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The effect of the US-Canada free trade agreement on the US banking market
Journal ELSEVIER
of Multinational 7 (1997)
Financial 145-157
Management
Journal of MULTINATIONAL FINANCIAL MANAGEMENT
The effect of the US-Canada free trade agreement on the US banking market John Harriott, Gay Hatfield *, M. Mark Walker Department of Economics and Finance, School of Business Administration, University of Mississippi, Oxford, MS 38677, USA
Abstract On January 2 1988 the United States and Canada signed the US-Canada Free Trade Agreement (FTA), which created one of the world’s largest free trade areas. While the US and Canadian banking industries function very differently, the FTA reduced various banking regulations and resulted in greater competition among US and Canadian banks. The research issue addressed in this study is whether the loosening of regulations by the FTA actually benefitted the US domestic banking market. The overall results of this study indicate that the market responded positively to the passage of the FTA for US banks with significant Canadian operations. After the passage of the FTA, however, US banks were generally not successful in penetrating Canadian markets. In contrast, most Canadian banks did expand their operations in the United States. 0 1997 Elsevier Science B.V. JEL classt$ication: Keywords:
F3; G2
Trade agreements; US banks; Canadian banks
1. Introduction
On January 2 1988, after a prolonged period of negotiation, the United States and Canada signed the US-Canada Free Trade Agreement (FTA). The major focus of the FTA was on trade goods, but one section concerned the banking industry. While the US and Canadian banking industries function quite differently, the overall effect of the FTA was to be a reduction in various banking regulations. The result would be greater competition among US and Canadian banks. The research issue addressed in this study is whether the loosening of regulations by the FTA actually benefitted the US domestic banking market. Cornett and Tehranian ( 1990) point out that an important issue in economic regulation is whether the agents that are the object of regulatory benefits are indeed the beneficiaries. A * Corresponding
author
1042-444X/97/$17.00
0 1997 Elsevier Science B.V. All rights reserved
PII s1042-444x(97)00009-1
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majority of the early research into the economic effects of regulation analyzed the issue using welfare economics (e.g. Stigler, 1971). Recent studies (Schipper and Thompson, 1983; Binder, 1985; Rose, 1985; Smith et al., 1986; Cornett and Tehranian, 1989,199O) have used stock market data to examine the effects of changes in regulation. The use of stock prices to measure market effects utilizes the position of Schwert (1981) that new information is rapidly impounded in stock prices (the efficient market hypothesis). This paper employs market returns to examine the effect of the FTA on the US domestic banking market. As with other trade agreements, there has been public disagreement as to the advantages and disadvantges of the FTA for both nations. Similar to Hogan and Sultan (1994), our methodology avoids the subjectivity of the arguments and allows the market to indicate its viewpoint on the matter. The overall results of this study indicate that the market responded very positively to the passage of the FTA for banks with significant Canadians operations. Specifically, two announcements which detail positive news in support of the FTA passage produced statistically significant abnormal returns to bank stockholders. First, on September 25 1987, Canada and the US held talks to discuss how to continue the negotiations. This was of major importance because the Canadian trade negotiator had broken off talks the day before. This announcement resulted in a significant positive abnormal return to stockholders of banks which already had substantial exposure in Canada. Secondly, on January 4 1988, the announcement that President Reagan and Canadian Prime Minister Brian Mulroney had signed the free trade agreement resulted in a significant positive abnormal gain to shareholders of banks which did not have any exposure in Canada at that time. Our study contributes to the literature in that no previous research to determine the effect of this international agreement on domestic banking markets exists, yet the banking section of the agreement was of paramount importance to US banks, especially those with substantial operations in Canada. Hogan and Sultan (1994) investigated the reaction to the FTA in the foreign exchange market (specifically, the exchange rate between the US and Canadian dollars). The results of their study indicate that news which supported passage decreased the volatility of exchange rates while news that negated passage increased volatility. The rest of this paper is arranged as follows: Section 2 describes the Canadian and US banking industries, the FTA and the negotiation process. Section 3 introduces the data methodology and hypotheses to be tested. The results are presented in Section 4 and Section 5 offers concluding remarks.
2. The US and Canadian banking systems, the FTA and negotiations 2.1. Comparison
of US and Canadian
banking
industries
The ‘diverse and fragmented’ nature of the US banking industry can be attributed to the McFadden Act, which prohibits interstate branch banking, and the Glass-Steagall Act, which separates commercial and investment banking. Moreover,
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US banks are regulated at both the state and federal levels (Libbey, 1994). The effect of this regulatory environment on the US banking industry was the subject of several hearings before the US Congress in the late 1980s. L. William Seidman, then Chairman of the Federal Deposit Insurance Corporation, testified that these laws were “archaic,” and that “US banks will be faced with corresponding competition from Canadian banks seeking to enter the larger and more profitable US market” (Seidman, 1990). Robert L. Clarke, Comptroller of the Currency, also testified that “US laws, such as the Glass-Steagall Act, may raise the cost of capital for US banks, placing them at a disadvantage in international markets” (Clarke, 1990). Finally, C. Fred Bergsten, Director for the Institute of International Economics, told Congress that “the weaknesses in this sector [financial institutions] are largely domestic in origin and self-inflicted through our macroeconomic policies and federal and state regulatory systems” (Bergsten, 1990). In contrast, Canadian banks are more centralized and less regulated. The Canadian banking system is characterized by a few large banks with numerous branches. Seven banks with 7000 branches control 50% of Canadian bank assets (Holland, 1990). Canadian bank regulation is administered at the federal level. In 1987, Canadian regulations were relaxed to allow banks, trust companies, and insurance companies to own securities firms (Henriques, 1987). 2.2. The US-Canada Free Trade Agreement The FTA was a comprehensive agreement to reduce tariffs and trade restrictions between the US and Canada. The agreement covered trade in goods, government procurement practices, services, financial services, and investments, and it established a dispute settlement process. The chapter on financial services (Chapter 17) dealt with the removal of restrictions on the banking industry. Specifically, US bank subsidiaries in Canada were exempted from the following: (1) the 10% cap on single non-resident ownership of a Canadian bank (except for large Canadian banks); (2) the 25% cap on total US ownership of a Canadian bank (except for large Canadian banks); and (3) the cap on asset size restricting foreign banks from owning more than 16% of total Canadian bank assets. Additionally, US banks were allowed to own securities, insurance and trust company subsidiaries. Canadian bank subsidiaries in the US were promised regulatory treatment equal to US banks, and were allowed to underwrite and distribute Canadian government bonds, and maintain their multistate charters. A dispute settlement mechanism, separate from that designed for the rest of the FTA, was established between the Canadian Department of Finance and the US Department of the Treasury (Department of External Affairs, 1988). The genesis of the FTA was the ‘shamrock summit’ between Canadian Prime Minister Mulroney and US President Reagan in March 1985 (Winham, 1988). The two leaders set 4, 6 and 12 month timetables to negotiate the removal of trade restrictions. In June 1985 the Canadian government asked the US to join in trade negotiations. Later that year, the McDonald study, commissioned by the Canadian government, urged the removal of tariffs between the two countries over a period of ten years. After a heated debate, in April 1986 the US Senate approved the
