October 17, 2019 – Restrictive rules holding back innovation in the financial sector should be updated to bolster Canada’s productivity, says a new report from the C.D. Howe Institute.
In “Productivity and the Financial Services Sector – How to Achieve New Heights,” authors Farah Omran and Jeremy Kronick note that over the past 15 years Canada has lagged behind many OECD countries in terms of productivity – including countries it is often compared to such as Australia, Norway and Sweden.
The authors examine the contribution of the financial services sector to Canada’s productivity growth and find it has been underwhelming, considering its potential. The financial services sector employs relatively more Canadians with postsecondary and postgraduate education than do other sectors, and promotes growth and productivity within the other complementary sectors that serve it. As a result, any increase of productivity in the financial sector has an outsized effect on Canada’s productivity at large. The report lays out how regulatory changes could improve the contribution of the financial sector to productivity by increasing competition through the development of fintechs (financial technology), and by bolstering lending to small and medium sized businesses (SMEs), through measures including a switch from a focus on mortgage lending to business lending.
Fintech: The report notes only $263 million in investments were made in Canada’s fintech market in the first half of 2018, compared with $14.2 billion in the United States and over $16 billion in the United Kingdom.
One obstacle to investment, productivity and scaling up of fintechs in Canada is legislation that until recently restricted the extent to which banks could invest and participate in fintechs and other technology-related activities. Although recent amendments to the Bank Act and the Insurance Companies Act raised the investment limits based on the value of the entity being acquired, the government has yet to provide sufficient clarity regarding these changes and set a date for enforcing them.
Lending to SMEs: Canada ranks dead last among OECD peers in small business lending as a share of total business lending, and near the bottom in overall business and small businesses lending as a percentage of GDP. This indicates a need to investigate whether it is necessary to deepen Canada’s capital markets beyond domestic bank debt financing, which according to OECD data was 60 percent of all SME financing in 2017 (approximately 80 percent if we include foreign banks, credit unions and caisses populaires).
One reason for this is that the alternative to business lending – residential mortgage lending – is risk free, and SME operational costs might be too binding and crowd out SME credit. This risk-free mortgage lending is a result of the 100 percent insurance that Canada Mortgage and Housing Corporation (CMHC) provides lenders of insured mortgages. As a start, the authors recommend that CMHC begin scaling insurance premiums to the credit-worthiness of mortgage borrowers instead of the present one-size-fits all approach.
“Although regulations are necessary to protect consumers and maintain the stability of the financial system,” says Omran, “They should be balanced between protecting against potential risks and ensuring appropriate competition – often from new entrants – which is crucial for the generation of innovative ideas and, in turn, productivity growth.”
More broadly, the authors recommend:
- the continued removal of barriers to the development of fintech through a flexible regulatory approach that is both based on the specific function of individual fintechs, and proportional to the risk involved in the services provided;
- more explicit competitiveness mandates for Canada’s financial services regulators to spur innovation;
- continued strengthening of the links between regulatory bodies both across provinces and different regulatory areas;
- changes to the incentive structure so that financial institutions move away from a focus on mortgage lending to one on business lending.
For more information contact: Farah Omran, Policy Analyst; Jeremy Kronick, Associate Director, Research; and David Blackwood, Communications Officer, the C.D. Howe Institute on 416-865-1904 Ext. 9997, or dblackwood@cdhowe.org