs to be done for the property and casualty sector to be stable and more resilient.
The following is a summary of the major topics in the second consultation document.
Clarifying the Fintech Business Powers of Financial Institutions
The number one ask of Canada's banks in the upcoming legislative review is to deal with the restrictive statutory language in the Bank Act that is seen as an impediment to their ability to offer expanded fintech services. By way of background, banks are permitted to engage in the "business of banking" (i.e., financial services) as their core business power and there are significant restrictions around their ability to conduct commercial activities other than financial services. In the early 1990s, a restriction was placed in business and powers provisions of the Bank Act that required a Ministerial consent before a bank could engage in a number of information and technology activities. In simple terms, the purpose behind these provisions was to ensure that banks did not morph into technology companies and remained in their core business. However, as technology has dramatically altered the manner in which banks provide and could provide their banking services in ever expanding and innovative ways, the statutory provisions no longer work and in fact are often an impediment to innovation in this space.
Accordingly, the Department is seeking views on whether to clarify and modernize the type of information and technology activities that federally regulated financial institutions are permitted to undertake in-house, while maintaining the long-standing prohibition on commercial activities.
Facilitating Fintech Collaboration
Just as the current statutory wording in the financial institutions statutes is an impediment to offering expanded fintech services, other provisions of these statutes restrict a number of interactions between a financial institution and a fintech company – examples of which are the need for statutory powers which do not restrict, and instead permit activities such as: (i) collaboration between financial institutions and a fintech company; (ii) greater flexibility for investments in fintechs by financial institutions; (iii) referrals by financial institutions to fintechs; and (iv) arrangements where fintechs provide outsourcing services to financial institutions.
The Department is seeking views on providing federally regulated financial institutions with additional flexibility to make non-controlling investments in fintechs and the corresponding authority to make referrals.
The Government is committed to working with provincial and territorial regulatory authorities to co-ordinate and share information for regulatory transparency reasons. It will also continue to provide fintechs with more information on the regulatory framework, including regulatory contact information, with which they interact to also be transparent and assist fintechs to grow and succeed.
Encouraging Small and Mid-sized Banks and Streamlining the Bank Entry and Exit Framework
In order to enhance competition in the retail banking space, the Government has, through a number of statutory changes to the Bank Act, encouraged the creation of small and mid-sized banks. Over the last 15 years, we have seen a number of new banks successfully emerge that serve consumers, particularly in the credit card and mortgage spaces, as mono-line banks offering only one or a few limited products. However, since the financial crisis, there have been increasing complaints by new entrants that the process of creating and being in a position to operate a new bank is not transparent enough and that the process is too long, complex and costly. In addition, small and mid-sized banks, particularly those that offer only one or a few products to their customers, complain that they face challenges due to a proportionately higher regulatory burden and capital expectations relative to their larger counterparts, and are of the view that these requirements are not reflective of the overall stability risk posed by small and mid-sized banks. While OSFI has introduced a number of measures to address both of these issues, new entrants and industry participants remain very concerned about these matters.
Against this backdrop, the Department is seeking views on how best to ensure that small and mid-sized banks can participate in enhancing the innovative and competitive potential of the Canadian economy. The Department recognizes that they often target different areas and market segments, whether by product and/or market, and notes that they can deliver more affordable and innovative financial services to customers. The Department has also indicated that it will also take this opportunity to seek views on whether to undertake a series of targeted refinements to streamline and promote a smooth entry and exit process on a number of fronts, including for fintechs. In particular, they suggest that the number of officers a newly incorporated federally regulated financial institution may remunerate could be increased to better meet OSFI's prudential expectations around designated officers and that the Superintendent could be provided with the authority to extend the period to issue an Order to Commence and Carry on Business in exceptional circumstances. This latter suggestion is made because the statutes provide that there is a time limit of one year between the date the financial institution comes into existence and the date the Order of the Superintendent is given allowing the institution to commence and carry on business. In the current application process, many applications are taking more than that one year period.
