Canada’s Domestic Stability Buffer: Swimming Against the Tide - Remarks by Assistant Superintendent Jamey Hubbs, Toronto, Ontario, January 23, 2019

Quote

"…By making the Domestic Stability Buffer more transparent and its purpose and functioning more widely understood, we hope that future increases or decreases to the buffer are seen as normal course of business and stabilizing actions, rather than market events unto themselves."

Introduction

Thank you for joining me today, and I would also like to thank the C.D. Howe Institute for hosting this luncheon.

Warren Buffet is credited with saying "Only when the tide goes out do you discover who's been swimming naked". While said in a different context, I believe this colourful phrase carries an important lesson for those of us working in the arcane world of bank regulation.

During the last global financial crisis we learned about the appropriate level of capital and that a lot of global banks fell below that level. We learned about the quality of capital, and in a number of situations, we learned that capital instruments did not have the loss absorbing capabilities that we previously thought that they did.

We learned that we need to be better prepared for, and better insulated against, crises. And globally, as regulators, we acted on those learnings. We improved the quality and quantity of capital held by our institutions, particularly our systemic institutions, through a combination of regulatory capital and even private capital buffer requirements.

We have created buffers against losses, most certainly. But if the tide goes out again, are these preparations enough to help us manoeuvre through? To pursue Mr. Buffet's analogy, as a frontline supervisor, part of my job is to ensure our largest banks have enough buoyant clothing - or capital to withstand the potential shock of a "low tide", that is an impending crisis or a significant loss event. Likewise, if we see evidence of a rapidly rising tide, I would argue that it is OSFI's responsibility to take action, to help swimmers navigate to shore safely, similar to a lifeguard.

Understandably, market participants watching from the beach may be prone to panic in the absence of clear and credible information about the situation. Since panic is never a good thing in financial markets, we think OSFI has a role to play here too.

This is what OSFI's Domestic Stability Buffer is all about and is what I want to talk about today: about positioning our capital regime as part of the solution for stress situations, though transparency and through prudent action. And specifically, through the 'usability of capital'.

Usability

Capital is a measure of a banks' resilience, but how the capital regime is designed to work in times of stress can often be misunderstood.

For instance, I would suspect that many here today believe that when risks go up, capital should go up; that regulators feel that bank capital levels can, and should, only rise during times of stress. Similarly, capital requirements, including capital buffers, may be viewed as sacrosanct - a floor below which a bank's capital can never fall.

It is true that banks hold capital to preserve the confidence of depositors, creditors and markets. However, the real test of a capital regime is whether and how that capital is used in times of stress to support stability. OSFI believes that an adjustable capital buffer, well communicated and understood, and responsive to conditions in the financial system is the way to achieve this objective.

And, that is why, in June of 2018, OSFI publicly disclosed the Domestic Stability Buffer for Canada's six largest banks, known as our domestic systemically important banks, or D-SIBs.

The Domestic Stability Buffer differs from other capital buffers in that the size of the Domestic Stability Buffer depends on our view of the vulnerabilities and risks currently in the financial system – for example, how vulnerable are banks to losses if economic conditions deteriorate. OSFI would increase the size of the buffer when we assess vulnerabilities to be elevated or increasing, but when those risks actually materialize in the economy, we are inclined to release the buffer, ensuring that capital is available to absorb losses.

What that means is that we build up the Domestic Stability Buffer when vulnerabilities are high but conditions are more stable, and we release the buffer when needed so that banks can use that capital cushion in order to continue to provide loans and services to Canadians. As a result, the primary feature of the Domestic Stability Buffer is that it may very well increase during stable economic times and, specifically before the risks actually materialize.

This only works in the context of regular transparent communication. As a result, twice a year, after assessing the prevailing economic conditions, OSFI will communicate publicly whether it will raise, maintain or lower the Domestic Stability Buffer. This public announcement is a commitment to transparency OSFI has made regarding the capital being held by Canada's largest banks.

Why is increased transparency around the Domestic Stability Buffer important?

This additional transparency came about as OSFI realized that while holding an appropriate amount of capital is important, markets also need to be aware when the regulator expects and is comfortable with banks being able to use that capital in times of stress.

