Canadian banking regulator maintains domestic stability buffer for large lenders

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Canada’s banking regulator has upheld the capital cushion the country’s largest lenders must keep in reserve, signalling that financial institutions are weathering the trade war and economic uncertainty wrought by escalating geopolitical tensions.

The Office of the Superintendent of Financial Institutions said Thursday that the domestic stability buffer – capital banks must maintain to endure the blow of an economic downturn – will remain at 3.5 per cent of a bank’s risk-weighted assets.

Superintendent Peter Routledge said banks have evaded significant impacts from higher tariffs, rising loan loss reserves and consumer and business concerns about a deteriorating economy. But the regulator is focusing on potential “spillovers” of these issues amid persistent uncertainty.

“Conditions thus far are better than our planning assumption earlier in the year. We take only a moderate level of comfort from that and we remain focused on downside scenarios,” Mr. Routledge told reporters during a news conference Thursday.

“We view the Canadian banking system as well positioned to absorb a deterioration in conditions, if they occur.”

In recent years, OSFI increased the buffer twice – hiking it from 2.5 per cent – to build a bigger safety net. The higher level forced lenders to reserve billions of dollars in excess cash, taking a chunk out of profits.

To do so, it had to increase the potential range of the buffer to between 0 and 4 per cent, up from a maximum of 2.5 per cent.

Analysts and senior bankers have expressed concerns about how higher capital levels could harm the competitiveness of Canada’s banking sector by putting lenders at a disadvantage to global peers. The standard range set by Basel III, an international accord struck after the 2008 financial crisis to help prevent bank failures, is 0 to 2.5 per cent of a bank’s risk-weighted assets.

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The U.S. has been easing up on regulations for the financial sector, prompting regulators in other countries to rethink their approaches. Yesterday, the U.S. Federal Reserve voted in favour of reducing the supplementary leverage ratio requirements for banks, which requires them to hold capital against all assets equally, regardless of the level of risk.

“Lighter regulation in the U.S. could mean the same for Canada in due course. Communication from the new Vice Chair for Supervision of the Federal Reserve, Michelle Bowman, has indicated a shift in policy to light regulatory requirements in the future,” CIBC analyst Paul Holden said in a note to clients.

“While only the first step in the process, we view this as indicative of the direction the regulators are likely to go. We would not be surprised if the minimum common equity tier 1 requirement set by OSFI is reduced at some point in the future.”

The domestic stability buffer also affects the minimum capital levels that a bank is expected to hold. The common equity tier 1 (CET1) ratio – a measure of a lender’s ability to absorb losses – remains at 11.5 per cent.

Mr. Routledge said Canada’s biggest banks have remained profitable even amid the challenges of the global economy.

The average CET1 ratio of the country’s largest lenders sits at 13.6 per cent, up almost 30 basis points over the past six months. (A basis point is one-100th of a percentage point.) The median CET1 ratio for global, systemically important banks is 13.4 per cent, indicating that OSFI’s rules are on par with those of other regulators, Mr. Routledge said.

“The DSB is a resilience buffer, and we don’t set that giving any consideration to competitive issues,” he said. “We set it giving consideration to what the impacts of a stress scenario would have on the balance sheets of banks.”

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In February, OSFI indefinitely paused an increase to the Basel III output floor, which is aimed at ensuring a bank’s internal risk assessment models do not deviate from the standardized guidelines.

Mr. Routledge said that was done in part to level the playing field with global markets, many of which had not yet implemented the new rule.

While the regulator can change the DSB at any time, OSFI announces a decision to change or hold the level twice a year. The requirement applies to financial institutions that are considered systemically important, including Royal Bank of Canada, Toronto-Dominion Bank, Bank of Nova Scotia, Bank of Montreal, Canadian Imperial Bank of Commerce and National Bank of Canada.

OSFI would consider a decrease in the event of a shock to the financial system. During the pandemic, it lowered the buffer by 125 basis points to free up capital so banks could continue lending.

OSFI is monitoring ongoing threats, including higher household debt levels and worsening housing and commercial real estate valuations.

“Given the unusual degree of economic uncertainty at present, OSFI stands ready to lower our capital expectations of Canada’s systemically important banks as financial conditions warrant,” Mr. Routledge said.