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Reagan administration’s request to ‘fast track’ these negotiations.’ From November 1986 to September 1987, 17 working groups developed the terms of the agreement. The agreement on Financial Services (Chapter 17) was an adjunct to the overall agreement, and was negotiated separately by the US Department of the Treasury and the Canadian Department of Finance. The most contentious issue of the overall trade negotiations, separate from the Financial Services negotiations, was the trade settlement dispute mechanism. The US position was for a more voluntary approach to compliance, while the Canadian position was aimed at compulsory compliance. This disagreement led the Canadians to terminate discussions in September 1987. After 2 weeks of intense, high-level negotiations, a middle ground was found, and the agreement was signed on October 5 1987. Over the next 3 months, special interest groups in both countries voiced objections as the treaty meandered through the legislative bodies of each country. On January 4 1988, Reagan and Mulroney formally signed the pact to be effective January 1 1989.’ Prior to the advent of the FTA, US officials had analyzed the treatment of US banks in other countries. They concluded that Canada offered the worst treatment of any of the G-7 nations, and that this was in contrast to the strong position of Canadian banks in the US market (Winham, 1988). The FTA removed the asset and ownership restrictions imposed on US banks. It also opened the door to allow US banks to own Canadian securities firms. From the Canadian perspective, a key issue was the concept of reciprocity in financial services. Canada had opened its banking industry to the securities business, and reciprocity from the Canadian perspective implied an exemption from the Glass-Steagall Act for Canadian bank subsidiaries in the United States. The US position called for ‘national treatment’ which meant that Canadian banks in the US should face the same restrictions as US banks (Kraus, 1987). The Canadians did not achieve reciprocity, but the FTA gave Canadian banks in the US the right to sell Canadian government securities and the right to maintain their multi-state charters. In a joint letter from the Canadian Banker’s Association and the American Banker’s Association to the US Senate, the expectation was expressed that the FTA “should enhance competitive opportunities for both nation’s institutions. It may also serve to strengthen the competitive effectiveness of our institutions in the face of inroads from financial institutions from foreign countries” (Yingling, 1988). In testimony before the US Senate, Edward L. Yingling, Executive Director of the American Bankers’ Association, stated that the FTA “will abet continued integration of these two financial marketplaces and allow financial hrms from both sides of the border to compete on a more equal basis” and that “by allowing for greater competition and efficiency in the North American financial services market, the FTA provisions on financial services will help us meet these global challenges” (referring to European integration and Japanese banks). In a general sense, then, the banking communities of both nations looked for the FTA to level the competitive playing ’ ‘Fast track’ refers to an arrangement wherein the US Congress must vote on the treaty within 60 days after it is signed. ’ This survey of the negotiations was taken from various editions of the Wall Street Journal 19851989.
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field in North America, and to help each side compete in the changing global marketplace including competitive threats from a unified European banking system, and a well capitalized Japanese banking system. 2.3. US and Canadian bank subsidiaries By any measure of size, the US banks with subsidiaries operating in Canada are from the largest 100 commercial banks in the United States. Table 1 lists the total assets of US bank subsidiaries in Canada.3 In 1986, the Canadian subsidiaries tended to serve niche markets including foreign exchange services, investment banking, leasing and real estate. They also focused more on providing fee-producing services Table 1 Total assets of US banking
operations
US Banks
American Express Bank America” Bank of Boston” Bankers Trusta Chemical Bank” Citibank” Comerica Continental First Interstatea The Bank of New York Irving Bank” Manufacturers Hanover” Mellon Bank” Morgan Bank” National Bank of Detroit Republic National of NY Seattle First Security Pacific” Chase Manhattana First National of Chicago” Wells Fargo Total Percentage change (year over Source: Canadian a Indicates banks
in Canada
October
31
1982
1983
1190 244 1249 2313 76 688 36 104 411 691 327 61 157 456 350 63 8417 year)
($million
1984
Canadian
dollars)
1986
1987
1985
1988
1989
1990 333 1514 268 445 607 5615
1308 108 277 1418 2853 95 717 73
1073 160 334 1503 2991 180 400 161
990 138 264 1359 4607 149 416 182
1095 212 440 1154 4464 14 420 105
803 234 341 1176 4859
1098 284 439 642 4142
1302 275 542 461 5290
137
199
200
187 514 146 643 295 54 46 196 577 405
248 567 235 804 324 105
335 729 220 1089 384 309
202 646 292 991 439 350
339 641 231 1117 481 399
242 705 308 1287 439 461
241 471 336 1776 488 607
415 272 1390 452 651
207 498 429
217 484 266
497 613 189
421 700 272
550 1008 198
604 196 300
634 906 282
109 10 022 19.07
89 10 308 2.85
12158 17.95
12124 -0.28
12 002 - 1.23
13 691 14.07
operations
(group
Bankers Association. with significant Canadian
12 151 0.22
147 177
14 170 3.50
1)
3 All of the data in Table 1 and Table 2 came directly from Mr Brian Davidson at the Canadian Bankers Association in Toronto, Ontario. He provided the schedules of assets, liabilities and operating results for US banks’ subsidiaries operating in Canada. The banks listed in Table 1 comprise all of the US banks’ operating subsidiaries in Canada.
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rather than retail banking services. This focus helped them achieve returns on equity in excess of the average American or Canadian bank.4 Citibank has the largest American subsidiary in Canada, and it earned a return on equity of 14.95% in 1986 and 15.27% in 1987. The FTA opened the door for further expansion of US subsidiaries into established niches, retail banking, trust services (Holland, 1990) and the Canadian securities industry.5 Table 2 lists the total assets of Canadian subsidiaries operating in the US during the 1980s and early 1990s. Given that the Canadian market is ‘overbanked,’ the opportunity raised by the FTA for Canadian banks was the increased access to a larger, more lucrative retail market than that at home. Moreover, Canadian banks viewed their retail banking capabilities as a competitive strength in comparison with US retail banks. As evidenced by the Royal Trustco of Canada’s takeover of Pacific First of Seattle, potential targets for Canadian banks, after the FTA, were mortgage and leasing institutions as well as small savings and loans (Holland, 1990).
3. Data and methodology 3.1. Data The test period for this study is January 2 1987 to December 29 1989. The sample selected for this study includes 203 US banks6 The banking SIC codes were used Table 2 Total assets of Canadian banking operations in the US ($million US dollars) Canadian Banks
June 30 1984
Bank of Montreal Bank of Nova Scotia National Bank of Canada Candian Imperial Bank of Commerce Toronto Dominion Bank Total Percentage change (year over year)
6224 4860
1985
1986
1987
1988
1989
1990
1991
1992
1993
15 892 16622 16 826 18 589 18936 19079 20 125 22 880 20 509 4281 4966 9905 10370 8123 7623 16784 17 190 15 479
748
868
1231
1419
1562
1296
2355
3318
4737
6059
5407
6010
5764
3899
4075
8473
6401
8037
7841
6822
4835
5643
4648
2927
3586
3160
13 967 15 150 4626
4696
28899 40478 41397 45699 46079 42364 42945 57307 67730 64053 40.07 2.27 10.39 0.83 -8.06 1.37 33.44 18.19 -5.43
Source: American Banker (19851994)
4 ‘International Briefing’ American Banker September 4 1986, p. 2. ’ ‘The Other Barrier Falls in Canada - but no Rush is Seen,’ American Banker July 1 1988, p. 2. 6 A total of 324 banks were selected by SIC code; however, 121 banks had to be deleted from the sample due to missing data during the test period.
