Adapting Prudential Policy for the New Normal - Remarks to the C.D. Howe Institute, Toronto, Ontario, September 28, 2020 via webcast

Thank you for inviting me to speak to you today about how OSFI is adapting prudential policy for the new normal. The “new normal” is difficult to define but important to embrace, as it has become clear that we will be dealing with the health, economic and financial impacts of the pandemic for some time to come.

So much has happened since March that it is easy to forget what we’ve done and why. We haven’t had the time to catch our breath and explain what we’ve been doing to address issues as quickly as they arise. However, we are aware of our obligation to connect with our stakeholders and explain what we’ve done. I hope that my remarks today explain our actions prior to the pandemic, our responses during the pandemic and our approach in the future.

Like all of you, we are moving ahead with caution because nobody knows what may be around the next corner. But move ahead we must, even with limited historical experience for such extraordinary times.

OSFI’s mandate is to protect depositors, policyholders, financial institution creditors and private pension plan beneficiaries while allowing institutions to take reasonable risks and compete effectively. We meet this mandate through the operation of two core functions:

  • regulation, which is about setting expectations for the financial institutions and pension plans we regulate via prudential policy and guidelines; and
  • supervision, which is about assessing plans’ and institutions’ practices against our expectations and responding to any gaps we identify.

Both of these core functions are essential in delivering our mandate. Adjusting the emphasis between them is what makes for a responsive and flexible approach to support effective risk management, thereby contributing to confidence in the Canadian financial sector.

As a prudential supervisor, we always have an eye to the future and are constantly seeking to ensure that our prudential framework is comprehensive, practical and risk-focused. This approach of continuous improvement has served us well in the past and continues to guide us in the current circumstances.

We have observed that acting on the lessons from the previous crisis have enhanced the resilience of the Canadian financial system. The international regulatory reform agenda following the Global Financial Crisis (GFC) has redefined the nature of prudential regulation in Canada preparing us all for the uncertain world we now find ourselves facing.

This reform agenda is made up of five inter-related areas: first, building more resilient financial institutions; second, ending too-big-to-fail; third, making derivatives markets safer; fourth, enhancing resilience of non-bank financial intermediation; and fifth, making progress in other areas, such as the rollout of new accounting standards for expected credit losses and a focus on audit quality.

These regulatory measures were clearly required to build resilience in the global financial system. However, what helped turn the Canadian economy around post-GFC was a persistently low interest rate environment and, at the time, a relatively lower household debt. In 2007, Canadian household debt to income was around 130%.

For OSFI, we have led prudential policy setting to build resilience in financial institutions, while also supporting the implementation of other aspects of the regulatory reform agenda by our federal and provincial partners. With respect to resilience, the increase in the quantity and quality of capital held by banks has improved their capacity to absorb unexpected losses and continue to operate during periods of financial stress. Moreover, we have made significant progress towards facilitating an orderly resolution of our largest banks and minimizing taxpayers’ exposure to loss. And new rules governing liquidity have improved banks’ ability to make good on their obligations even in stressful market conditions as well as promoted the use of more stable sources of funding.

One lesson-learned post-GFC was that regulators needed more policy levers to address the broader economic risks and interdependencies across the domestic and international financial system via so-called macro-prudential regulation. New measures, such as the countercyclical capital buffer or in Canada, the Domestic Stability Buffer (DSB), were evidence of this. OSFI created this buffer to allow us to respond to any build-up of risks in the financial system. These buffers are reserves held at our largest banks with the purpose of being available for use when risks become reality. Critically, they provide OSFI with the flexibility to allow banks to support the Canadian economy during a downturn while not imperiling our overarching objective of maintaining financial safety and soundness.

More recently, we have paid increasing attention to the threats posed to operational resilience. Non-financial risks include those risks related to people, organizational culture and technology. While this focus pre-dates COVID-19, the operational challenges posed by the pandemic reinforces how “non-financial risks” can become material financial risks where there is a lack of focus on operational risk management and operational resilience. Dealing with non-financial risks is therefore an important part of building overall resilience in the face of uncertainty.

