The international community has made some very significant improvements to the bank capital regime since the global financial crisis. At the same time, we recognize that there is still some hard work to do to complete the regime. We are confident that there is a way forward that should be satisfactory to jurisdictions around the world.
Canada is playing its part in moving this work forward, guided by the three objectives for a sound bank capital regime that I have set out today.
My thanks go to the Institute for International Bankers for inviting me to speak here this afternoon. It is my pleasure to be here in New York to address this audience, on this important topic.
Prudential bank regulators around the world have been occupied with the design and implementation of capital requirements for banks for more than a quarter century. The global financial crisis provided even more impetus to focus intently on the capital regime.
Since that time, substantial progress has been made through agreements reached by the Basel Committee on Banking Supervision and in individual jurisdictions. Today, I want to bring you the Canadian perspective on the progress made to date, and what work still remains.
What do we want the bank capital regime to accomplish?
To bring you that perspective, we need to start with a fundamental question: what do we want the bank capital regime to accomplish? What purpose, or purposes, should bank capital requirements serve?
We can identify three related objectives of a sound bank capital regime.
The first objective is an obvious one: to ensure minimum capital requirements are in place to protect the solvency of banks in the event of losses. Having lived through the global financial crisis, and continuing to live with its consequences, I hope we can agree to take this objective as self-evident.
The second objective is to maintain confidence in the banking system. This is related to the first objective, of course, but it is distinct. It is not enough for there to be adequate capacity to absorb losses if no one recognizes that this capacity exists. We also want the bank capital regime to foster widespread confidence — among depositors, other creditors, clients, counterparties, investors, and the public more broadly — that sufficient loss absorbing capacity is indeed in place, and that it will be replenished if needed.
The third objective is to provide healthy incentives to banks in both good times and bad.
In good times, we want a regime that requires banks to add capital as they take on more risk. The Basel capital regime is built on a system that places a risk weight on each exposure that a bank faces. Properly designed, these risk weights put the right prices on risk taking, prices that give banks a strong reason to seek to reduce their risks. At the same time, a well-designed system of risk weights ensures that banks need to add to their loss-absorbing capacity commensurate with any decisions to take on more risk.
In bad times, a well-designed capital regime should play an additional role: it should reduce the likelihood that banks will try to de-lever too rapidly during an economic downturn. Of course, when economic prospects deteriorate we have to expect that banks will slow loan and asset growth. After all, the demand for loans will fall and the number of creditworthy will borrowers decline.
That said, a well-designed capital regime should, at a minimum, not exert any additional incentive for banks to put a quick stop to loan growth or to rapidly sell assets at “fire sale” prices. This de-leveraging would ultimately be counterproductive: the additional drag on the economy and on asset prices would trigger a further de-leveraging, and so on. In a well-designed regime banks are obliged to maintain adequate capital buffers above the regulatory minimum in good times, and are able to use some of these buffers in bad times.
How has the international capital regime for banks improved since the global financial crisis?
Having set out the objectives of a sound capital regime, let us consider the progress that the international community has made since the financial crisis. Despite the relative stability of the Canadian financial system during the global financial crisis, Canada has been active in developing the agenda for international capital regime reform. We have also been assiduous in implementing those new requirements in Canada.
We recognize that the next crisis will not be identical to the previous one, and that the success of Canada’s regime during the last crisis does not guarantee future success. We also have an interest in contributing to the design and implementation of an improved regime that better supports the stability of the global economy and provides a more level playing field for all internationally active banks, including our own.
The post-crisis agreements forged by the Basel Committee have helped the global community achieve substantial increases in the requirements for both the quantity, and quality, of capital. That new capital regime also requires incremental capital for those institutions deemed systemically important to the global financial system. These are called globally systematically important banks, or G-SIBs. Even though none of Canada’s banks are classified as a G-SIB, we have applied the same approach to our domestically systematically important banks.
More capital, and better quality capital, has meant progress relative to both the first and second objectives of a good capital regime: by better protecting solvency against losses and by improving confidence in banks — although the extent of that improvement varies from country to country.
By being more risk-sensitive, the new capital rules also contribute to the third objective of good capital regimes: to provide the right incentives. For example, the Basel Committee has increased what had been very low risk weights attached to off-balance-sheet and securitization activities. Another example is the introduction of a new capital charge aimed at improving banks’ resilience against mark-to-market losses from deterioration in the creditworthiness of their counterparties.
For all of the progress made at the Basel table since the financial crisis, there are still outstanding issues. I will focus the remainder of my remarks on two areas that are of particular importance to us at OSFI:
- the unwarranted variability of risk weights across banks; and
- the usability of the buffers that are built into the capital regime.
Warranted variability of risk weights
As I noted earlier, risk weights play a key role in the capital regime. Getting the right risk weight for each type of exposure helps to ensure that banks have the appropriate amount of loss absorbing capacity and ensures that banks are subject to the right incentives.