Two important lessons learned from the global financial crisis include:

  1. Market confidence can be fickle if that confidence is based on a view of the usability of capital that is not shared by banks or regulators; and
  2. Transparency around risks is critical to managing risks

Let me expand on each of these, beginning with the question of market confidence,

Informed confidence

Capital has been the most visible element of prudential regulation for many years. OSFI is well aware that regulators are not the only ones interested in capital levels and risk. Shareholders and rating agencies have their own expectations of the banks. Robust levels of capital are one of the reasons Canada has traditionally been viewed as a safe harbour when a crisis looms.

During the financial crisis, confidence in banks was a more precious commodity than capital.
Some banks that were well capitalized could not raise funding because the market had lost confidence in them.

Confidence shores up stability. It can be influenced by many things, including, by what market participants anticipate regulators will do, particularly in times of stress.

Expectations resulting from previous crises or previous successes are only reliable if nothing has changed. However, the reality is that there has been significant change in financial markets and in vulnerabilities in Canada since the global financial crisis.

Without knowing the purpose of the Domestic Stability Buffer, markets may misread signals when OSFI reduces the buffer and the capital is used. This could result in negative speculation and increased uncertainty, when the capital is in fact being used for its intended purpose.

To increase public understanding of OSFI's intent, when setting the Domestic Stability Buffer level this past December we included information on the construction of the buffer, and its intended use.

While the intent of the buffer was well understood in the financial analyst community, and many noted the prudent nature of the change given healthy economic conditions, some analysts were more pessimistic.

To paraphrase their assessment, "nice idea but it won't work when times get tough". Essentially, the concern raised was that even if OSFI decreases the buffer in a downturn, the market is unlikely to accept declining capital ratios when loan losses are rising.

So let me be clear: in the event that systemic risks begin to materialize, OSFI will promptly and proportionately lower the Domestic Stability Buffer. This is part and parcel of the counter-cyclical design of the buffer: banks will be able to use the capital they have built up in "good times" when it is most needed in "bad times".

As a first step, by making the Domestic Stability Buffer more transparent and its purpose and functioning more widely understood, we hope that future increases or decreases to the buffer are seen as normal course of business and stabilizing actions, rather than market events unto themselves.

Identifying the risks

It is important to be transparent about the use and design of the Domestic Stability Buffer, but it is also important to be transparent about the identified risks and vulnerabilities that the buffer is there to protect against.

When we first announced the Domestic Stability Buffer level in June of 2018, the level was 1.5% of total risk-weighted assets. We noted that the buffer will be reviewed semi-annually and range from 0 and 2.5% based on OSFI's assessment of D-SIB exposures to identified risks.

These included: high levels of consumer indebtedness; asset imbalances in the Canadian market, in particular in residential housing, and Canadian institutional indebtedness, in particular non-financial corporate debt.

These risks are well known and have been growing in Canada for some time.

This past December, we set the level at 1.75%. This decision was based on our assessment that systemic vulnerabilities continue to be elevated, warranting a higher level of capital to safeguard against the possibility of them materializing. Given the generally stable economic and credit conditions, a modest increase in the buffer was prudent.

The December buffer increase is in line with our view that banks should build up capital to buffer themselves from risks when economic times are relatively good and capital is easier to build and hold.

As part of the buffer review process, OSFI consults with other federal financial sector agencies including the Bank of Canada on its assessment of risks.

Effectively mitigating risks relies on accurate and timely information. That is why we committed to provide updates on the Domestic Stability Buffer and the related risks every June and December, and when and if circumstances warrant a more urgent change.

Not only will this give more insight into the overall amount of capital being set aside by the banks, it will contribute to broader financial stability by providing additional information on the key risk exposures to Canada's largest banks.

Conclusion

In the lead-up to the global financial crisis, risks were building that few were openly discussing. Tightly held but credible information about vulnerabilities in the U.S. mortgage market was overlooked. Being transparent in the discussion of risks, and taking actions to address them is a lesson that none of us should have to learn twice.

The availability of more information about the capital regime and the supervisor's views of risk results in better decision making by all stakeholders. By publicly announcing the Domestic Stability Buffer and committing to regular updates, we are better equipping institutions, markets, policy-makers and others with current information.

OSFI will continue to monitor for severe yet plausible risks to the financial system, and will be transparent in the actions that it is taking to address them.

We look forward to continuing our healthy dialogue with the industry so we are all better prepared for whatever comes next.

The Canadian financial system has been a bastion of stability for many years but this is no reason for complacency. We must always remember the dangers of swimming too far away from the shore when at any time the tide may unexpectedly go out.

I look forward to your questions.

Thank you.