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AmericasAugust 1 2004

Marriages face a rocky future

A newly-elected minority Liberal government has left the prospects for Canadian bank mergers looking uncertain. Sheldon Gordon reports from Toronto. Canada’s general election on June 28 produced the worst possible outcome for the country’s banking sector. Prime minister Paul Martin’s Liberals were returned to office but, with only a plurality of the seats, they will have to cater to two smaller, left-wing parties in order to command a majority in parliament. Bankers would clearly have preferred the stability of a clear-cut victory by either Mr Martin’s Liberals or their main opponent, the Conservative Party.
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Minority government almost certainly means a continued moratorium on Canadian bank mergers. Mr Martin had blocked two proposed mergers in 1999 while finance minister, thwarting a Royal Bank of Canada (RBC) union with Bank of Montreal (BMO) and another marriage between Toronto-Dominion Bank and Canadian Imperial Bank of Commerce (CIBC).

Disappointing result

Bankers had anticipated, however, that Mr Martin, once safely elected as prime minister and backed by a parliamentary majority, would be sympathetic to a renewed round of merger proposals. A Conservative majority government would have been even more accepting of consolidation.

“It’s less likely with a minority government than with a majority,” says Peter Currie, chief financial officer at the RBC in an interview before the election. “As a businessperson, I’d rather see a majority.”

Instead, the bankers will have to reckon with the bank-averse policies of the socialist New Democratic Party (NDP) and the separatist Bloc Québecois. “We are very concerned about bank mergers,” NDP leader Jack Layton says. “These mergers would make this kind of economic power in the marketplace that much greater.” Mr Layton not only opposes bank mergers, but he also said during the election campaign that he would force banks to invest more in smaller communities.

As for the Bloc Québecois, its principal mission is to promote Québec sovereignty but, in other respects, its socio-economic outlook is close to that of the NDP. The Liberals captured 135 seats, compared with the Conservatives’ 100 seats. While the Liberals ended up 20 short of a parliamentary majority, the NDP’s 19 seats left them one short of holding the balance of power on their own. So the Liberals will have to also attract support from some of the 54 Bloc Québecois MPs.

Mr Martin has ruled out a formal coalition arrangement, preferring to enlist the smaller parties’ support on an issue-by-issue basis. In theory, this means he could bring forward leftist policies on healthcare and the environment that would appeal to the minor parties one week, and conservative banking and defence policies playing to the Conservatives the next.

Playing the parties off against each other, however, would increase the precariousness of the Liberals’ hold on power, and could lead to the opposition ganging up on the government and forcing another election before Mr Martin is ready to return to the polls. Many observers believe a new ballot may be only a year away, but the Liberals have made minority governments work for longer periods than that in past political eras.

The BMO, which analysts consider the bank most likely to be acquired if takeovers were allowed, saw its share price fall 77 cents to C$53.23 ($40.6), while CIBC was down 49 cents to C$65.31 and RBC sank 29 cents to C$59.40 in trading on the Toronto Stock Exchange the day after the election.

Ongoing debate

The banks that proposed mergers in the late 1990s argued that they needed to bulk up in size to be more competitive internationally. Canadian public opinion, on the other hand, was more concerned that consolidation would lead to large-scale lay-offs and the closure of branches, particularly in small communities where choice of financial service providers was already limited.

Although the Liberal government vetoed a third merger proposal in 2002 when the prime minister’s office was canvassed privately on the idea, Mr Martin’s successor as finance minister, John Manley, laid out a timetable to determine under which conditions banks would be allowed to merge. The current finance minister, Ralph Goodale, says the rules for the merger approval process will be issued as early as mid-summer, but almost no-one believes that clarification of the process will mean a lifting of the merger moratorium any time soon.

Faced with uncertainty over how long the Liberal minority government will cling to office, the banks will be looking at alternatives to mergers that might drive their growth. The Big Five face undeniable challenges in growing their franchises because the domestic retail banking market is mature and saturated. Moreover, foreign-owned competitors, such as HSBC and ING, have collectively increased their market share to 5% from 4%.

