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OSFI Annual Report 2018-2019

Federally Regulated Financial Institutions

Operating Environment

D-SIB Capital Requirements: 0-4.5% Minimum CET1 Capital Requirement, 4.5-7% Capital Conservation Buffer, 7-8% D-SIB Surcharge, 8-10% Domestic Stability Buffer
*As of October 31, 2019. More information on capital requirements for regulated financial institutions is available on the OSFI website

Federally regulated financial institutions have experienced supportive business conditions, led by a benign credit environment and a favourable economic backdrop, which has contributed to profitability and financial stability.

Business strategies continue to focus on product innovation and new services, expansion into new markets, efficiency improvements and reaping benefits from investment in technology.

To fulfill our mandate, OSFI strives to ensure that financial institutions can withstand severe but plausible risk scenarios that may affect their financial health and the stability of the broader financial system. The past year marked the tenth anniversary of the global financial crisis. OSFI and other foreign financial regulators have learned much from the crisis, including the setting of an appropriate quantity and quality of capital at financial institutions. An effective capital regime requires institutions to hold adequate capital buffers to protect against severe but plausible stress, while also encouraging them to use their buffers during times of stress to avoid fire sales of assets or drastic reductions in activities such as lending.

To maintain the effectiveness of Canada's capital regime, OSFI publicly disclosed the domestic stability buffer for Canada's six domestic systemically important banks (five D-SIBs and one G-SIB). The adjustable capital buffer is counter-cyclical, such that OSFI will lower the buffer in the event systemic risks materializes. Other measures taken by OSFI to support regime effectiveness include the release of the Total Loss-Absorbing Capital (TLAC) guideline and the TLAC public disclosure guideline for D-SIBs and the Life Insurance Capital Adequacy Test (LICAT) guideline and LICAT public disclosure guideline.

Financial Risks

On an ongoing basis, OSFI monitors and evaluates system-wide developments that may have a negative impact on financial institutions and the financial system. A primary risk to financial institutions continues to be elevated levels of household debt and asset imbalances, which would include Canadian housing markets. History has shown that relaxing financial institution's underwriting standards can lead to extreme and persistent levels of financial instability.

Lenders subject to OSFI supervision hold nearly 80 percent of all residential mortgages issued in Canada, and residential mortgage loans account for almost 30 percent of the total assets held by these lenders. Sound mortgage underwriting practices reduce risks to the financial system. OSFI has required lenders to assess a borrower's ability to pay their loan under a variety of conditions. Revisions to the guideline included measures requiring institutions to apply more rigor when assessing a borrower's ability to repay their loans such as employment status and income history; a revised minimum qualifying rate (stress test) and greater scrutiny on property valuations. OSFI has been monitoring the impacts of B-20 and has noted that fewer mortgages are being approved for highly indebted or over-leveraged individuals. The B-20 revisions are having the desired effect of promoting sound mortgage underwriting practices in financial institutions.

OSFI monitors and responds to other risks facing financial institutions, including liquidity, market and credit risks. The global financial crisis underscored the importance of adequate levels of liquidity to the proper functioning of the banking and financial system. Broker-deposit funding remains an area of focus because of its susceptibility to rapid withdrawal in a stress scenario. OSFI is paying close attention to the funding profiles of financial institutions and their dependency on broker-deposit funding. OSFI constantly reviews the liquidity, funding position and related risk management practices of all federally regulated institutions to ensure adequacy and appropriateness. OSFI updated its Liquidity Adequacy Requirements (LAR) guideline to include targeted modifications related to the Liquidity Coverage Ratio (LCR) and Net Cumulative Cash Flow (NCCF) metrics. These revisions promote the safety and soundness of institutions and allow the metrics to better reflect the increased risks posed by different types of retail deposits that may be subject to sudden withdrawals.

OSFI is also paying close attention to commercial real estate (CRE). The CRE market is highly cyclical; a market downturn can affect asset values resulting in financial losses. OSFI has directed its work at ensuring sound underwriting practices and appropriate risk management by financial institutions. Another area of emphasis is debt to the non-financial corporate sector. Business debt has seen significant growth in the past few years with a growing proportion of weaker structures, e.g. less strict loan covenants. OSFI examines the underwriting practices of federally regulated institutions to ensure that proper standards are applied. We also assess the soundness of risk management practices.