Concerns about unwarranted variability of risk weights across banks are currently on the international agenda, where they belong. It is important, however, not to confuse unwarranted variability with variability more generally.
Overall risk weights should vary across banks. The simplest reason for this is that business strategies should vary across banks, and risk weights should vary across exposure categories. These differences result in warranted variation in overall risk weights.
There can also be warranted variability from one country to another within the same exposure category. This can be warranted by structural and practical differences between jurisdictions.
As an example, the exposure level of non-performing loans is much lower in Canada than in many other countries. This partly reflects the conservative approach to underwriting by Canadian banks. However, it also reflects a legal system that allows banks to resolve non-performing loans much more quickly than in some other countries. This can lead to risk weights that are lower in Canada than in jurisdictions where the resolution of a defaulted loan is slower and more difficult.
Even within a country, there can be warranted variations in risk weights within a single exposure category. This can arise when banks are authorized to base their capital requirements for certain exposure categories on the results of the bank’s own models; models that reflect differences in experience, underwriting and business practices across banks.
Allowing approved banks to use the Internal Ratings Based, or IRB, approach provides an additional means for capital requirements to reflect differences in risk. Moreover, the IRB approach can bring some important additional benefits. For example, it forces banks to explicitly consider a borrowers’ ability to repay, which is not always the case with a standardized approach, in particular when a loan appears to be well secured. This level of scrutiny plays an important macroprudential role, particularly when asset prices are rising.
Furthermore, having the IRB option available provides strong incentives for banks to invest in their risk data and modelling capacity. This in turn improves their capabilities in risk management, capital planning and stress testing.
While we see a number of advantages to the IRB approach, we also recognize that if our banks are to use their own models as input for their capital requirements that activity needs to be closely supervised. Accordingly, Canadian banks require our approval to start using a model, or to make material modifications to an existing model. We also assess the performance of their approved models on an on-going basis.
Unwarranted variability of risk weights
These are some of the reasons why we should expect some variation in overall risk weights across banks, and why we should welcome variation as long as it is warranted by underlying differences in risk exposures.
At the same time, the Basel Committee’s own studies have shown that, within the same exposure category, the extent of variation in risk weights across all internationally active banks is often difficult to reconcile with what we know about variation in the underlying risks.
This is illustrated most clearly when various banks are asked to determine the risk weight they would assign to the same hypothetical portfolio. In a study that looked at exposures to large corporate borrowers, one bank assigned a risk weight to the hypothetical portfolio that was 40 per cent lower than the median risk weight assigned by the other banks surveyed in the study. And when looking at exposures to other banks, the lowest risk weight was 60 per cent below the median!
This degree of variation in risk weights for the same credit should give us all pause, as it fails against all three objectives of a sound capital regime.
First, if the median risk weight in the sample is about right, then the outlier portfolios risk lacking enough protection against loss.
Second, unwarranted variation in the risk weights undermines confidence in the banking system. If the risk weights that a bank is using are not representative of its underlying risks then its measured capital ratios are not representative of the true capitalization of the bank.
Thirdly, if unwarranted variability is left unchecked the regime will not provide healthy incentives to banks. Rather, it will provide an incentive to try to manipulate the system to reduce risk weights, which is the last thing we want banks to be working on.
So we strongly support the view that this issue needs to be at the top of the agenda for the Basel Committee.
The way forward
What, in our view, is the way forward on this issue? We need a solution that will improve the performance of the capital regime against all three of the objectives.
To meet the first objective — protection of solvency against loss — there needs to be an increase in required capital that offsets the unwarranted variation in risk weights.
To meet the second objective — confidence in the system — we need to demonstrate that our solution addresses the underlying problem. To make that demonstration, we need to produce evidence that our solution will reduce variability in risk weights where it is unwarranted. As I noted, that is not the same as reducing the variability of overall risk weights. If we mix up these two measures we could easily fail to address the underlying problem. That would also undermine confidence that the Basel process is capable of addressing the real issues it faces.
We also need to abide by the goal set by the governing body of the Basel Committee which is to address this issue without a material increase in required capital worldwide. Canada supports this goal for a number of reasons, not least of which is that it will discipline us to address the underlying problem, rather than paper it over with a generalized increase in capital requirements.
To meet the third objective — to provide healthy incentives — we need a solution that both reduces the incentives of banks to game the system while simultaneously making the system more sensitive to variations in underlying risk.
With those considerations in mind, we are very supportive of initiatives to better discipline the internal ratings based system. This includes proposals that would constrain the use of internal ratings in those exposure categories where there is limited loss data.
By contrast, we are not in favour of proposals that would put Canada’s major banks on a regime that mimics the standardized approach by eliminating any role for internal models whether directly or indirectly. As I have already outlined, Canada’s experience with internal ratings has demonstrated several strengths that we are determined to retain.