Examining the Merits of Open Banking
The consultation document notes that new technologies and business models transform the ways in which Canadians interact with their financial service providers and also contribute to an innovative and competitive financial sector. Accordingly, the Department intends to examine the merits of open banking - a framework under which consumers have the right to share their own banking information with other financial service providers. The document goes on to note that open banking holds the potential to make it easier for consumers to interact with financial service providers and increase competition and that it is also an area that stakeholders, including fintechs, identified as key to encouraging innovation in the sector.
Consumer Protection - A New Consumer Code
The Federal Government has been increasing its oversight of banks in the consumer protection and payment fields over the last several years by enacting new consumer protection measures under the Bank Act and entering into voluntary codes with the financial services industry. Many years ago, the Government signaled its intention to introduce a comprehensive federal consumer code which would apply to all federally regulated financial institutions – banks, federal credit unions and foreign bank branches. While this objective may have still been several years in the making, its importance was accelerated as a result of the decision of the Supreme Court of Canada in a series of three cases known as Marcotte.
By way of background, Canada's Constitution provides that the regulation of banking is exclusively a federal matter, but the provinces also have a recognized jurisdiction over general consumer protection. For decades, the conventional wisdom has been that where a consumer protection disclosure provision exists under the Bank Act, and the regulations under it, any similar provincial consumer protection disclosure requirement does not apply to a bank. In September 2014, the Supreme Court of Canada released its decision in Bank of Montreal v. Marcotte, dealing with the question of which level of government has constitutional authority over consumer protection issues involving banks. In this decision, the Supreme Court of Canada adjusted the balance of federalism by holding, for the first time, that the provincial consumer protection legislation can apply to bank's consumer contracts even if those provincial provisions overlap with the federal legislative scheme applicable to the same contracts.
There is no question that as soon as the Marcotte case was released, it was considered the most significant court ruling affecting banks in decades. The financial services industry was stunned by the decision. For Canada's banks, it meant having to consider the thousands and thousands of provincial and territorial consumer protection provisions and decide, for each and every one of them, what those provisions meant as against the federal ones. This task was made even more difficult because while many of the provinces have similar consumer protection legislation, none of them are identical, which means there are 13 different statutes to be considered and compared to each other in addition to the federal law. From a legal perspective, many of the provisions are in conflict with each other, and many of them are impossible to comply with. In addition, there are many irreconcilable provisions. On a policy level, it meant that if the provincial law did apply, banks could no longer deliver the same financial services and products to customers on a national basis. There would be a patchwork of rules on a province by province basis and still it would be impossible to comply with all.
In the fall of 2016, the Government introduced a series of amendments to the Bank Act in its budget bill - Bill C-29. The three main purposes of Bill C-29 were to: (i) add strong language to the preamble of the Bank Act and add new purpose and paramountcy clauses, all of which were targeted at enhancing the argument that only the federal government and not the provinces may regulate banking products and services (i.e., a response to Marcotte); (ii) consolidate the consumer protection provisions of the Bank Act into one new section, further enhance those provisions and set out principles on which the new consumer provisions was to be based; and (iii) enhance the provisions of the Bank Act in the areas of corporate governance, business practices, public reporting, disclosure of information and access to basic banking services.
However, when Bill C-29 reached the Senate, some senators took issue with the proposed amendments to the Bank Act that were intended to enhance the argument that only the federal government and not the provinces may regulate banking products and services. As a result, the proposed amendments to the Bank Act were withdrawn from Bill C-29, and the remainder of the budget bill was passed. The Minister of Finance referred the whole issue to the FCAC and asked the Commissioner of the FCAC to examine best practices in financial consumer protection across Canada.
The consultation document indicates that the Government is committed to the principle of improving consumer protection for bank consumers but unfortunately, the question of if, how and when the uncertainty created by Marcotte will be resolved for Canada's banks remains unclear.
