Regulator puts Canadian banks on fast track for new capital rules
Canada’s top banking regulator is pushing the country’s largest financial institutions toward faster adoption of new riskbased capital rules than their international counterparts.
Analysts expect the changes, intended as an interim step to a fiveyear phase-in by the international banking community beginning in 2022, to provide a near-term benefit to most of Canada’s biggest banks by giving them slightly more flexibility when it comes to their capital requirements.
“We work hard to influence the direction of international standards so they are fit for purpose in the Canadian context and we have been successful at this on many fronts,” Carolyn Rogers, assistant superintendent of financial institutions at the Office of Superintendent of Financial Institutions, said in a speech to industry players and investors this week. “But we have also learned to not hesitate to make adjustments to international standards where we feel they are necessary to meet Canada’s objectives.”
One of the capital rules OSFI is updating this year as it prepares final implementation plans for the global regulatory framework known as Basel III involves the way banks measure a so-called “output floor” — a standard implemented in 2008 to make sure the level of capital held by banks that rely on internal models does not fall below a prescribed level.
Under the Basel framework, banks don’t have to begin phasing in a new, more risk-sensitive standardized approach until the year 2022, but Rogers says the current rule is already “showing its age” by using definitions of capital and risk-weighted assets that are more than 10 years old and are significantly less risk sensitive.
Leaving the existing rules in place for another 10 years has operational risks for Canadian banks, and also risks distorting incentives OSFI views as critical to creating a credible capital regime, she said. It would also require legacy systems to be maintained at banks “for the sole purpose of calculating a backstop metric.”
As a result, Canadian banks will begin the transition to the new risk-based standard next quarter, and finish in the fourth quarter of this year.
Under the old approach, when banks used their own internal riskweighting models for assets, their risk-weighted assets were required to be at least 90 per cent of what they would have been using standardized models. If they fell below that Basel 1 “output floor,” the backstop was triggered requiring them to make a capital adjustment.
In her speech this week, Rogers described the 90-per-cent threshold as “a relatively high calibration point.” The new approach calls for the floor to be “calibrated at 75 per cent,” with details to be published by OSFI soon, she said.
It is perhaps noteworthy that the floor was initially established to bridge the treatment and measurement of capital between the implementation of global regulatory standards established by the Basel 1 and Basel II frameworks. Global regulators, including OSFI, are currently determining the final phase-in of rules under Basel III.
Gabriel Dechaine, a bank analyst at National Bank Financial, said most Canadian banks — particularly Toronto-Dominion Bank — will benefit from OSFI’s decision to replace the Basel 1 floor ahead of global banks. He noted that Canadian banks began triggering the 10-year old Basel 1 floor in late 2016, and now all but one of the country’s Big Six banks have triggered it.
“What was once an annoyance more than anything else has become a material source of capital consumption,” the analyst wrote in a note to clients. In dollar terms, he said it represents an aggregate risk-weighted average figure of nearly $70 billion, or $7 billion of a typical CET 1 capital cushion of 10 per cent.
“Therefore, relaxation of this particular standard represents a meaningful source of capital for the group,” Dechaine wrote, adding that TD is potentially the largest beneficiary. Canada’s second largest bank by market capitalization took a 90 basis point hit to its CET 1 capital ratio in the fourth quarter as a result of the Basel rule.
Other banks that took smaller hits include Bank of Nova Scotia, Bank of Montreal, and Royal Bank of Canada. Dechaine noted that Canadian Imperial Bank of Commerce has less relative upside, having taken just an 11 basis point hit, while National Bank of Canada has not triggered the existing capital floor at all.
“To be clear, we do not know if the change will completely eliminate the impact of the Basel 1 floor. However, a lower output floor (75 per cent versus 90 per cent) would suggest some relief,” Dechaine wrote.
Rogers said OSFI will also be making adjustments to the banks’ capital regime to increase transparency. In her speech, she said the Canadian regulator is still considering options and consulting with stakeholders, but the objective is to increase the likelihood that existing capital will be drawn on as intended during times of financial stress.
“If we are going to ensure our capital regime works as intended we need to ensure it is well understood, not only by banks, but by investors and the broader market,” she said. “It’s not enough that regulators expect that a bank will draw down its capital buffers in times of stress; the market must also expect it.”
OSFI’s consultations on Basel III implementation, under terms agreed upon by the international community in December, are expected this spring.