Change of tack

Meanwhile, US strategies are being revisited because of mixed results and somewhat disappointing returns on investments. The only successful Canadian banking presence in the US is Chicago-based HarrisBank, acquired in 1984 by BMO.

Through the acquisition of smaller banks in Chicago, HarrisBank has tripled the size of its branch network, client base and share of retail deposits in the past decade.

HarrisBank has also provided a solid platform for BMO’s entry into the US wealth management business. Early acquisitions included two small banks in wealthy communities in Florida and Arizona; and two direct brokerage firms in Chicago and Seattle, which were successfully integrated into BMO’s US business. More recently, BMO bought CSFBdirect, a highly-rated online brokerage, and added the online accounts of Morgan Stanley Investors Group.

The incremental US strategies of the other banks have been much less successful. In an effort to replicate itself south of the border, RBC, Canada’s largest financial institution, has spent nearly C$6bn on acquisitions in the US since 2000.

The key purchases were Centura Banks of Rocky Mount, North Carolina, regional brokerage Dain Rauscher of Minneapolis, Minnesota, mortgage services and some insurance operations.

RBC’s US operations lost C$17m in the three months ended April 30 due to mortgage problems and weaker investment returns – the third consecutive quarter of disappointing results.

Credit ratings agency Standard & Poor’s (S&P) warned last month that RBC could suffer a downgrade to its rating if its US operations did not improve soon. Donald Chu, director of S&P’s financial institutions rating group, says the bank has earned about $251m on US assets, which represents a return on equity “in the low single digits”.

One analyst recently predicted in a note to clients that RBC would eventually exit its US mortgage business. In recent months, however, the bank has been on a recruitment drive for mortgage loan officers in Georgia and Florida, the key markets for its mortgage business. It has also been opening new RBC Centura Banks branches in the US southeast to capitalise on cross-selling opportunities with its mortgage business.

Difficult times ahead

Canadian banks will face difficulties in the US, in both retail banking and corporate finance, Tanya Azarchs, a managing director at S&P, told a Toronto conference last month.

She said that few foreign banks had succeeded there, and consolidation among US banks would make it even harder. Canadian banks have been scaling back their corporate loans, which will put them on a less competitive footing vis-ŕ-vis their large US counterparts.

CIBC, to satisfy its shareholders’ demands for improved performance, has already retreated from much of its US activity. It intended to expand into US retail banking through Amicus Bank, a “clicks and mortar” approach offering online services and using minimally staffed supermarket branches. But Amicus was a dismal failure, losing C$600m over three years before being closed down in October, 2002.

CIBC also acquired Oppenheimer & Co for C$525m in 1997 to obtain a foothold on Wall Street, but in late 2002 sold off its private client and asset management parts, cutting back the research and investment banking units and absorbing them into CIBC World Markets.

Toronto Dominion Bank’s major US presence has been TD Waterhouse Securities (TDW), acquired in 1996. But despite the bank’s affirmation that TDW is an integral part of its business, there have been recurring reports that the brokerage was up for sale, in part because its value has not been reflected in the bank’s share price.

Bank of Nova Scotia has differentiated itself from its rivals by building up its foreign (non-US) operations in the past few years, especially in Latin America and the Caribbean. It now has the largest international operations of the Canadian banks. International operations provide 30% of its revenues and profits.

Although the bank had to write off its long-time subsidiary, Scotiabank Quilmes, in Argentina in 2002, it has had better results with its holdings in the Caribbean and Central America. Scotia is now focusing on expanding in Mexico, where the economy is growing the North American Free Trade Agreement. It also wants to open more branches in China and acquire stakes in banks elsewhere in Asia.

Canada’s major banks recently reported strong second-quarter results thanks largely to fewer problem loans, strong equity markets and low interest rates.

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