Specialized Infrastructure Investment Powers for Life and Health Insurance Companies
The background document notes that federally regulated life and health insurers have traditionally relied on fixed income investments (e.g., government and corporate bonds, mortgages) to build their asset portfolios to meet their long-term insurance policy obligations and that in adapting to a low-yield environment, life and health insurers are increasingly looking to alternative investments such as infrastructure.
Accordingly, the Department is seeking views on whether to provide federally regulated life and health insurers with additional investment powers in infrastructure. The Department is also seeking views on the conditions that should be applied to additional infrastructure investment powers of life and health insurers so as to protect policyholders and maintain the long-standing limitation on commercial investments.
Under the heading of corporate governance, the Department has asked for comment on a number of areas:
- the implementation of a "comply or explain" model to promote the participation of women on boards of directors and in senior management;
- eliminating staggered director terms and establish annual elections with fixed, one-year terms to increase director accountability for corporate performance and allow shareholders to voice their views more frequently;
- prohibiting slate voting and mandating individual director elections in order to allow shareholders to express their support or opposition for directors on an individualized basis;
- whether, in an uncontested election, where the number of available director seats equals the number of nominees, candidates would require more votes in favour of their candidacy than against them in order to be elected (or re-elected) to a board;
- permitting the use of the "notice and access" system as established by provincial-territorial securities regulators which allows companies to notify shareholders of a meeting and the means to gain access to essential material without sending an entire information package at the outset; and
- prohibiting the use of bearer shares and bearer share warrants to safeguard the integrity of federally regulated financial institutions against money laundering and terrorist financing.
Repeal of the Cooperative Credit Associations Act
As there are no longer any active institutions currently subject to the Cooperative Credit Associations Act, the Department is seeking views on the merits of maintaining or repealing that Act.
Limitations on Using the Terms "Bank," "Banker" and "Banking"
The Bank Act has long contained significant prohibitions on the use of the terms "bank," "banker" and "banking" by any person other than a bank. The policy behind this prohibition has been the significance of what it means to be a bank and that it is therefore important that consumers know when they are dealing with a bank, rather than another type of financial service provider. The prohibition in the Bank Act applies broadly, including to all prudentially regulated non-bank deposit-taking institutions (e.g., provincial credit unions and trust and loan companies), securities dealers and brokers, and other financial services providers, such as financial technology companies. Even though these statutory provisions have existed for some time, there has been a slow increase in the use of words and phrases such as use of the word "bank" as a verb and the term "banking" to describe activities and the services provided to Canadians by non-bank financial services entities, such as by having online "banking" websites or using the marketing phrase "come do your banking with us,".
On June 30, 2017, OSFI issued Advisory 2017-01 which set out how OSFI interprets and administers the Bank Act restrictions on the use of the words "bank", "banker" and "banking", and the exception to these restrictions that applies where the use of the words is not in relation to a financial services business. OSFI issued the Advisory to provide clarity regarding its interpretation of the Bank Act restrictions. OSFI set out an implementation period for compliance by those who were in contravention of the statutory provisions. There was much coverage in the press regarding this Advisory and representations were made to the Minister of Finance, particularly by credit unions, who indicated that they believe they would be competitively disadvantaged unless they are allowed to use banking-related terms to describe their business activities.
With the release of the second consultation document, in an unprecedented move, OSFI suspended application of its Advisory pending the outcome of the consultation by the Department on the question of whether prudentially regulated non-bank deposit-taking institutions should be given flexibility to use the terms "bank" or "banking" to describe their activities and services in appropriate circumstances.
