New capital rules will be costly for Canadian banks and economy, says analyst

Basel regulations could crimp lending and put banks on unequal footing with global counterparts

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New capital rules for Canada’s largest banks are expected to come with a raft of business and economic costs, potentially crimping lending and putting the banks on unequal footing with counterparts in the United States and Europe, according to a veteran analyst.

In a report published late Tuesday, National Bank Financial analyst Gabriel Dechaine told clients that the phased-in Basel rules introduced in 2023, which affect the way banks calculate risk-weighted asset ratios, will begin to have an impact on most of Canada’s big banks as full implementation in early 2026 approaches.

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It will affect the calculation of risk-weighted assets by shifting away from sole reliance on a measure that has been criticized for not reflecting the risks inherent in loan books. In the process, there will be hits to the banks’ closely watched common equity tier one (CET 1) capital ratios.

The new Basel rule, called the output floor, will impose “greater conservatism on banks…conservatism that comes at a cost,” Dechaine wrote, adding that the lower CET 1 will mean less return on equity for the banks.

For perspective, he applied the full impact to the balance sheets of the Big Six banks in the second quarter of fiscal 2024 and estimated an additional $80 billion of risk-weighted assets alongside a 45-to-50-basis-point hit to bank CET 1 ratios (with the exception of Toronto-Dominion Bank, for which there was no impact.)

“For additional perspective, that amount of RWAs (risk-weighted assets) would equate to the eighth largest bank in Canada,” Dechaine wrote, adding that the costs of the new rules would extend beyond return on equity for the banks.

Some banks have already begun to shed certain loans outright or curbed lending, Dechaine wrote, adding that although such strategies to “optimize” balance sheets and capital consumption may not be tied directly to the upcoming phased-in Basel rules, they should not be viewed in isolation.

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“That strategy reduces individual bank earnings potential, while also possibly shifting them away from low-risk activities into higher-risk ones that are a better fit under the existing regulatory capital framework,” the analyst wrote. “Moreover, banks that restrict lending to certain segments ultimately hurt consumers by reducing competition, which is counter-intuitive in an industry that faces criticism for a lack thereof.”

He noted that there has also been some activity in credit risk transfers, which he called “an ‘originate to distribute’ business model,” adding that it could potentially introduce other risk factors to the banks’ business.

Beyond the banks, Dechaine said, restrictions on credit supply due to the intensification of capital regulation restrict the potential growth of the broader economy.

In his report to clients, the analyst pointed out that regulators in jurisdictions outside Canada appear to be re-thinking the costs of forcing such conservative capital management. Bank rule-makers in the United States, for example, are considering walking back the final and strictest Basel rules referred to as Basel III Endgame, part of the sweeping international risk management regime put in place following the 2008 financial crisis. In the European Union, meanwhile, an initiative know as the fundamental review of the trading book has been deferred.

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This cautious stance by regulators “suggests that the regulatory pendulum can swing in both directions,” Dechaine wrote.

In an interview with the Financial Post in April, less than a month after the U.S. Federal Reserve signalled plans to soften the strict final stages of Basel III for that country’s banks, Royal Bank of Canada CEO Dave McKay urged Canadian regulators to rethink capital requirements imposed on this country’s largest financial institutions.

“We cannot get out of sync with our two major competitive markets, Europe and America,” McKay said at the time, adding that having to hold more capital would render Canadian banks uncompetitive. “A level playing field is really important.”

The apparent about-face on imposing the final Basel III rules in the U.S. came after fierce pushback from banks in that country, with lobbying efforts focused on the argument that adopting the stringent final rules would hurt everyday Americans by potentially reducing the amount of money banks had available to lend.

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In the April interview, McKay, whose bank has significant operations in the United States, noted that Canada’s Office of the Superintendent of Financial Institutions had already updated its bank rules to reflect the final package of Basel reforms and put them into effect for Canada’s banks beginning in 2023.

“We’ve gotten out front on Basel III, expecting those markets to follow,” McKay said. “If anything changes, we have to rethink that trajectory.”

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