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to identify the banks which were on the Center for Research in Security Prices (CRSP) tapes. During the study period 13 banks had subsidiary banking operations in Canada (see Table 1). These banks are referred to as group 1. The remaining 190 banks (without subsidiary Canadian operations) are referred to as group 2. Daily security return data for each bank were obtained from the CRSP tapes. 3.2. Event dates To perform tests for a market reaction, it is necessary to identify any important new information about the passage of the FTA and the dates on which the news was made public. The new information was obtained by examining first the indexes and then the pertinent articles in The Wall Street Journal and American Banker. Although there were numerous articles over a lengthy period of time, not every article indicated progress in negotiations. Consequently, our search identified six significant events. The six events are listed in Table 3. June 5 1987 is the first date examined. On this date, the American Banker published an account of a speech by Thomas J. Berger, the head of the US Financial Services negotiation delegation, given at a seminar on the deregulation of the Canadian Financial Services industry. Mr Berger’s remarks made clear the US position concerning ‘reciprocity.’ He warned the Canadians that pursing any special treatment under the Glass-Steagall Act might lead to retaliatory action on the part of the United States. This date is significant because reciprocity might have given the Canadian bank subsidiaries in the US a competitive advantage over domestic banks (Kraus, 1987). As discussed above, Canada had opened its banking industry to the securities business; therefore, Canada viewed reciprocity as an exemption from the Glass-Stegall Act for Canadian bank subsidiaries operating in the United States. Progress on the trade talks had slowed down by August and September 1987 and Table 3 Descriptions of the events (the six major announcements and concomitant dates during the negotiation period leading up to the passage of the passage of the FTA) Date
Description of event
June 5 1987
In a speech, Thomas J. Berger, head of the US Financial Services negotiation delegation, made clear the US position concerning reciprocity. (Reciprocity as used by Mr Berger referred to the fact that Canada would not be allowed any special treatment under the Glass-Stegall Act.)
September 24 1987 Ten days before the “fast track” authority was to expire, the Canadian delegation broke off the negotiations. September 25 1987 The next day it was announced that talks to decide how to resume the negotiations would begin. October 5 1987 The US and Canada reached an accord. January 4 1988 The FTA was signed over the prior weekend by President Reagan and Canadian Prime Minister Brian Mulroney. December 27 1988 The Canadian House of Commons passed the FTA treaty legislation and it was announced that the Canadian Senate was expected to follow suit.
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on September 24, a major setback occurred when the chief negotiator for Canada suddenly returned to Ottawa. The WalZ Street Journal reported that the Canadian delegation broke off the negotiation just 10 days before the ‘fast track’ authority was to expire. The question raised was whether the break off was a strategic move or whether the talks really were over. The next day, September 25 1987, talks began to decide how to resume negotiations. By October 5, the US and Canada had reached an accord. Public news reported that the reaction was somewhat muted because the accord was a tentative agreement, and there were still major provisions to negotiate. Finally, on January 4 1988, President Reagan and Canadian Prime Minister Brian Mulroney signed the FTA. The agreement would not take effect for almost a full calendar year (January 1 1989), and Congress would have to vote on the measure. Less than a month before the FTA was to take effect (December 27 1988), The Wall Street Journal reported that the Canadian House of Commons passed the FTA treaty legislation, and that the Canadian Senate was expected to follow suit soon. Finally, on January 1 1989, after 2 years of weighty negotiations, the FTA went into effect. 3.3. Methodology We use stock prices to measure the effect of the passage of the FTA on the US domestic banking market. A multivariate regression model (MVRM) is employed. This methodology was also utilized by Schipper and Thompson (1983), Binder (1985), Smith et al. (1986) and Cornett and Tehranian (1989, 1990). We employ the MVRM because in the case of a regulatory passage, the event occurs on the same day for all affected firms; therefore, the residuals are not independent and identically distributed. The standard Brown and Warner (1980) event study methodology assumes independent and identically distributed residuals, and, as such, is not appropriate for this study. As Binder (1985) (p. 372) points out, the hypothesis tests using MVRM explicitly take into account “heteroscedasticity across equations and contemporaneous dependence of the disturbances.” The MVRM uses a dummy variable in the market model equation. The dummy variable is set equal to 1 on the date of the event and is equal to 0 otherwise. Each event’s impact on stock returns is measured by its respective dummy variable coefficient. Our model suggests a system of portfolio return equations for two portfolios: (1) US banks with Canadian subsidiaries; and (2) US banks without Canadian subsidiaries. The model is as follows:7
k=l ’ Flamrery and James (1984) found that the interest rate sensitivity of bank stock returns was related to the maturity composition of the firm’s net nominal assets. We checked for significant interest rate changes during our test period (January 2 1987 to December 29 1989). The average weekly change in yield was 6 basis points for the five weeks that contain the six event dates examined in this study. The maximum change for the six weeks was 22 basis points (for the week ending October 9, 1987), and the minimum change was a decrease of four basis points (for the week ending June 5 1987). Hence, we do not believe that interest rate changes seriously affect the results of this study, and following Comett and Tehranian (1990) do not include an interest rate variable in our model.
J. Harriott et al. /Journal of Multinational Financial Management 7 (1997) 145-157
R2t
=
~2
+
P2L
+
f:
~2kDkt
+
e”2t
153
(2)
k=l
where Rj, = the return on thejth portfolio (j= 1,2), of banks with Canadian exposure or banks without Canadian exposure on day t (from January 1987 through December, 1989); R,,= the return on the CRSP equally weighted index at time t; aj= an intercept coefficient for the jth portfolio (j= 1, 2); pj=risk coefficients for thejth portfolio (j= 1,2); yjk = the effect of the k announcements on thejth portfolio (k = 6); Dj, = dummy variables which equal 1 during the period of the kth announcement and 0 otherwise; and ejt = a random disturbance term. 3.4. Hypotheses The objective of this study is to examine the market’s reaction to several key events in the history of the FTA to determine the effect of this important international agreement on the US domestic banking market. While the FTA would increase banking competition in the US and Canada, it is not clear how US banks would perform in the new environment. We evaluate the effect of FTA passage on US banks with and without Canadian operations separately. The hypotheses are as follows: hypothesis 1 is the abnormal returns for all of the event dates are equal to zero for both portfolios jointly; hypothesis 2 is the abnormal return for each individual event date is equal to zero.
4. Results 4.1. Empirical results As stated above, use of the MVRM technique allows for the testing of joint hypotheses because the hypotheses tests take into consideration calendar time dependence and heteroscedasticity across equations. The expectation is that a regulation may be beneficial to some firms and harmful to others; thus, the joint hypotheses tests are of particular significance when employing the MVRM methodology for analyzing a new regulation. Hypothesis 1 tests whether the 12 abnormal returns (two portfolios x six event dates) are all equal to zero. The value of the test statistic is 1.59, which is significant at the 10% level. We therefore reject the null hypothesis that all 12 abnormal returns are equal to zero, and thus further testing is required. Hypothesis 2 examines each of the six individual announcements and tests for differences across the two portfolios (groups 1 and 2). The results of the MVRM analysis are presented in Table 4. Each event (announcement) is listed, along with its corresponding abnormal return and t-statistic. The abnormal returns and tstatistics are divided by group (US banks with Canadian exposure and US banks without Canadian exposure). As depicted in Table 4, two events show statistically
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Table 4 Multivariate regression model results
Event
1. Thomas J. Berger rejects reciprocity (615187) 2. Canadian negotiator breaks off talks on FTA. Impasse over how to resolve trade disputes (g/24/87) 3. Canada and US discuss how to continue the negotiations (g/25/87) 4. Canada and US reach trade agreement (10/5/87) 5. President Reagan and Canadian Prime Minister Brian Mulroney sign free trade agreement (l/4/88) 6. Canadian House of Commons passed the FTA; Canadian Senate expected to follow suit (12/27/88)
US banks with US banks without Canadian exposure (n = 13) Canadian exposure (n = 190) Abnormal return
t-statistic
-0.0009
-0.09
0.0029
-0.0040
-0.40
- 0.0009
0.0373 -0.0061
3.77*** -0.61
0.0029
0.29
0.0029
0.30
Abnormal return
0.0011 - 0.0000 0.0063
-0.0007
t-statistic
0.78 -0.23
0.30 -0.01 1.65*
-0.18
F-value”
0.30 0.12
7.36*** 0.19 1.48
0.05
a Test of the null hypothesis that ylr = yzk=O. *,**,*** Indicate signilicance at the 10, 5 and 1% levels, respectively, for a two-tailed test.