Safeguarding a Stable and Resilient Sector
The consultation document notes that a stable and resilient financial sector is critical to a healthy Canadian economy, and that in response to the global financial crisis the Government endorsed a G20 plan to make the global financial system more resilient to reduce the likelihood and potential severity of future crises. To that end, the Department has sought input on a number of areas:
- earthquake insurance – consideration of how to limit the system-wide risks an extreme earthquake could pose to federal property and casualty insurers. The consultation paper said "The property and casualty insurance sector is concerned about their ability to cope with low-probability high-impact earthquakes.". What is not said is there is a widespread belief that the Government needs to play a role in providing financial resources to provide for this risk and, unlike other Western world Governments, is not doing so. This sector is at least being candid to say that, depending on the severity of the earthquake, the industry may not be able to meet the claims made or could not survive;
- insurance resolution framework – assessment of whether additional measures should be taken to preserve financial stability in the unlikely event of a major life insurer's failure;
- cyber risk – assessing the legislative and regulatory changes that might be needed to create a new cyber security strategy that is forward-looking, enduring and responsive to a continually changing cyber security environment and make Canada a global leader in the provision of cutting-edge cyber security technology and the use of these technologies to promote safe and secure services to the global marketplace; and
- climate risk disclosure – improving disclosure of climate related risks.
Technical Amendments – Modernizing the Framework
The consultation document seeks input on a number of technical matters:
- OSFI publication requirements - what information about federally regulated financial institutions should OSFI publish on its website;
- transactions of public interest - in connection with transactions that require Ministerial or Superintendent consent, should the list of such approvals that require advance publication in the Canada Gazette be increased;
- unclaimed balances - whether to modernize the administration of unclaimed balances under the Bank Act;
- nuclear insurance – to address nuclear capacity shortages, there was an exemption to allow nuclear insurance to be provided from abroad by foreign insurers. The regulation of international reinsurance has since remedied this issue, making the exemption unnecessary. It would be appropriate to subject nuclear insurance to the general foreign companies regime and repeal the nuclear insurance exemption contained in Part XIII of the Insurance Companies Act. This change would provide greater regulatory consistency;
- place of records - whether to allow foreign insurers to hold records in Canada at a location other than the location of the chief agency of the foreign company. We have given opinions that a separate, secure, limited access technology centre, to which OSFI would have access if needed, is a part of a chief agency, a branch. But an amendment to make this clear would be helpful;
- structured settlement agreements - whether to allow property and casualty insurers and marine insurers to assume the periodic payment obligations associated with three-party structured settlement agreements. This potential change would provide greater regulatory consistency and would facilitate the reinsurance of three-party structured settlement agreements;
- increases in significant interest - whether to exempt persons who already control a federally regulated financial institution from having to seek Ministerial approval for indirect increases in their share ownership. This potential change would eliminate the need for an approval where a controlling shareholder merely increases their significant interest;
- electronic meetings - the appropriate conditions for increasing electronic participation in meetings so long as access to a physical meeting in Canada is provided;
- advanced voting (electronic or otherwise) - whether to clarify the rules regarding advance voting and how this may impact current practices, including determining record dates and notice of meetings;
- proposals by members of a Federal credit union - whether a threshold ought to apply before members of a federal credit union can bring forward a proposal, and what type of threshold would be appropriate;
- access to Federal credit union membership lists - whether to continue allowing members automatic access to FCU membership lists in support of transparent communication or whether access should only be provided on request;
- related-party regime - expanding the scope of the definition of "related party" (i.e., persons who are in positions of influence over a federally regulated financial institution) to include, as related parties of a federally regulated financial institution: (i) a person who holds a non-controlling significant interest in an entity that controls a federally regulated financial institution (would also apply to spouses, common-law partners, children under 18 years of age of that person, and entities controlled by the person or family members); and (ii) an entity controlled by an entity in which a person (including their spouse, common-law partner or child under 18 years of age) who controls a federally regulated financial institution has a substantial investment;