For OSFI, developing prudential policy post-GFC has been a deliberate, ‘step-by-step’ process that has built resilience in the system and flexibility for when crisis strikes. The careful preparations that we make in ‘good times’ are essential, but it is equally important to be ready to act decisively in a crisis.

Risks have evolved and so too should our policy development process. Keeping this in mind is part of our current, more adaptive approach to prudential policy making. Our aim is to remain responsive to the circumstances we face and support the financial sector’s resilience consistent with our mandate.

Make no mistake that we now are at a critical point in modern economic history. This is a test of lessons learned and our ability to act under pressure.

The economic and market conditions we have seen in 2020 and the collective decisions authorities have taken in response will shape the trajectory of future growth and prosperity. While the COVID-19 pandemic is not a disruption of the financial sector’s making, it is certainly testing many of the measures we and our federal partners put in place to prevent and manage financial crises, post-GFC.

Even before the pandemic, there were risks in the financial system that required our attention. Domestically, household debt to income had grown at 175.6%; asset imbalances and institutional indebtedness were all at the front of our minds.

Moreover, globally, equity markets were at all-time highs on the back of stretched valuations and a search for yield in a low interest rate environment. Therefore, when the magnitude of the crisis became apparent, markets reacted predictably and violently. Equities fell nearly 40%, volatility spiked to levels not seen since 2008/09, debt markets froze, and finally, an oil price war erupted in the midst of the market turmoil, exacerbating impacts domestically including all the negative knock-on effects for business activity, consumer confidence, and jobs.

Only unprecedented levels of fiscal stimulus and government support stemmed the immediate aftershocks of the pandemic declaration around the globe. For OSFI, our focus was on crisis response because, while the financial institutions and pension plans we supervise were well prepared for stress, extraordinary adjustments were clearly necessary to get through to more stable times. The immediate health crisis gave focus to our decisions and priorities: preserving financial and operational resilience. Our ‘business-as-usual’ approach to prudential policy needed to take a back seat in order to meet our mandate in such trying times.

As a result, on March 13, OSFI suspended all of its planned policy consultations and refocused on a series of temporary actions designed to provide financial institutions with the flexibility to respond quickly to the risks posed by COVID-19. These extraordinary actions were designed to be credible, consistent, necessary, and fit for purpose, and should not create unintended consequences for the broader economy and the financial outlook of financial institutions.

As part of its announcement, we lowered the DSB to support up to $300 billion in extra lending capacity. This action was intentionally “countercyclical” to avoid the risk of bank retrenchment and the negative economic effects of a ‘credit crunch’. Moreover, this action avoided any cost to the taxpayer while preserving room for future reductions in the DSB, if required.

In addition to the DSB adjustment, we made other decisions to support resilience.  Given the highly uncertain economic environment, we smoothed the capital impact of expected credit losses that would have been required as part of recently adopted international financial reporting standards. We also temporarily permitted special capital treatments for banks and insurers offering payment or premium deferrals to cushion the shock.

These were extraordinary actions for extraordinary times. They were designed to act as a temporary bridge to more stable conditions by allowing banks and insurers crucial time and flexibility to adjust to the new operating environment and thereby limit the excesses of possible retrenchment.

We also moved to protect private pension plan beneficiaries by placing a freeze on portability transfers and annuity purchases. This helped pension plans to manage through the volatile market conditions when asset transfers could have otherwise harmed the solvency of the plan at precisely the wrong time, putting pension plan members at risk.

We believe the actions we took were effective prudential policy measures. They limited the immediate impact of the crisis on our institutions, increased the security of pension plan benefits, and reduced obstacles for broader economic recovery efforts. As well, they helped to cushion households and firms during a record downturn, which, in turn, contributed to financial stability and has so far mitigated individual and corporate defaults.

I would like to discuss how we are negotiating the difficult path before us. Uncertainty remains high and the health and economic effects stemming from COVID-19 are still very much part of our daily deliberations. Our approach to policy decisions considers these conditions while continuing to look at the severe yet plausible scenario.

