Canada's financial watchdog says bank buffers big enough to weather storms

‘We have enough insurance for a severe but plausible downside scenario’

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The Office of the Superintendent of Financial Institutions has maintained the additional capital buffer the country’s biggest banks must hold at 3.5 per cent, a decision that some analysts say will cheer bank investors as an increase was expected. 

OSFI last raised the buffer in June by 50 basis points, citing risks including high household and corporate debt levels, the rising cost of debt and increased global uncertainty around fiscal and monetary policy.

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The domestic stability buffer was introduced in 2018 as an adjustable tool applied to Canada’s largest banks deemed most important to the stability of the domestic financial system. It requires them to build up capital that can be used to absorb losses and encourage lending in times of stress.

As a result of the decision, Canada’s six largest banks are expected to target a Common Equity Tier 1 ratio of at least 11.5 per cent of risk-weighted assets. All six are currently above 12 per cent.

“OSFI elected to hold the DSB at its current level because Canada’s six largest, or systemically important, banks have each reached a level of reserve capital that is sufficient to absorb losses if current vulnerabilities materialize into actual losses,” OSFI said in a Dec. 8 statement.

Gabriel Dechaine, an analyst at National Bank of Canada, told clients in a Dec. 4 note it was widely expected that OSFI would raise the domestic stability buffer by 50 basis points, which would have compelled the large banks to hold a common equity Tier 1 capital ratio of at least 12 per cent of risk-weighted assets.

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“If OSFI surprises, and holds the DSB flat, then we could see bank stocks rally,” Dechaine wrote.

On Dec. 8, the analyst called OSFI’s decision a “relief” but said he expects the banks to maintain more capital than is required by the regulator to meet share buyback and acquisition aspirations and to prepare for the possibility that OSFI could raise the domestic stability buffer rate to four per cent if new or heightened risks emerge.

Peter Routledge, superintendent of OSFI, noted that the hold follows several increases to the domestic stability buffer (DSB) to ensure the big banks were positioned to handle shocks, including risks from heavily indebted Canadian households and rising interest rates.

“Over the last year, OSFI has increased the DSB by 100 basis points, adding to the robust capital reserve for Canada’s six largest, or systemically important, banks. We believe this action has bolstered the banking system’s capacity to absorb losses if current vulnerabilities materialize into actual losses.”

The risks cited in June have remained, but conditions have not worsened, Routledge said during a media briefing after the announcement.

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“Household debt remained elevated,” and commercial real estate continues to present risks to banks, especially in the office sector, but these risks “didn’t get any worse,” he said.

Moreover, there were positive signals such as declining household debt-to-income ratios.

“Over the last year, or 18 months, as we’ve implemented this policy of raising the DSB, we saw it as an advantageous time to do so, because earnings remain strong, credit growth remains strong,” Routledge said, comparing it to buying insurance at a cheap price when times are good.

“Now we have enough insurance, we believe, for a severe but plausible downside scenario. And we wanted to communicate that with this decision.”

If it appears that losses are going to materialize for the banks, Routledge said OSFI will consider lowering the domestic stability buffer to allow banks to absorb those losses with the cushion they’ve built up.

OSFI sets the domestic stability buffer every six months, but can do so at other times if deemed warranted. This gives the regulator additional opportunities to react as an estimated 2.2 million mortgages come up for renewal at potentially much higher interest rates in 2024 and 2025. This represents about 45 per cent of all outstanding mortgages in Canada, according to the Canada Mortgage and Housing Corp.

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Routledge said Bank of Canada’s decision to hold the overnight interest rate steady at five per cent during the last three rate-setting sessions, as well as predictions by many economists that interest rates will begin to come down by spring, were taken into consideration in maintaining the domestic stability buffer for Canada’s largest banks.

The looming renewals and recent interest rate decisions “were certainly part of the calculus but … not limited to that,” he said.

“We see the DSB as something that is driven by vulnerability, or risk. Vulnerabilities are risks that haven’t materialized into actual losses yet.”

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