Canada to Tighten Capital Rules if Basel Process Remains Stalled

By Peter Menyasz

Canada is ready to go on its own and impose more stringent bank capital rules if the Basel Committee process doesn’t resume soon, Superintendent of Financial Institutions Jeremy Rudin said April 6.

Canada’s six largest banks—Bank of Montreal, Scotiabank, Canadian Imperial Bank of Commerce, National Bank of Canada, Royal Bank of Canada and Toronto-Dominion Bank—could be required to hold more reserve capital to hedge against risky assets and use a different approach to classifying asset risks.

Canada would prefer to work internationally to address the remaining issues in the Basel Committee on Banking Supervision’s program of far-reaching reforms, but the process has stalled and it’s unclear when it will resume, Rudin said April 6 in remarks prepared for delivery to the Toronto-based C.D. Howe Institute think-tank.

“We wouldn’t stand still,” he said. “Canada is preparing to move ahead on its own, with a Canada-specific plan for improving our capital regime. If we conclude that the Basel process is unlikely to restart in the near future, the Office of the Superintendent of Financial Institutions (OSFI) will put that plan into action in a measured way.”

Talks on updating the Basel III capital framework have bogged down for myriad reasons, including a potential shift in the U.S. stance on the international standards. EU officials have said they’re waiting for U.S. President Donald Trump’s administration to install new faces at the four institutions that represent the U.S. on the committee, led by the Federal Reserve. Trump has vowed to roll back domestic financial regulation, and since taking office he has begun to pull the U.S. out of international agreements such as the Trans-Pacific Partnership trade deal.

Prepared to Act

Rudin acknowledged that Canada doesn’t have a “free hand” to act independently on capital rules, as it must preserve a level playing field domestically and for Canadian banks that compete internationally. But it is prepared to impose higher standards than the international minimums to ensure safety and soundness, he said.

“We have done this in the past, we are doing it to some extent in the present and we are prepared to do so in the future,” he said.

Canada’s banks agree with the regulator’s preference for an international consensus, Terry Campbell, president of the Canadian Bankers Association, told Bloomberg BNA April 6. Until then, Canadian banks will work with the regulator to ensure the domestic banking system remains “sound and strong,” he said in an email.

“For a number of years prior to the financial crisis, Canadian banks held capital levels well above international minimums. However, in practice, Canadian banks often set their own internal capital targets well above the minimum OSFI requirements,” Campbell said.

Appropriate Buffer Incentives

The Basel III changes to the international bank capital regime, approved in 2009, significantly improved protection of bank solvency, but less progress has been made on improving the incentives for banks to boost their capital regimes, Rudin said.

The system should require banks to hold more loss-absorbing capacity if their assets are riskier, as that discourages them from loading up on risks and ensures they have capacity to absorb losses they could reasonably face, he said.

Buffers that go beyond minimum capital requirements must allow banks to dip into them without triggering a severe loss of confidence, he said. Banks that start with capital well above the regulatory minimum could use some of the buffer as a “normal first step” in recapitalizing during economic downturns, he said.

“Not only should the capital regime foster confidence in bad times, it should also provide appropriate incentives to banks in bad times. In particular, the capital regime should avoid adding any artificial incentive for banks to rapidly de-level during an economic downturn, either by selling assets at fire sale prices or sharply restricting new lending,” he said.

Regulators need to set the circumstances for allowing, if not encouraging, banks to allow their capital ratios to decline into, but not fall below, the buffer range, he said. Otherwise, the capital regime may be part of the problem during a downturn rather than part of the solution, he said. An international consensus on buffers may be “too much to ask” at this point, but Canada can act alone, he said.

Proper Risk Weighting Crucial

Rudin also said that the Basel Committee’s two current approaches to classifying bank assets based on the weighting of defined categories of risk aren’t good enough.

The standardized approach, used by Canada’s small and midsized banks, generates risk weights that don’t vary enough from bank to bank, while the internal ratings approach, used by Canada’s largest banks, provides too much variation, he said.

The Basel Committee studied the internal ratings-based approach on a model portfolio of assets, finding that one bank assigned a risk weight 40 percent below the median risk weight of the others, which means it would hold 40 percent less capital than other banks for the same level of risk, he said.

“This is the type of outlier result that should not occur,” he said.

Banks in those situations lack sufficient protection against loss, which level of variation undermines confidence in the overall banking system and a regime that tolerates such variability doesn’t offer healthy incentives to banks to manage their risks, he said.

Balanced Approach Touted

The Office of the Superintendent of Financial Institutions currently authorizes banks to use the internal ratings-based approach when it believes the outcome will provide a more accurate risk weight than the standardized approach, he said.

That is based on a belief that the effort banks put into building and maintaining a model to calculate its risk weights creates a degree of discipline and knowledge that should help it better manage risks, he said.

Such a balanced approach could be the basis for an international consensus to better discipline the use of internal models, but the possibility remains that the Basel negotiations could be stalled for some time, particularly given the current questions about the value of multilateralism, he said.

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