significant cumulative abnormal returns. The first significant event is September 25 1987 (the day after the Canadian negotiator broke off talks on the FTA), when it was announced that Canada and the US were discussing how to continue the negotiations. Stockholders of US banks with Canadian exposure earned an abnormal return of 3.73% (t=3.77). The second significant event was on January 4 1988, when it was announced that President Reagan and Canadian Prime Minister Mulroney had signed the FTA during the prior weekend. The stockholders of US banks without Canadian exposure earned an abnormal return of 0.63% (t= 1.65). This reaction was not as strong as for the FTA talk resumption announcement (significant at the 10% level versus the 1% level, respectively). In fact, the null hypothesis that yls = yzs = 0 cannot be rejected at conventional levels. No statistically significant reaction was identmed for the remaining events. These results indicate that the US banks with Canadian exposure were more affected by the passage of the FTA than banks without Canadian exposure. For US banks with Canadian exposure, the FTA removed the ownership and asset restrictions and allowed these banks to own Canadian securities firms. Banks which already had Canadian subsidiaries were in a much better position to quickly take advantage of these new competitive opportunities.
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4.2. Postscript: after the passage of the FTA As one might expect, given the removal of the 16% asset ceiling, US banking assets in Canada rose by 14% in 1989 and 3.5% in 1990 (see Table 1).8 However, by 1991 the profit picture for US banks deteriorated. By then, Wells Fargo, Continental Corporation and Comerica had pulled out of Canada. Chemical Bank and Banker’s Trust had reduced operations, the Bank of New York had put its Toronto-based subsidiary up for sale and Citicorp had dropped plans to expand its branch network. The Bank of Boston and the First Interstate planned to stay, and each cited niche businesses as the reason (factoring for the Bank of Boston, and exchange trading for First Interstate) (Kraus, 1991). These findings suggest that US banks did not have the retail network necessary to compete with the large Canadian banks in Canada. Regarding entry into the Canadian securities business, as of July 1988 only two US banks had invested in Canadian securities firms. In sharp contrast to the poor performance of US banks in Canada, Canadian banks were successful in expanding their US operations. Seidman (1990) notes that by mid-year 1989, Canada was the third largest foreign country operating in the US banking industry. Feeling that it had a competitive advantage in retail banking, in 1990 the Bank of Montreal announced acquisition plans to increase US earnings by 50%. The Royal Bank of Canada and the Canadian Imperial Bank of Commerce also announced that they were considering expansions of their US operations (Kraus, 1990). As shown in Table 2, total assets of US operations of Canadian banks did, in fact, increase by 33% in 1991 and by 18% in 1992. Canadian banks followed their customers into the United States, and in the combined US-Canada marketplace, Canadian banks appear to have taken the initial advantage over their US competitors. Their advantage in the retail sector can be attributed to the size of their centralized operations in comparison with the decentralized nature of US branch banking. In the Canadian securities business, the Canadian banks have a natural ‘home field’ advantage over the US banks in Canada. Both of these factors are the result of differences in the regulatory environments between the two countries.
5. Conclusions The results of this research show that the Free Trade Agreement had a positive effect on the stock prices of US banks with significant banking operations in Canada. The announcement of September 25 1987, which reported that the negotiations would be resumed despite the fact that the Canadians had broken them off the prior day, produced statistically significant abnormal returns to stockholders. There was also a statistically significant reaction to the announcement that President Reagan and Canadian Prime Minister Mulroney had signed the FTA (January 4 1988).
8 Data on US bank subsidiaries
operating
in Canada
are not available
after 1990.
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While the stock market did not react to the final passage of the FTA, the information concerning passage was already well-known to the market. Key industry representatives were optimistic that the FTA would create a more level competitive playing field within the combined Canadian-US market, and that it would help Canadian and US banks fight the Japanese and European incursion into this market. The stock market’s positive reaction suggests that, from the market’s perspective, this more open environment enhanced the value of US banks with a stake in the Canadian market. The post-accord withdrawal of many US banking operations in Canada, however, indicates that US banks were generally not successful in expanding their Canadian operations. Most Canadian banks, on the other hand, were successful in expanding their US operations. As a result, we conclude that Canadian banks, by virtue of their more deregulated domestic environment, have some competitive advantages over US banks. The FTA represents one step in the deregulation of the banking industry within North America. The implementation of NAFTA (the North American Free Trade Agreement) will build on the current FTA in opening up the Mexican banking industry. The major provisions of NAFTA will: (1) allow US and Canadian banks to provide all types of banking services to Mexican citizens; and (2) give Mexican banks access to Canada and the United States. Like the Canadian banking environment, and unlike the US environment, Mexico’s banks are federally chartered and regulated and there is no wall between investment and commercial banking. Given the experience of the FTA, it is likely that the Canadian banks will have a competitive advantage over US banks in the retail sector within Mexico, if not the entire free trade zone. US banks may continue to be at a disadvantage in the North American market as long as they must comply with US regulations such as the Glass-Steagall and McFadden Acts.
References Bergsten, C.F., 1990. Statement before the Committee on Banking, Finance and Urban Affairs, US House of Representatives, April 24. Binder, J.J., 1985. Measuring the effects of regulation with stock price data. Rand Journal of Economics 16, 167-183. Brown, S.J., Warner J.B., 1980. Measuring security price performance. Journal of Financial Economics 8, 205-258. Clarke, R.L., 1990. Statement before the Committee on Banking, Finance, and Urban Affairs, US House of Representatives, March 21. Comett, M.M., Tehranian, H., 1989. Stock market reactions to the depository institutions deregulation and Monetary Control Act of 1980. Journal of Banking and Finance 13, 81-100. Comett, M.M., Tehranian, H., 1990. An examination of the impact of the Gam-St Germain Depository Institutions Act of 1982 on commercial banks and savings and loans. Journal of Finance 45, 95-111. Department of External Affairs, 1988. The Canada-US Free Trade Agreement: Synopsis. Ottawa, Ontario, Canada. Flannery, M.J., James, C.M., 1984. The effect of interest rate changes on the common stock returns of financial institutions. Journal of Finance 39, 1141-l 153.
