Published in the Financial Post
Canada’s financial regulator is in a ticklish situation. On March 6, United States Federal Reserve Chairman Jerome Powell signalled that U.S. regulators are reconsidering their plans to hike capital requirements for large banks in accordance with what is commonly referred to as the “international Basel III endgame agreement.”
The obvious question? Should Canada’s counterpart, the Office of the Superintendent of Financial Institutions (OFSI), follow suit? The obvious answer? In my view, yes, the OSFI should suspend its plans to implement similar changes for the six major Canadian banks until it is clear whether the U.S. and other major jurisdictions actually proceed.
The Basel III endgame agreement is the final chapter of a suite of changes to bank capital requirements that were designed to foster a safer, more resilient global banking system in the wake of the 2007-2008 global financial crisis. This last chapter will limit banks’ ability to use their own risk management models to compute their regulatory capital requirements and instead impose standardized models on them that typically generate more stringent requirements.
Quick off the mark, OSFI has moved faster on the endgame agreement than major jurisdictions, including the U.S., EU, and U.K. It has already implemented key changes to the measurement of risk, whether credit, market or operational.
The final and most contentious changes are introduction of a capital floor and the constraint on banks’ use of their own risk models. When fully implemented by OSFI in 2026, the capital floor will prevent bank capital requirements from falling below 72.5 per cent of those calculated using a standardized capital framework that uses internationally-agreed supervisory parameters. By contrast, before Powell’s latest announcement, the U.S. had been planning to implement its changes by 2028, while the EU and U.K. are targeting 2030.
An analysis of the capital changes published by Scotiabank’s equity research team suggests the main impact in Canada will be higher capital requirements related to loans to large corporations and to lending secured by real estate, including residential mortgages and income-producing real estate. The reason is that banks’ risk-model-derived capital requirements for these types of loan are well below those emerging from the standardized framework.
Because greater capital requirements on loans to these sectors would raise their costs, some people have argued OSFI should delay its phasing-in of the capital floor so as not to discourage investments needed to enhance productivity and expand the housing stock.
That alone doesn’t justify a pause, however. However worthy the goals of enhancing Canada’s productivity and expanding housing, using bank regulation as an instrument to promote lending to specific economic sectors is a bad idea — tantamount to asking bank depositors and creditors to subsidize the costs and risks associated with such lending in an opaque manner.
On the other hand, a couple of prudential points do argue in favour of OSFI pushing pause on its endgame implementation.
First, are current bank capital levels adequate or not? If they are adequate, then the even higher requirements the endgame mandates are unnecessary. Alternatively, OSFI could continue with the endgame but allow the impact of the new requirements to be neutralized by some offsetting measures. Total regulatory capital requirements could remain unchanged through some combination of adjustments to the capital buffers contained in bank capital plans and/or reducing the size of OSFI’s “domestic stability capital buffer” applied to the six major banks. Lowering it reduces the amount of capital banks must hold.
Second, Powell’s announcement suggests that not just the U.S. implementation timeline, but also the new U.S. rules could change. If so, the EU, U.K. and others may follow the American lead, in which case, for all intents and purposes the endgame agreement collapses. OSFI shouldn’t impose a new regulatory floor on our banks that in the real endgame the world’s leading banking markets simply opt out of.
Events in the U.S. have given the rest of us an opportunity to pause and wait to see if and when other jurisdictions actually implement the endgame agreement. If OSFI wants to carry on with its current implementation plans, it should explain why Canada’s six big banks should have to meet tough new requirements before their international competitors do.
Mark Zelmer, a senior fellow with the C.D. Howe Institute, was deputy superintendent of financial institutions at OSFI from 2011 to 2016.