- related party regime – Insurance Companies Act - expanding the application of the related-party regime to the following entities under the Insurance Companies Act: (i) parents of insurance companies incorporated in Canada that are currently exempted from related-party status because the parent is a foreign company with branch operations in Canada; and (ii) subsidiaries and substantial investments of foreign insurance companies. These potential changes would ensure that transactions between these entities and a company, or foreign company, are subject to the related-parties rules, including providing OSFI with the authority to approve certain transactions for which no approval was previously required;
- related parties - permitted credit exposures - whether to reduce the current limit permitting directors, officers and their interests to undertake transactions with a federally regulated financial institution representing up to 50% of regulatory capital of the institution to 25%. This potential change would bring the exposures for these related parties in line with OSFI's expectations regarding large exposures for domestic federally regulated financial institutions;
- approvals for "Substantial Investments" - whether to realign the scope of Superintendent approvals to better match the administrative burden to prudential risks through the following potential changes: (i) establishing a materiality threshold for Superintendent approval of the acquisition of unregulated entities, up to 2% of the consolidated assets of the acquirer; (ii) eliminating Superintendent approval where a federally regulated financial institution acquires control of a limited partnership investment fund (that is not a mutual fund entity or a closed-end fund) only because it controls the general partner of that partnership. This potential change would recognize that limited partners, and not general partners, are exposed to a fund's market or credit risk; and (iii) requiring Superintendent approval for the acquisition of control of a factoring or financial leasing entity, subject to the materiality threshold. This potential change would make the federal framework more consistent, as these entities can pose credit risks similar to those posed by finance entities, where Superintendent approval is currently required;
- Mutual Fund Distribution and Real Property Brokerage Entities - in the case of "mutual fund distribution entities" and "real property brokerage entities" the merits of removing the principal and primary tests that are part of the definitions for these entities, and requiring these entities to exclusively engage in authorized activities, consistent with the rules for other unregulated entities;
- reclassification of investments - whether to clarify that when a financial institution reclassifies an investment, it would be deemed to be acquiring the investment at the time it originally made the acquisition. At the moment, the federal framework permits a federally regulated financial institution to reclassify the category under which it holds an investment (e.g., specialized financing, temporary investment), subject to meeting the requirements of the new category. A reclassification resets the period over which the investment can be held. For example, reclassification into the specialized financing category would allow the investment to be held for an additional 13 years. This allows federally regulated financial institutions to hold investments for longer than the framework intends;
- indeterminate extensions - whether to eliminate indeterminate extensions for certain categories of investments (i.e., temporary investments, loan workouts, realization of a security interest) that may currently be held for a temporary period and instead to reclassify the investment under the "permitted entity" category, which would make it subject to the normal statutory framework (e.g., approval or control requirements);
- frequently traded and easily valued assets - whether to narrow the scope of the circumstances under which a federally regulated financial institution must seek Superintendent approval when undertaking a large asset transaction (i.e., over 10% of assets) so that certain types of large asset transactions, involving assets considered to be "frequently traded and easily valued" (i.e., government securities, money market instruments, and other widely distributed debt securities), are exempt from this approval so that the Superintendent is only required to review transactions involving significant financial risks, which may not have been contemplated when the exemptions were drafted, such as collateralized debt obligations and credit default swaps; and
- Canada Deposit Insurance Corporation's claims in liquidation - whether to change the Canada Deposit Insurance Corporation Act to clarify that the liquidator of a CDIC member institution has no right to apply set-off against a claim related to insured deposits. This potential change would protect CDIC's ability to recoup the full payment of insured deposits made to depositors. Under the Winding-Up and Restructuring Act, the liquidator of a failed financial institution has the right to apply set-off on claims. This allows the liquidator to reduce the amount of claims of a party by the amount of debt that party owes to the estate of the failed institution. In a liquidation, CDIC would pay out on insured deposits to depositors and would then submit a claim to the liquidator for the amounts paid. Should the liquidator decide not to recognize CDIC's full claim, because it applied set-off against a deposit, CDIC's ability to recoup the full payment of insured deposits could be reduced.