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1.57
Henriques, D., 1987. Baby Bang - Canada’s Financial Markets Brace For Deregulation. Barrons (June 20 1987). Hogan, K., Sultan, J., 1994. Foreign exchange market reaction to the US-Canada Free Trade Agreement, The Journal of Financial Research 17, 5399549. Holland, C.R., 1990. North Americanization of the Retail Financial Services Industry. Bottom Line (February 1990). Kraus, J., 1987. International Briefing. American Banker (June 5 1987). Kraus, J., 1990. Big Canadian Banks Look South for Acquisition Opportunities. American Banker (February 20 1990). Kraus, J., 1991. Chill on Profits is Driving Many US Banks Out of Canada. American Banker (March 7 1991). Libbey, B., 1994. Impact of NAFTA on commercial banking. Journal of Economic Issues 28, 5Oll508. Rose, N.L., 1985. The incidence of regulatory rents in the motor carrier industry. Rand Journal of Economics 16, 2999318. Schipper, K., Thompson, R., 1983. The impact of merger-related regulations on the shareholders of acquiring firms. Journal of Accounting Research 21, 1844221. Schwert, G.W., 1981. Using financial data to measure the effects of regulation. Journal of Law and Economics 25, 121-158. Seidman, W.L., 1990. Testimony on international trends in the financial services industry. Statement before the Committee on Banking, Finance, and Urban Affairs, US House of Representatives, March 22. Smith, R.T., Bradley, M., Jarrell, G., 1986. Studying firm specific effects of regulation with stock market data: an application to oil price regulation. Rand Journal of Economics 17, 467-489. Stigler, G.J., 1971. The theory of economic regulation. Bell Journal of Economics and Management Science 2, 3-21. The other barrier falls in Canada - but no rush is seen. American Banker (July 1 1988). Winham, G.R., 1988. Trading with Canada. Priority Press Publications, New York. Yingling, E.L., 1988. Statement before the Senate Banking Committee, US Senate, May 20.
of Multinational 7 (1997)
Financial 145-157
Management
Journal of MULTINATIONAL FINANCIAL MANAGEMENT
The effect of the US-Canada free trade agreement on the US banking market John Harriott, Gay Hatfield *, M. Mark Walker Department of Economics and Finance, School of Business Administration, University of Mississippi, Oxford, MS 38677, USA
Abstract On January 2 1988 the United States and Canada signed the US-Canada Free Trade Agreement (FTA), which created one of the world’s largest free trade areas. While the US and Canadian banking industries function very differently, the FTA reduced various banking regulations and resulted in greater competition among US and Canadian banks. The research issue addressed in this study is whether the loosening of regulations by the FTA actually benefitted the US domestic banking market. The overall results of this study indicate that the market responded positively to the passage of the FTA for US banks with significant Canadian operations. After the passage of the FTA, however, US banks were generally not successful in penetrating Canadian markets. In contrast, most Canadian banks did expand their operations in the United States. 0 1997 Elsevier Science B.V. JEL classt$ication: Keywords:
F3; G2
Trade agreements; US banks; Canadian banks
1. Introduction
On January 2 1988, after a prolonged period of negotiation, the United States and Canada signed the US-Canada Free Trade Agreement (FTA). The major focus of the FTA was on trade goods, but one section concerned the banking industry. While the US and Canadian banking industries function quite differently, the overall effect of the FTA was to be a reduction in various banking regulations. The result would be greater competition among US and Canadian banks. The research issue addressed in this study is whether the loosening of regulations by the FTA actually benefitted the US domestic banking market. Cornett and Tehranian ( 1990) point out that an important issue in economic regulation is whether the agents that are the object of regulatory benefits are indeed the beneficiaries. A * Corresponding
author
1042-444X/97/$17.00
0 1997 Elsevier Science B.V. All rights reserved
PII s1042-444x(97)00009-1
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majority of the early research into the economic effects of regulation analyzed the issue using welfare economics (e.g. Stigler, 1971). Recent studies (Schipper and Thompson, 1983; Binder, 1985; Rose, 1985; Smith et al., 1986; Cornett and Tehranian, 1989,199O) have used stock market data to examine the effects of changes in regulation. The use of stock prices to measure market effects utilizes the position of Schwert (1981) that new information is rapidly impounded in stock prices (the efficient market hypothesis). This paper employs market returns to examine the effect of the FTA on the US domestic banking market. As with other trade agreements, there has been public disagreement as to the advantages and disadvantges of the FTA for both nations. Similar to Hogan and Sultan (1994), our methodology avoids the subjectivity of the arguments and allows the market to indicate its viewpoint on the matter. The overall results of this study indicate that the market responded very positively to the passage of the FTA for banks with significant Canadians operations. Specifically, two announcements which detail positive news in support of the FTA passage produced statistically significant abnormal returns to bank stockholders. First, on September 25 1987, Canada and the US held talks to discuss how to continue the negotiations. This was of major importance because the Canadian trade negotiator had broken off talks the day before. This announcement resulted in a significant positive abnormal return to stockholders of banks which already had substantial exposure in Canada. Secondly, on January 4 1988, the announcement that President Reagan and Canadian Prime Minister Brian Mulroney had signed the free trade agreement resulted in a significant positive abnormal gain to shareholders of banks which did not have any exposure in Canada at that time. Our study contributes to the literature in that no previous research to determine the effect of this international agreement on domestic banking markets exists, yet the banking section of the agreement was of paramount importance to US banks, especially those with substantial operations in Canada. Hogan and Sultan (1994) investigated the reaction to the FTA in the foreign exchange market (specifically, the exchange rate between the US and Canadian dollars). The results of their study indicate that news which supported passage decreased the volatility of exchange rates while news that negated passage increased volatility. The rest of this paper is arranged as follows: Section 2 describes the Canadian and US banking industries, the FTA and the negotiation process. Section 3 introduces the data methodology and hypotheses to be tested. The results are presented in Section 4 and Section 5 offers concluding remarks.