Other risks we are monitoring include the potential for financial system stress emanating from the financial market, including trade or geopolitical developments in Europe and China.

Non-Financial Risks

Financial institutions are expanding their business capabilities through a powerful combination of new technology and rapid digitization. Institutions are extending channels for existing financial products and services, digitizing paper-based processes and outsourcing many aspects of their businesses to third-party providers, some of which are significant in size and span of control. Many of these developments have been outside of the traditional banking institutions, giving rise to new risks.

Senior Supervisor, SMSB Group, Vancouver, Deposit-taking Supervision Sector
Senior Supervisor, SMSB Group, Vancouver, Deposit-taking Supervision Sector

Globally, highly publicized cases of financial institution misconduct, significant fines and impacts to reputation risk have heightened the focus by regulators and behavioural scientists on the importance of culture and its impact on the effectiveness of risk management, boards and senior management. OSFI has conducted a number of risk culture assessments of institutions and is looking to advance our abilities and skill sets to assess other prudential aspects related to culture such as the decision-making process and leadership development. OSFI also issued a revised Corporate Governance guideline (September 2018), which reinforces the role of the board and senior management in establishing and overseeing a sound risk culture.

This shifting landscape requires OSFI to maintain its focus on financial resilience while also considering the quality of risk management of non-financial risks by financial institutions.

The creation of a new non-financial risk group brings four divisions under one umbrella, namely the Technology Risk Division, which includes cyber and fintech; the Model Risk Division, the Operational Risk Division and the Culture and Conduct Risk Division. Shifting toward a more integrated and functional view allows risk capabilities to be responsive and evolve more seamlessly over time.

Within the non-financial risk space, three areas warrant increased attention. The first area is reliance by financial institutions on significant third parties, which may lack information security protocols and can expose financial institutions to operational disruption. Secondly, the increase in advanced analytics through artificial intelligence or machine learning enhances greater predictability from new and different forms of data but poses operational and reputation risks. The credibility of analytical outcomes may erode as transparency and justification become more difficult to demonstrate and explain. OSFI continues to monitor developments in this area with plans to develop regulatory and supervisory expectations around the use of advanced analytics.

Lastly, cyber risk, brought on by information technology and digitization advances, has the potential to present serious vulnerabilities that could put depositors, policyholders and creditors at risk, and may undermine the security and confidence of Canada's financial system. Cyber risk is an area that requires partnership and collaboration to mitigate the potential for disruption and damage. OSFI is involved in a number of national and international forums to leverage best practices in guidance and supervision. We are also working with the new Canadian Centre of Cyber Security to enhance coordination and collaboration in the event of a national security incident.

Climate risks

Climate change risk has become an area of increased focus and can have significant impacts on financial institutions and private pension plans.

Property and Casualty insurers face physical risk due to the increasing frequency and magnitude of physical damage from climate-related events. Other institutions and pension plans also face transition risks as the economy adjusts to a low-carbon environment, including exposure to investment risk associated with carbon-linked investments. A third type of risk is liability risk associated with injured parties seeking to recover losses from other parties they hold responsible. The industry is very familiar with this type of long-term risk exposure from asbestos-related liabilities.

OSFI supports the view that institutions should adopt a strategic approach to addressing climate change risk. OSFI will be evaluating the progress made by financial institutions in identifying, monitoring, assessing and responding to climate change risk. OSFI will be enhancing our knowledge and understanding of the risks, developing supervisory capabilities and assessing the impacts on supervisory practices and guidance.

How climate change risk will evolve ultimately remains uncertain. Climate change and global warming are the subject of frequent discussions at international regulatory meetings. OSFI has joined 22 other countries as a member of the Sustainable Insurance Forum (SIF). The SIF is a network of leading insurance supervisors and regulators seeking to strengthen their understanding of, and responses to, sustainability issues for the insurance business. As a member, OSFI will contribute to an issues paper on the level of insurance company awareness and adoption of the recommendations of the Task Force on Climate-Related Disclosures. Some insurers have started to test the impacts of climate change through DCAT, ORSA and other scenario-testing methods.

OSFI will continue to monitor global developments such as climate change risk, and determine appropriate responses that support overall financial stability.

Overall, OSFI is keeping abreast of developments supporting risk identification, monitoring, assessment and measurement to determine appropriate responses that will promote the safety and soundness of financial institutions and financial stability.

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