We recognize that proposals that would re-impose a standardized approach on our major banks could indeed increase their required capital. But this would probably do little or nothing to directly reduce risk, as those banks already hold capital well above the minimum requirements. More importantly, such an approach could lead to an increase in risk taking by creating an incentive for banks to load up on riskier exposures without any compensating increase in capital. That would more than undo any risk-reducing benefits from higher required capital. These same considerations underly our approach to setting the minimum level for the soon-to-be-adopted international leverage ratio standard.
We have been fortunate in Canada that our banks have chosen relatively low-risk business models. Some of the impetus for lower-risk banking has come from our regulatory regime. If we were to undo the healthy incentives in our capital regime, we would only have ourselves to blame for the consequences.
The usability of capital buffers
Let us turn now to another important issue, the usability of capital buffers.
If the capital regime is to meet all three of the objectives that I set out earlier it needs to sometimes encourage, and sometimes require, banks to hold a capital buffer above the bank’s minimum capital requirements. The current regime includes a number of potential buffers that must, or may, be established with regard to various risks. For my purposes today we can ignore these complications and think of a single combined buffer which I will refer to as: the buffer, for simplicity.
The size of the buffer plays a straightforward role in addressing the first objective of the capital regime. Other things equal, the larger the buffer, the greater the loss absorbing capacity of the bank and thus the greater protection for solvency against losses.
When it comes to the other objectives of the capital regime, however, the role of the buffer is less straightforward. Consider next the goal of enhancing confidence.
One might hope that an increase in the buffer would increase confidence simply because it increases loss absorbing capacity. But this will only be the case if banks can allow their capital ratios to dip into the buffer range without triggering a loss of confidence simply due to crossing the buffer line. If investors and counterparties believe that the definition of a sound bank is one that always maintains capital above the buffer, then widening the buffer will increase capital, but it may not increase confidence. Indeed, it could diminish it.
Of course, a bank that is using up its capital needs to recapitalize. If this goes on long enough, or happens quickly enough, dramatic measures may be required. But for a bank that starts with capital well above its regulatory requirements, we all need to see the idea of using some of the bank’s capital buffer as the normal first step in the process of recapitalization. Otherwise, we will have inadvertently designed a capital regime that does not foster confidence in the system, and can even undermine it.
Turn now to our third objective for the capital regime: to provide healthy incentives to banks in good times and bad. In particular, I noted earlier that the capital regime should avoid adding any artificial incentive to banks to rapidly de-leverage during an economic downturn.
We need to think about what will happen when the next major economic downturn arrives. I hope and expect that that day is a long way off, but no one can know for certain. So there is all the more reason for banks — and bank regulators and supervisors — to be talking about it now.
Those jurisdictions, like Canada, where bank capital ratios are well above the regulatory minimums, appear to be well positioned for any potential economic weakness. In the event that earnings decline, banks in these jurisdictions will still be able to grow loans to creditworthy borrowers and continue to support capital market activity, because they will have substantial room to grow assets more quickly than their retained earnings, while still meeting their regulatory capital requirements.
But will banks use this option, which involves some modest decline in their capital ratios, or will they instead seek to de-lever rapidly? The choice will depend on what banks believe about the expectations of their investors, and the expectations of their regulators and supervisors.
What can regulators and supervisors do to keep the healthier options on the table? One contribution we can make is to open the conversation about the purpose of buffers, and how we expect to see them used. I encourage you to participate in that conversation.
We can also be open to ideas that would further increase the likelihood that buffers will play their intended role. Here is one idea that we are looking at in Canada, still at an early stage of our thinking. It relates to that part of the existing buffer regime that sets a threshold for the capital ratio such that a bank is required to restrict distributions from the bank if the ratio drops below that threshold.
If we have only one bank whose capital ratios are falling, it may make sense to set that threshold fairly high. If only one bank is trying to de-lever quickly, we do not need to consider possible systemic impacts as the other banks will be well placed to replace the missing loan growth or to buy the assets being shed. Setting a high threshold in this case will encourage the bank to react quickly, which may well make sense.
However, that same threshold could be inappropriately high if the entire system was under stress. When economic prospects fall for all banks, it could make sense for them to mobilize more of their capital buffers, as long as those buffers were healthy to begin with. This would alleviate the risk of triggering a counterproductive systemic de-leveraging; a risk that we do not need to worry about when there is only one bank in question.
With these issues in mind, we welcome an international dialogue on the usability of buffers, and we look forward to a productive discussion among regulators, supervisors, banks and investors.
I will conclude by reminding you that the international community has made some very significant improvements to the bank capital regime since the global financial crisis. At the same time, we recognize that there is still some hard work to do to complete the regime.
We are confident that there is a way forward that should be satisfactory to jurisdictions around the world.
Canada is playing its part in moving this work forward, guided by the three objectives for a sound bank capital regime that I have set out today.