1FINANCIAL SERVICE CLUSTERS IN CANADA
A well-functioning financial services sector is vital because it serves critical functions in our society. The sector is also economically important in its own right, directly employing 780,000 Canadians and accounting for 6.8 per cent of Canadian GDP in 2014, according to data from the Conference Board of Canada. By far the largest cluster of financial services firms is in the Toronto area, and they account for 32.3 per cent of Canada’s financial services employment. Nearly one worker in twelve in the metro Toronto area is directly employed by the financial services industry, which accounts for 13.2 per cent of the area’s GDP. Typically, Toronto is included in Top 10 rankings of global financial centres, with the Global Financial Centres Index ranking the city eighth in the world.1 Toronto’s financial sector also has substantial links to Waterloo’s tech sector, and the two are often considered part of the same GTA-KW nance ecosystem.2 Financial Technology (known as fintech) investments are growing rapidly in Canada, with OMERS Ventures reporting that 100 fintech start-ups in Canada have collectively raised more than $1 billion in funding since 2010.3
2INNOVATION IN THE FINANCIAL SERVICES INDUSTRY
The term “innovation” has mixed connotations in the financial services industry. While innovation can boost productivity and living standards, financial innovations, such as loan securitization, tranched securities and credit default swaps, are seen as having played a role in the U.S. financial crisis of 2007-2008.4 Beck et. al. found that while increased financial innovation is correlated with higher GDP growth, it is also correlated with economic volatility and bank fragility.5 As such, there is a stronger link between innovation and regulation than in most industries. Regulators need to ensure an environment is created in which beneficial innovations are not being stifled while at the same time consumers are protected and systemic macroeconomic risk is guarded against.
3PAST STUDIES OF CANADIAN FINANCIAL SERVICES INNOVATION
We are not the first researchers to examine the state of innovation in Canada’s financial services industry. Past Canadian examinations include:
Conference Board of Canada (2015): The Conference Board found that despite strong financial performance relative to its international peers, the Canadian financial sector was a productivity laggard. While Canadian financial companies scored quite well on input-based measures of innovation, these inputs were not manifesting themselves in labour productivity growth.
McDonald-Laurier (2014): The report discusses the number of different regulators in Canada that financial rms must answer to and raises worries about a lack of policy coherence between regulators. The authors recommend that the federal government create a “world-class Financial Innovation Institute whose mandate would be to identify, back and promote the adoption of the ‘new’ and put Canada at the forefront of 21st-century financial institutional leadership.”
Munk (2011): There are some issues around the linkages between the financial sector and the Information and Communications Technology (ICT) sector highlighted by this study. Concerns are raised that Canadian financial institutions are not protecting their intellectual property to the same degree as their American counterparts and that the U.S. Patriot Act is causing issues for Canada’s financial sector. Not all is gloomy, however, as the report discusses some comparative advantages the Toronto cluster has over international competitors, including “strong physical infrastructure in terms of the transportation network and a first-rate airport … as well as a competitive research infrastructure in terms of the presence of world-class universities and community colleges.”
Munk (2015): A three-sentence paragraph of the report does an excellent job of summarizing the ndings of the paper: “While the GTA has all the necessary components for a dynamic and thriving ntech ecosystem, they are weakly linked. The consequence is that the parts do not currently add up to an e ective ecosystem. In short: we have many of the essential parts, but are missing the system.” The reasons cited for the lack of an e ective ecosystem include the need to go to the U.S. for an adequate level of funding for ntech rms to scale up, the lack of a national securities regulator, di culty getting regulatory approval in every province and the lack of inexpensive incubator centres. One interviewee cited coordination as being a problem: “There are few forums to connect. There are lots of products, campuses, financial institutions, and start-ups in the GTA, but it is hard to see a forum for all these people to come together.”6
4WHAT OUR ROUNDTABLE TOLD US
Canada 2020 made its way to Bay Street in Toronto and assembled a group of financial industry experts, from government, non-governmental organizations, big banks and ntech startups. Some themes emerged in our two-hour conversation.
Market structure and incentives: When asked, “What is the biggest barrier to innovation in Cana- da’s financial sector?” a common answer was the structure of the industry and the incentives that it creates. Canada’s financial sector is dominated by six big banks. Due to the oligopolistic nature of the industry (caused, in part, by high barriers to entry), Canada’s Big Six are more pro table than similarly sized banks in other countries. Combined, Canada’s six largest banks earned $35 billion in pro t last year.7 In the view of some start-ups, this creates an incentive for the banks to ght disruptive innova- tions, as those disruptions put oligopolistic pro ts at risk. However, the counter-argument was given that the banks recognize that these innovations are inevitable, so the banks have an incentive to be active participants, rather than facing challenges from outside, such as from global players like Google and Apple.
Stability versus innovation: Innovation is a tricky concept in the financial services industry since innovations are seen as playing a role in the financial crisis of 2008. The roundtable unanimously recognized that regulators have an important role in protecting consumers as well as in protecting the integrity of the financial system from systemic risks. It was recognized that regulators have the near-impossible task of nding a way to protect the system while not sti ing useful innovations and keeping abreast of rapidly changing technologies.
A concern was raised that regulators are judged solely on their ability to prevent “bad things from happening,” which comes at a cost of innovation. One participant gave an analogy of judging road-safety regulatory bodies solely on the number of crashes, saying their response would be to “[make] all roads ve miles per hour.” A suggestion was made that financial industry regulators be given a dual mandate of consumer protection and innovation development.