2. The US and Canadian banking systems, the FTA and negotiations 2.1. Comparison
of US and Canadian
banking
industries
The ‘diverse and fragmented’ nature of the US banking industry can be attributed to the McFadden Act, which prohibits interstate branch banking, and the Glass-Steagall Act, which separates commercial and investment banking. Moreover,
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US banks are regulated at both the state and federal levels (Libbey, 1994). The effect of this regulatory environment on the US banking industry was the subject of several hearings before the US Congress in the late 1980s. L. William Seidman, then Chairman of the Federal Deposit Insurance Corporation, testified that these laws were “archaic,” and that “US banks will be faced with corresponding competition from Canadian banks seeking to enter the larger and more profitable US market” (Seidman, 1990). Robert L. Clarke, Comptroller of the Currency, also testified that “US laws, such as the Glass-Steagall Act, may raise the cost of capital for US banks, placing them at a disadvantage in international markets” (Clarke, 1990). Finally, C. Fred Bergsten, Director for the Institute of International Economics, told Congress that “the weaknesses in this sector [financial institutions] are largely domestic in origin and self-inflicted through our macroeconomic policies and federal and state regulatory systems” (Bergsten, 1990). In contrast, Canadian banks are more centralized and less regulated. The Canadian banking system is characterized by a few large banks with numerous branches. Seven banks with 7000 branches control 50% of Canadian bank assets (Holland, 1990). Canadian bank regulation is administered at the federal level. In 1987, Canadian regulations were relaxed to allow banks, trust companies, and insurance companies to own securities firms (Henriques, 1987). 2.2. The US-Canada Free Trade Agreement The FTA was a comprehensive agreement to reduce tariffs and trade restrictions between the US and Canada. The agreement covered trade in goods, government procurement practices, services, financial services, and investments, and it established a dispute settlement process. The chapter on financial services (Chapter 17) dealt with the removal of restrictions on the banking industry. Specifically, US bank subsidiaries in Canada were exempted from the following: (1) the 10% cap on single non-resident ownership of a Canadian bank (except for large Canadian banks); (2) the 25% cap on total US ownership of a Canadian bank (except for large Canadian banks); and (3) the cap on asset size restricting foreign banks from owning more than 16% of total Canadian bank assets. Additionally, US banks were allowed to own securities, insurance and trust company subsidiaries. Canadian bank subsidiaries in the US were promised regulatory treatment equal to US banks, and were allowed to underwrite and distribute Canadian government bonds, and maintain their multistate charters. A dispute settlement mechanism, separate from that designed for the rest of the FTA, was established between the Canadian Department of Finance and the US Department of the Treasury (Department of External Affairs, 1988). The genesis of the FTA was the ‘shamrock summit’ between Canadian Prime Minister Mulroney and US President Reagan in March 1985 (Winham, 1988). The two leaders set 4, 6 and 12 month timetables to negotiate the removal of trade restrictions. In June 1985 the Canadian government asked the US to join in trade negotiations. Later that year, the McDonald study, commissioned by the Canadian government, urged the removal of tariffs between the two countries over a period of ten years. After a heated debate, in April 1986 the US Senate approved the
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Reagan administration’s request to ‘fast track’ these negotiations.’ From November 1986 to September 1987, 17 working groups developed the terms of the agreement. The agreement on Financial Services (Chapter 17) was an adjunct to the overall agreement, and was negotiated separately by the US Department of the Treasury and the Canadian Department of Finance. The most contentious issue of the overall trade negotiations, separate from the Financial Services negotiations, was the trade settlement dispute mechanism. The US position was for a more voluntary approach to compliance, while the Canadian position was aimed at compulsory compliance. This disagreement led the Canadians to terminate discussions in September 1987. After 2 weeks of intense, high-level negotiations, a middle ground was found, and the agreement was signed on October 5 1987. Over the next 3 months, special interest groups in both countries voiced objections as the treaty meandered through the legislative bodies of each country. On January 4 1988, Reagan and Mulroney formally signed the pact to be effective January 1 1989.’ Prior to the advent of the FTA, US officials had analyzed the treatment of US banks in other countries. They concluded that Canada offered the worst treatment of any of the G-7 nations, and that this was in contrast to the strong position of Canadian banks in the US market (Winham, 1988). The FTA removed the asset and ownership restrictions imposed on US banks. It also opened the door to allow US banks to own Canadian securities firms. From the Canadian perspective, a key issue was the concept of reciprocity in financial services. Canada had opened its banking industry to the securities business, and reciprocity from the Canadian perspective implied an exemption from the Glass-Steagall Act for Canadian bank subsidiaries in the United States. The US position called for ‘national treatment’ which meant that Canadian banks in the US should face the same restrictions as US banks (Kraus, 1987). The Canadians did not achieve reciprocity, but the FTA gave Canadian banks in the US the right to sell Canadian government securities and the right to maintain their multi-state charters. In a joint letter from the Canadian Banker’s Association and the American Banker’s Association to the US Senate, the expectation was expressed that the FTA “should enhance competitive opportunities for both nation’s institutions. It may also serve to strengthen the competitive effectiveness of our institutions in the face of inroads from financial institutions from foreign countries” (Yingling, 1988). In testimony before the US Senate, Edward L. Yingling, Executive Director of the American Bankers’ Association, stated that the FTA “will abet continued integration of these two financial marketplaces and allow financial hrms from both sides of the border to compete on a more equal basis” and that “by allowing for greater competition and efficiency in the North American financial services market, the FTA provisions on financial services will help us meet these global challenges” (referring to European integration and Japanese banks). In a general sense, then, the banking communities of both nations looked for the FTA to level the competitive playing ’ ‘Fast track’ refers to an arrangement wherein the US Congress must vote on the treaty within 60 days after it is signed. ’ This survey of the negotiations was taken from various editions of the Wall Street Journal 19851989.
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field in North America, and to help each side compete in the changing global marketplace including competitive threats from a unified European banking system, and a well capitalized Japanese banking system. 2.3. US and Canadian bank subsidiaries By any measure of size, the US banks with subsidiaries operating in Canada are from the largest 100 commercial banks in the United States. Table 1 lists the total assets of US bank subsidiaries in Canada.3 In 1986, the Canadian subsidiaries tended to serve niche markets including foreign exchange services, investment banking, leasing and real estate. They also focused more on providing fee-producing services Table 1 Total assets of US banking
operations
US Banks
American Express Bank America” Bank of Boston” Bankers Trusta Chemical Bank” Citibank” Comerica Continental First Interstatea The Bank of New York Irving Bank” Manufacturers Hanover” Mellon Bank” Morgan Bank” National Bank of Detroit Republic National of NY Seattle First Security Pacific” Chase Manhattana First National of Chicago” Wells Fargo Total Percentage change (year over Source: Canadian a Indicates banks
in Canada
October
31
1982
1983
1190 244 1249 2313 76 688 36 104 411 691 327 61 157 456 350 63 8417 year)
($million
1984
Canadian
dollars)
1986
1987
1985
1988
1989
1990 333 1514 268 445 607 5615
1308 108 277 1418 2853 95 717 73
1073 160 334 1503 2991 180 400 161
990 138 264 1359 4607 149 416 182
1095 212 440 1154 4464 14 420 105
803 234 341 1176 4859
1098 284 439 642 4142
1302 275 542 461 5290
137
199
200
187 514 146 643 295 54 46 196 577 405
248 567 235 804 324 105
335 729 220 1089 384 309
202 646 292 991 439 350
339 641 231 1117 481 399
242 705 308 1287 439 461
241 471 336 1776 488 607
415 272 1390 452 651
207 498 429
217 484 266
497 613 189
421 700 272
550 1008 198
604 196 300
634 906 282
109 10 022 19.07
89 10 308 2.85
12158 17.95
12124 -0.28
12 002 - 1.23
13 691 14.07
operations
(group
Bankers Association. with significant Canadian
12 151 0.22
147 177
14 170 3.50
1)
3 All of the data in Table 1 and Table 2 came directly from Mr Brian Davidson at the Canadian Bankers Association in Toronto, Ontario. He provided the schedules of assets, liabilities and operating results for US banks’ subsidiaries operating in Canada. The banks listed in Table 1 comprise all of the US banks’ operating subsidiaries in Canada.
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rather than retail banking services. This focus helped them achieve returns on equity in excess of the average American or Canadian bank.4 Citibank has the largest American subsidiary in Canada, and it earned a return on equity of 14.95% in 1986 and 15.27% in 1987. The FTA opened the door for further expansion of US subsidiaries into established niches, retail banking, trust services (Holland, 1990) and the Canadian securities industry.5 Table 2 lists the total assets of Canadian subsidiaries operating in the US during the 1980s and early 1990s. Given that the Canadian market is ‘overbanked,’ the opportunity raised by the FTA for Canadian banks was the increased access to a larger, more lucrative retail market than that at home. Moreover, Canadian banks viewed their retail banking capabilities as a competitive strength in comparison with US retail banks. As evidenced by the Royal Trustco of Canada’s takeover of Pacific First of Seattle, potential targets for Canadian banks, after the FTA, were mortgage and leasing institutions as well as small savings and loans (Holland, 1990).