What we have observed since March is that financial institutions’ capital levels remain sound and stable in the face of uncertainty. There remains ample liquidity in the financial system and markets are comparatively stable compared to where they were in March. Further, the operational challenges that required a quick shift to widespread remote working are now better understood and managed. Such outcomes were less apparent in the midst of the initial phase of the pandemic and this drove our quick decisions in March.

By the end of August, the initial phase of the pandemic had passed, meaning that some of the adjustments we made in March were no longer credible, consistent, necessary or fit for purpose and therefore required review. For instance, market conditions had stabilized enough that we were confident to discontinue the portability freeze on private pensions. We also announced a gradual phase-out of special measures related to loan and premium payment deferrals given the need to maintain the credibility of the capital framework.

Other measures that we took in March will also phase out, for example, the transitional bank capital measures for expected credit losses or the smoothing of capital requirements for life insurers. Conversely, some other measures will continue to remain effective in the current environment and will remain in place until further notice; these include the DSB remaining at 1% and prohibiting divided increases and share buybacks.

As conditions continue to stabilize, it is also time for us to refocus on the broader risk landscape. We are monitoring the continuing effects of COVID-19, as policy measures unwind and the true economic cost and future trajectory of the pandemic becomes clearer. The solvency impacts on different sectors will vary, so our focus will be on the supervision of credit risks during a downturn, albeit with more dramatic economic drivers.

Canadian households and businesses have benefitted from historic support from across the public sector. The cost of direct support measures for individuals and businesses is approximately $214 billion, but significant transition risks remain as sectors adjust to the new normal. This complicates the outlook for asset values and their relationship with economic fundamentals. Transition risk also underscores the importance of sound underwriting throughout the economic cycle and is one of the reasons why we decided to phase out the special capital treatment for payment deferrals, as it will help to restore a better view of credit quality. 

It is also clear to us that many of the risks prior to the pandemic remain and in some cases have intensified. For instance, there is an increased reliance on reinsurance and the business models in the insurance sector have been changing. Further, cyber risks have also become more critical as digitization accelerates.

All of these issues require ongoing contact with financial institutions, private pension plans and the public through regular and repeated communications on policy responses and priorities. The current environment also requires close collaboration with other Canadian government agencies and international counterparts. The results from our ongoing supervisory work will continue to inform the prudential policy decisions we make based on the risks that we see and the tools that we have available.

I had best cover what we see and what we are doing now. We have seen the continued resilience of financial institutions and pension plans in recent months and we need to be confident that they are prepared for what may come next – in the immediate as well as the longer term.

While current economic forecasts are at the more optimistic end of what is a tough set of possible outcomes, uncertainty continues to drive the decisions of governments, institutions and Canadians. Household debt remains high although it recently dropped due, in part, to the direct support measures (158.2% in Q2 compared to 175.6% in Q1); corporate and sovereign indebtedness has increased; and geopolitical events with environment, social, and governance (ESG) impacts are part of the broader risk landscape.

Again, we expect to face a persistent low interest rate environment that puts further pressure on financial institutions and pension plans with long duration liabilities. As well, a particular challenge may arise at the eventual tapering of significant government support for the economy and financial markets.

Standing still is therefore not an option, even if the outlook remains highly uncertain. Risks continue to confront the institutions we oversee and this requires forward thinking.

Our stance now is to re-start the development of prudential policy that preserves a resilient financial system while also responding to the unprecedented levels of uncertainty due to the pandemic. We are doing this because the pandemic poses new risks, but also threatens to act as an accelerant for pre-existing vulnerabilities. We have posted on our website our policy development plans for the next few quarters focusing on elements of risk management and compliance, capital and accounting. This policy restart is responsive, relevant and realistic and further develops our already robust framework.

I began my remarks with a focus on the regulatory work completed to protect against financial risks. Each of the regulated sectors we oversee faces different exposure to financial risks and so our prudential policy priorities reflect this.