“LOOKING BACK, WE WERE VERY LUCKY WE RAISED MONEY BEFORE WE HAD WRITTEN CODE …
WE SPENT THREE TIMES AS MUCH ON LEGAL AND REGULATORY COMPLIANCE AS WE DID ON IT.”
The bulk of industry regulation applies equally to big banks and financial start-ups. Some members of the roundtable questioned whether this is always appropriate, given that the failure of small players does not create the systemic risk that the failure of a big bank would. The idea of a “regulatory sand- box,” a tool used from Singapore to the United Kingdom, was discussed. The sandbox would allow ntech companies that remained under a speci ed size to face a reduced set of regulations. Given that one of our ntech participants spent three times the amount of money on regulatory research as on writing html code, and another spent their first $25,000 entirely on researching regulations, such an idea has a natural appeal. One participant was concerned that the sandbox could create a wall that would prevent rms from growing past a certain size, and might deter venture capital investment if the venture capitalists thought there was a chance the rm would not be able to one day “play outside the sandbox.”
Cultural barriers to innovation: A concern was raised that Canadian investors and managers may be too risk averse to be full participants in a highly innovative industry. As one participant put it, “[In Canadian MBA programs] there’s not a lot on how to take risk … . In [New York], the mentality of grads out of the U.S. is to take risks. There’s an acceptance that if you do that and fail that’s OK. In Cana- da, there’s stigma around failure.” A suggestion was made that foreign investors from countries with higher appetites for risk, such as China, may be able to ll some of the financial (but not necessarily managerial) gaps.
Immigration issues: If there are talent (or cultural) gaps in the system, immigration might o er an answer. However, one roundtable participant noted that it takes so long to bring executive-level talent into Canada under the Temporary Foreign Worker Program that a candidate will have typically moved on to other opportunities by the time their application is approved.
Access-to-capital gaps: Members of the roundtable stressed the importance of looking at the entire life-cycle of a ntech company when discussing possible gaps in access to capital. The consensus was that seed funding for good ideas was available through angel investors and family members; as one participant put it, “There’s no shortage of people willing to write $50,000 cheques.” The bigger chal- lenge appears to be nding enough money to reach scale, with our ntech roundtable reporting that
it is more di cult to nd second-round funding than it is first. Canadian venture capitalists were seen as requiring higher rates of return or lower risk than their U.S. and Chinese counterparts, and there was a perceived talent gap between the quality of Canadian and American venture capitalists. Fintech companies partnering with banks was seen as an option, though there were concerns that accessing capital this way would come with too many restrictions. As one ntech start-up put it, “The challenge is allowing ntech to ourish while you’re in the hug of a big bank. The problem is I’d be dead in a year because I couldn’t go as fast as I need to go.”
Collaboration: Members of our roundtable saw increased collaboration as a way to increase innova- tion in the sector. One participant felt that there were tighter ties between the investment and ntech start-up communities in the United States, which allowed for information sharing and the building of trust and stated, “Interaction, sharing ideas among startups, isn’t something you get a sense of in Canada. We need a safe spot for founder-to-founder, investor-to-investor interactions.” Increasing interactions was seen as a way to identify gaps in the industry’s ecosystem and help match startups with investors. Some members of the roundtable felt that interactions between regulators and ntech start-ups were vital, while others believed that there was “no upside for [us] to talk to regulators.”
One participant called their interactions with regulators “unsatisfactory,” and described a typical interaction: They receive a letter from a regulator asking for information to determine whether or not they are compliance with a certain rule or regulation. A lawyer drafts a reply, at a cost of $5,000. The regulator determines the startup is in compliance, but doesn’t bother to let them know. Conversely, if the regulator determines the startup is not in compliance, they receive another letter, hire the lawyer to write a reply, and wait to nd out whether the regulator’s response will be silence or another letter.” One recommendation for an improved industry-to-regulator relationship is increased collaboration be- tween companies, which would allow them to speak in a single voice through the publishing of industry letters, white papers and other means. As one regulator described the current situation, “Government hears so many voices and has to prioritize.”
“IF REGULATORY BARRIERS AND OTHER INNOVATION ROADBLOCKS ARE IGNORED, THERE’S GOING TO BE LESS CAPITAL IN THE SYSTEM. IF THE MESSAGE BROADLY TO THE INVESTMENT COMMUNITY IS, WE DON’T WANT TO… HELP ENTREPRENEURS BUILD UP THEIR BUSINESSES OR WE WANT TO PUT REGULATORY ROADBLOCKS IN THE WAY, [INVESTORS WILL WONDER HOW THEY CAN INVEST IN A BUSINESS THAT CAN’T SUCCEED IN THIS COUNTRY.”
Final thoughts: Overall, the roundtable saw fantastic innovation potential in Toronto’s financial services industry thanks to banks that compete on the international stage and a critical mass of skilled graduates between Waterloo and Toronto. Increased innovation would bene t consumers, by giving them additional choices, more convenience, greater access to capital and lower costs when choosing financial products. A failure to innovate would see the pro table parts of the industry swallowed up by large U.S. players, with Canadian banks largely becoming commodity producers.
1 All data from the Conference Board report: Financial Services – an Engine for Growth 2015
2 One such example is the Munk School report Current State of Financial Technology Innovation.
3 Remarks by Carolyn Wilkins, Deputy Governor of the Bank of Canada
4 Financial Innovation and the Financial Crisis of 2007-2008 http://jerrydwyer.com/pdf/innovation.pdf
5 Financial Innovation: The Bright and the Dark Sides http://www.efa2012.org/papers/t1d2.pdf
6 Munk School – Current State of Financial Technology Innovation, page 16
7 http://www.cbc.ca/news/business/bank-pro ts-rise-1.3348661