3. Data and methodology 3.1. Data The test period for this study is January 2 1987 to December 29 1989. The sample selected for this study includes 203 US banks6 The banking SIC codes were used Table 2 Total assets of Canadian banking operations in the US ($million US dollars) Canadian Banks
June 30 1984
Bank of Montreal Bank of Nova Scotia National Bank of Canada Candian Imperial Bank of Commerce Toronto Dominion Bank Total Percentage change (year over year)
6224 4860
1985
1986
1987
1988
1989
1990
1991
1992
1993
15 892 16622 16 826 18 589 18936 19079 20 125 22 880 20 509 4281 4966 9905 10370 8123 7623 16784 17 190 15 479
748
868
1231
1419
1562
1296
2355
3318
4737
6059
5407
6010
5764
3899
4075
8473
6401
8037
7841
6822
4835
5643
4648
2927
3586
3160
13 967 15 150 4626
4696
28899 40478 41397 45699 46079 42364 42945 57307 67730 64053 40.07 2.27 10.39 0.83 -8.06 1.37 33.44 18.19 -5.43
Source: American Banker (19851994)
4 ‘International Briefing’ American Banker September 4 1986, p. 2. ’ ‘The Other Barrier Falls in Canada - but no Rush is Seen,’ American Banker July 1 1988, p. 2. 6 A total of 324 banks were selected by SIC code; however, 121 banks had to be deleted from the sample due to missing data during the test period.
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to identify the banks which were on the Center for Research in Security Prices (CRSP) tapes. During the study period 13 banks had subsidiary banking operations in Canada (see Table 1). These banks are referred to as group 1. The remaining 190 banks (without subsidiary Canadian operations) are referred to as group 2. Daily security return data for each bank were obtained from the CRSP tapes. 3.2. Event dates To perform tests for a market reaction, it is necessary to identify any important new information about the passage of the FTA and the dates on which the news was made public. The new information was obtained by examining first the indexes and then the pertinent articles in The Wall Street Journal and American Banker. Although there were numerous articles over a lengthy period of time, not every article indicated progress in negotiations. Consequently, our search identified six significant events. The six events are listed in Table 3. June 5 1987 is the first date examined. On this date, the American Banker published an account of a speech by Thomas J. Berger, the head of the US Financial Services negotiation delegation, given at a seminar on the deregulation of the Canadian Financial Services industry. Mr Berger’s remarks made clear the US position concerning ‘reciprocity.’ He warned the Canadians that pursing any special treatment under the Glass-Steagall Act might lead to retaliatory action on the part of the United States. This date is significant because reciprocity might have given the Canadian bank subsidiaries in the US a competitive advantage over domestic banks (Kraus, 1987). As discussed above, Canada had opened its banking industry to the securities business; therefore, Canada viewed reciprocity as an exemption from the Glass-Stegall Act for Canadian bank subsidiaries operating in the United States. Progress on the trade talks had slowed down by August and September 1987 and Table 3 Descriptions of the events (the six major announcements and concomitant dates during the negotiation period leading up to the passage of the passage of the FTA) Date
Description of event
June 5 1987
In a speech, Thomas J. Berger, head of the US Financial Services negotiation delegation, made clear the US position concerning reciprocity. (Reciprocity as used by Mr Berger referred to the fact that Canada would not be allowed any special treatment under the Glass-Stegall Act.)
September 24 1987 Ten days before the “fast track” authority was to expire, the Canadian delegation broke off the negotiations. September 25 1987 The next day it was announced that talks to decide how to resume the negotiations would begin. October 5 1987 The US and Canada reached an accord. January 4 1988 The FTA was signed over the prior weekend by President Reagan and Canadian Prime Minister Brian Mulroney. December 27 1988 The Canadian House of Commons passed the FTA treaty legislation and it was announced that the Canadian Senate was expected to follow suit.
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on September 24, a major setback occurred when the chief negotiator for Canada suddenly returned to Ottawa. The WalZ Street Journal reported that the Canadian delegation broke off the negotiation just 10 days before the ‘fast track’ authority was to expire. The question raised was whether the break off was a strategic move or whether the talks really were over. The next day, September 25 1987, talks began to decide how to resume negotiations. By October 5, the US and Canada had reached an accord. Public news reported that the reaction was somewhat muted because the accord was a tentative agreement, and there were still major provisions to negotiate. Finally, on January 4 1988, President Reagan and Canadian Prime Minister Brian Mulroney signed the FTA. The agreement would not take effect for almost a full calendar year (January 1 1989), and Congress would have to vote on the measure. Less than a month before the FTA was to take effect (December 27 1988), The Wall Street Journal reported that the Canadian House of Commons passed the FTA treaty legislation, and that the Canadian Senate was expected to follow suit soon. Finally, on January 1 1989, after 2 years of weighty negotiations, the FTA went into effect. 3.3. Methodology We use stock prices to measure the effect of the passage of the FTA on the US domestic banking market. A multivariate regression model (MVRM) is employed. This methodology was also utilized by Schipper and Thompson (1983), Binder (1985), Smith et al. (1986) and Cornett and Tehranian (1989, 1990). We employ the MVRM because in the case of a regulatory passage, the event occurs on the same day for all affected firms; therefore, the residuals are not independent and identically distributed. The standard Brown and Warner (1980) event study methodology assumes independent and identically distributed residuals, and, as such, is not appropriate for this study. As Binder (1985) (p. 372) points out, the hypothesis tests using MVRM explicitly take into account “heteroscedasticity across equations and contemporaneous dependence of the disturbances.” The MVRM uses a dummy variable in the market model equation. The dummy variable is set equal to 1 on the date of the event and is equal to 0 otherwise. Each event’s impact on stock returns is measured by its respective dummy variable coefficient. Our model suggests a system of portfolio return equations for two portfolios: (1) US banks with Canadian subsidiaries; and (2) US banks without Canadian subsidiaries. The model is as follows:7
k=l ’ Flamrery and James (1984) found that the interest rate sensitivity of bank stock returns was related to the maturity composition of the firm’s net nominal assets. We checked for significant interest rate changes during our test period (January 2 1987 to December 29 1989). The average weekly change in yield was 6 basis points for the five weeks that contain the six event dates examined in this study. The maximum change for the six weeks was 22 basis points (for the week ending October 9, 1987), and the minimum change was a decrease of four basis points (for the week ending June 5 1987). Hence, we do not believe that interest rate changes seriously affect the results of this study, and following Comett and Tehranian (1990) do not include an interest rate variable in our model.
J. Harriott et al. /Journal of Multinational Financial Management 7 (1997) 145-157
R2t
=
~2
+
P2L
+
f:
~2kDkt
+
e”2t
153
(2)
k=l
where Rj, = the return on thejth portfolio (j= 1,2), of banks with Canadian exposure or banks without Canadian exposure on day t (from January 1987 through December, 1989); R,,= the return on the CRSP equally weighted index at time t; aj= an intercept coefficient for the jth portfolio (j= 1, 2); pj=risk coefficients for thejth portfolio (j= 1,2); yjk = the effect of the k announcements on thejth portfolio (k = 6); Dj, = dummy variables which equal 1 during the period of the kth announcement and 0 otherwise; and ejt = a random disturbance term. 3.4. Hypotheses The objective of this study is to examine the market’s reaction to several key events in the history of the FTA to determine the effect of this important international agreement on the US domestic banking market. While the FTA would increase banking competition in the US and Canada, it is not clear how US banks would perform in the new environment. We evaluate the effect of FTA passage on US banks with and without Canadian operations separately. The hypotheses are as follows: hypothesis 1 is the abnormal returns for all of the event dates are equal to zero for both portfolios jointly; hypothesis 2 is the abnormal return for each individual event date is equal to zero.