We are resuming our work on insurance and pension-related guidance. For pension plans, we will progress work on instruction guides for benefit reductions, the preparation of actuarial reports and pension plan registration and termination. As well, at the beginning of August, we officially relaunched our engagement with the industry on their adoption of a new international financial reporting standard for insurance contracts, known as IFRS 17, and its implications for capital adequacy reporting for insurers and actuarial standards. We will also be restarting our consultations related to reinsurance practices given its critical role and importance to insurance business capacity and resiliency.

For the banking sector, we will be moving forward with the domestic implementation of the Basel III Reform Package, including Pillar 3 disclosure expectations. We deferred domestic implementation by one year following the announcement of the Basel Committee on March 27th. We will also resume our work that looks at the proportionality of requirements for small and medium-sized deposit-taking institutions given the distinct nature of these institutions in comparison to larger, internationally active banks.

We are also watching developments in underwriting practices for residential lending. As I mentioned in my last talk at C.D. Howe in January of this year, our incremental revisions to Guideline B-20 have had the intended positive effects for mortgage underwriting. Canada’s mortgage market is important to institutions, financial stability, and to Canadians. Sound underwriting remains as important in both good times and bad. While I also identified an opportunity to update the uninsured mortgage benchmark rate, the risk outlook and the responsiveness of mortgage rates remain moving targets and we are not yet ready to return to this consultation.  

I also noted the importance of operational risks in affecting the overall resiliency of financial institutions. Our priorities also include an intention to improve institutions’ and pension plans’ preparedness for, and resilience to, these non-financial risks. While this goal existed before the pandemic, the pace of digitization in financial services during the period of physical distancing has only served to reinforce our work on technology-related risks.

We recently launched a discussion paper on technology risks that covers a broader range of issues than our usual practice. It highlights cyber security, third-party risks, artificial intelligence, data and more. This range of topics requires that we reach out to a broader than usual spectrum of stakeholders. This broader reach is to ensure that our next steps on prudential policy target good prudential outcomes while allowing institutions to compete through healthy innovations.

The prudential risks for institutions and private pension plans we regulate are changing. The impact of these changes will affect different financial sectors at different rates and over different timelines. An important part of our stakeholder engagement will be the launch of a consultation that will help us determine what more we need to do to promote resilience to financial risks stemming from climate change.

Up to this point, financial institutions and pension plans have responded to the risks and volatility caused by COVID-19 quickly and effectively. The strength of the Canadian financial system leading in to the pandemic also held us in good stead. But we need to plan for where we must go from here.

Looking ahead to 2021, there is a very real possibility of a vaccine becoming widely available, bringing with it the promise of economic growth and fewer headwinds for our financial system. However, our experience in the years following the GFC would suggest that the effects of the COVID-19 crisis are unlikely to be short-lived. OSFI is warming up for a marathon, not a sprint.

We are therefore taking a cautious approach: focusing on the immediate safety and stability of the financial system, institutions and pension plans we oversee. This requires close monitoring and careful calibration of our policy responses. Our intention is that OSFI’s measures will act as a bridge to more stable conditions, guided by our mandate and lessons from previous crises.

Looking further ahead, we are now at a point where we can and must re-commence our policy agenda. We must also be prepared, where appropriate, to adapt our approach for the new normal. Like the marathon runner, we need to be thinking about the last ten miles as much as the first ten. This means beginning to act now to prepare for an uncertain future.

With six months having passed since the declaration of the pandemic, we have already learned many lessons from COVID-19. We have all seen the importance of decisive crisis management, open and timely communication and the ability to adapt under pressure – rolling out operational and financial measures not seen before.

As in the aftermath of 2008, we will take the time to learn from these experiences and reflect them in the future design of prudential policy. What we learned from the GFC we acted on, making us stronger and better prepared for current events.

I believe that the lessons from COVID-19 will carry us even further, sharpening our focus on the horizon and the risks and opportunities that lie ahead. In the meantime, we continue to work closely with our federal partners and other key stakeholders to safeguard Canada’s financial system.

I look forward to further conversations about how we achieve this together.