4. Results 4.1. Empirical results As stated above, use of the MVRM technique allows for the testing of joint hypotheses because the hypotheses tests take into consideration calendar time dependence and heteroscedasticity across equations. The expectation is that a regulation may be beneficial to some firms and harmful to others; thus, the joint hypotheses tests are of particular significance when employing the MVRM methodology for analyzing a new regulation. Hypothesis 1 tests whether the 12 abnormal returns (two portfolios x six event dates) are all equal to zero. The value of the test statistic is 1.59, which is significant at the 10% level. We therefore reject the null hypothesis that all 12 abnormal returns are equal to zero, and thus further testing is required. Hypothesis 2 examines each of the six individual announcements and tests for differences across the two portfolios (groups 1 and 2). The results of the MVRM analysis are presented in Table 4. Each event (announcement) is listed, along with its corresponding abnormal return and t-statistic. The abnormal returns and tstatistics are divided by group (US banks with Canadian exposure and US banks without Canadian exposure). As depicted in Table 4, two events show statistically
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J. Harriott et al. /Journal of Multinational Financial Management 7 (1997) 145-157
Table 4 Multivariate regression model results
Event
1. Thomas J. Berger rejects reciprocity (615187) 2. Canadian negotiator breaks off talks on FTA. Impasse over how to resolve trade disputes (g/24/87) 3. Canada and US discuss how to continue the negotiations (g/25/87) 4. Canada and US reach trade agreement (10/5/87) 5. President Reagan and Canadian Prime Minister Brian Mulroney sign free trade agreement (l/4/88) 6. Canadian House of Commons passed the FTA; Canadian Senate expected to follow suit (12/27/88)
US banks with US banks without Canadian exposure (n = 13) Canadian exposure (n = 190) Abnormal return
t-statistic
-0.0009
-0.09
0.0029
-0.0040
-0.40
- 0.0009
0.0373 -0.0061
3.77*** -0.61
0.0029
0.29
0.0029
0.30
Abnormal return
0.0011 - 0.0000 0.0063
-0.0007
t-statistic
0.78 -0.23
0.30 -0.01 1.65*
-0.18
F-value”
0.30 0.12
7.36*** 0.19 1.48
0.05
a Test of the null hypothesis that ylr = yzk=O. *,**,*** Indicate signilicance at the 10, 5 and 1% levels, respectively, for a two-tailed test.
significant cumulative abnormal returns. The first significant event is September 25 1987 (the day after the Canadian negotiator broke off talks on the FTA), when it was announced that Canada and the US were discussing how to continue the negotiations. Stockholders of US banks with Canadian exposure earned an abnormal return of 3.73% (t=3.77). The second significant event was on January 4 1988, when it was announced that President Reagan and Canadian Prime Minister Mulroney had signed the FTA during the prior weekend. The stockholders of US banks without Canadian exposure earned an abnormal return of 0.63% (t= 1.65). This reaction was not as strong as for the FTA talk resumption announcement (significant at the 10% level versus the 1% level, respectively). In fact, the null hypothesis that yls = yzs = 0 cannot be rejected at conventional levels. No statistically significant reaction was identmed for the remaining events. These results indicate that the US banks with Canadian exposure were more affected by the passage of the FTA than banks without Canadian exposure. For US banks with Canadian exposure, the FTA removed the ownership and asset restrictions and allowed these banks to own Canadian securities firms. Banks which already had Canadian subsidiaries were in a much better position to quickly take advantage of these new competitive opportunities.
J. Harriott et al. 1 Journal of Multinational Financial Management 7 (1997) 145-157
155
4.2. Postscript: after the passage of the FTA As one might expect, given the removal of the 16% asset ceiling, US banking assets in Canada rose by 14% in 1989 and 3.5% in 1990 (see Table 1).8 However, by 1991 the profit picture for US banks deteriorated. By then, Wells Fargo, Continental Corporation and Comerica had pulled out of Canada. Chemical Bank and Banker’s Trust had reduced operations, the Bank of New York had put its Toronto-based subsidiary up for sale and Citicorp had dropped plans to expand its branch network. The Bank of Boston and the First Interstate planned to stay, and each cited niche businesses as the reason (factoring for the Bank of Boston, and exchange trading for First Interstate) (Kraus, 1991). These findings suggest that US banks did not have the retail network necessary to compete with the large Canadian banks in Canada. Regarding entry into the Canadian securities business, as of July 1988 only two US banks had invested in Canadian securities firms. In sharp contrast to the poor performance of US banks in Canada, Canadian banks were successful in expanding their US operations. Seidman (1990) notes that by mid-year 1989, Canada was the third largest foreign country operating in the US banking industry. Feeling that it had a competitive advantage in retail banking, in 1990 the Bank of Montreal announced acquisition plans to increase US earnings by 50%. The Royal Bank of Canada and the Canadian Imperial Bank of Commerce also announced that they were considering expansions of their US operations (Kraus, 1990). As shown in Table 2, total assets of US operations of Canadian banks did, in fact, increase by 33% in 1991 and by 18% in 1992. Canadian banks followed their customers into the United States, and in the combined US-Canada marketplace, Canadian banks appear to have taken the initial advantage over their US competitors. Their advantage in the retail sector can be attributed to the size of their centralized operations in comparison with the decentralized nature of US branch banking. In the Canadian securities business, the Canadian banks have a natural ‘home field’ advantage over the US banks in Canada. Both of these factors are the result of differences in the regulatory environments between the two countries.
5. Conclusions The results of this research show that the Free Trade Agreement had a positive effect on the stock prices of US banks with significant banking operations in Canada. The announcement of September 25 1987, which reported that the negotiations would be resumed despite the fact that the Canadians had broken them off the prior day, produced statistically significant abnormal returns to stockholders. There was also a statistically significant reaction to the announcement that President Reagan and Canadian Prime Minister Mulroney had signed the FTA (January 4 1988).
8 Data on US bank subsidiaries
operating
in Canada
are not available
after 1990.
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While the stock market did not react to the final passage of the FTA, the information concerning passage was already well-known to the market. Key industry representatives were optimistic that the FTA would create a more level competitive playing field within the combined Canadian-US market, and that it would help Canadian and US banks fight the Japanese and European incursion into this market. The stock market’s positive reaction suggests that, from the market’s perspective, this more open environment enhanced the value of US banks with a stake in the Canadian market. The post-accord withdrawal of many US banking operations in Canada, however, indicates that US banks were generally not successful in expanding their Canadian operations. Most Canadian banks, on the other hand, were successful in expanding their US operations. As a result, we conclude that Canadian banks, by virtue of their more deregulated domestic environment, have some competitive advantages over US banks. The FTA represents one step in the deregulation of the banking industry within North America. The implementation of NAFTA (the North American Free Trade Agreement) will build on the current FTA in opening up the Mexican banking industry. The major provisions of NAFTA will: (1) allow US and Canadian banks to provide all types of banking services to Mexican citizens; and (2) give Mexican banks access to Canada and the United States. Like the Canadian banking environment, and unlike the US environment, Mexico’s banks are federally chartered and regulated and there is no wall between investment and commercial banking. Given the experience of the FTA, it is likely that the Canadian banks will have a competitive advantage over US banks in the retail sector within Mexico, if not the entire free trade zone. US banks may continue to be at a disadvantage in the North American market as long as they must comply with US regulations such as the Glass-Steagall and McFadden Acts.
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