Fireside chat with Peter Routledge at the 2024 TD Securities annual financial services conference

On January 19, 2024, the Superintendent of Financial Institutions, Peter Routledge, sat down for a fireside chat at the 2024 TD Securities Annual Financial Services Conference. The following is the transcript of that conversation.

Domestic Stability Buffer

Moderator: In June 2023, OSFI raised the Domestic Stability Buffer (DSB) and raised the upper range to 4%. That was surprising to me. What is your reasoning/logic behind the recent DSB decision?

Superintendent Routledge:

• OSFI’s DSB decisions are based on our assessment of a wide range of quantitative and qualitative information. This information is related to vulnerabilities and risks our institutions are exposed to, as well as results from recent stress tests and supervisory judgment.
• Setting the DSB at 3.50% in June was a prudent and responsibly measured decision, and it reflected our assessment that systemic vulnerabilities were heightened.
• Three factors underlined our decision not to change the DSB in December:
  1. Since our DSB announcement last June, systemic vulnerabilities have remained elevated but have not worsened;
  2. We judged the loss absorbency implicit in a 3.5% DSB as adequate insurance against a severe but plausible deterioration in financial conditions; and
  3. The prudent approach to capital management taken by the Boards of Directors of Canada’s systemically important banks, all of which produced CET1 ratios exceeding 12%.
• In summary, over the last year, OSFI has increased the DSB by 100 basis points, adding to the robust capital reserve for Canada’s six largest banks. We believe this action has bolstered the banking system’s capacity to absorb losses if current vulnerabilities materialize into actual losses.

Moderator: The decision in June made me worry that OSFI's bias was to the conservative end. What do you need to see to take the DSB down?

Superintendent Routledge:

• OSFI continuously monitors the appropriateness of the level and range of the DSB for the current circumstances. The DSB is a flexible tool. When vulnerabilities worsen, OSFI takes further steps to build resilience.
• We can increase the DSB when we see rising household and institutional debt levels, market imbalances in Canadian asset prices, and vulnerabilities related to systemic external and geopolitical developments that could have spillover effects to the Canadian financial system.
• And we can decrease the DSB and take further supervisory action as appropriate if losses rise unexpectedly, or when indicators suggest a high probability of a recession. Also, a partial release of the buffer could be warranted to help ensure smooth and stable lending conditions and lower the risk of a credit crunch.
• For example, during the pandemic, the DSB was lowered by 1.25% (on March 13, 2020) providing banks in excess of $300 billion of additional lending capacity. This action was taken to support banks' ability to continue to provide loans and services to Canadians.
• Let’s not forget that OSFI can move swiftly to revisit the range or level if circumstances warrant. We are also monitoring key vulnerabilities closely and engaging with institutions through regular supervisory processes. This will help mitigate the risks of vulnerabilities from materializing.

Mortgage / Housing market

Moderator: Variable rate mortgages with fixed payments have come under material scrutiny and you have been clear that is not a product OSFI is fond of.  You've also been clear that that you don't like seeing amortization periods extended materially. What can OSFI do if the institution identifies a product it doesn't like?

Superintendent Routledge:

• Firstly, I would clarify that there is a common misperception that these mortgages’ amortization period extends, largely because monthly mortgage statements calculate a transient amortization period based on the amount of principal paid down in that month. In fact, the contractual amortization period does not change. And mortgagors will have to make up the deferred principal paydowns when they renew. This means they are at risk of suffering a significant payment shock.
• For that reason, I have said previously that I think the housing finance system would produce better outcomes for borrowers and lenders alike if this product was less prevalent. And I stand by that statement.
• Having said that, all products entail a certain amount of risk—some more than others—and our job is to make sure that financial institutions are appropriately managing these risks. We do this in a number of ways.
• When setting up mortgages, it’s important that lenders be proactive and apply OSFI’s Guideline B-20 expectations when underwriting the loan, including the Minimum Qualifying Rate (MQR), also known as the “stress test”, for a range of financial and economic conditions before loans are granted.  
• Beyond that, we’re making changes to capital requirements that 1) ensure both lenders and mortgage insurers are holding adequate capital for the risks presented by negative amortization, and 2) set incentives for lenders to prevent negative amortizations to begin with. Published October 20th and coming into effect, now in fiscal Q1, 2024.
• Lenders should also adhere to the key principles in the Financial Consumer Agency of Canada’s (FCAC’s) Guideline on Existing Consumer Mortgage Loans in Exceptional Circumstances.
• Ultimately, these are decisions that will be made at the lender level and we appreciate that lenders are working with Canadians to help them stay in their homes, while also ensuring the actions taken remain within the institutions’ risk appetite, including holding appropriate reserve levels.

Moderator: On October 16, OSFI announced the results of public consultation on B-20 focused on debt serviceability measures. Can you outline the response and the reasoning behind OSFI's decision to pursue targeted supervisory actions to limit exposure to high household indebtedness? Discuss decision on debt service coverage restrictions particularly.

Superintendent Routledge:

• Residential mortgage lending has been identified consistently as a top risk in our Annual Risk Outlook and its fall update. High household indebtedness is still relevant to credit risk, the safety and soundness of FRFIs, and the overall stability of the financial system. During the low interest rate environment, mortgage and other household indebtedness continued to build up despite existing measures.
• As the prudential regulator, our role is to ensure that lenders follow sound underwriting standards, and use prudent lending, portfolio and account management practices.
• We are developing a loan-to-income limit (LTI) at the portfolio level for uninsured mortgages. Our intent is to set limits that do not affect business operations under current interest rates and would prevent the buildup of a highly leveraged borrower base in times of low interest rates.
• These actions will take into account the size, nature, complexity, and risk profile of each federally regulated financial institution. It will balance sound risk management against the need for federally regulated financial institutions to compete effectively and take reasonable risks.
• These are supervisory actions. Further details are not permitted to be disclosed under the Supervisory Information Regulations.

Modernizing the supervisory framework

Moderator: New in April 2024. What's changing and why did you feel the need to change? I'm particularly interested in how the changes would allow OSFI to take early corrective actions.

Superintendent Routledge:

• The risk environment is changing rapidly, and we are modernizing our Supervisory Framework to ensure it remains fit for purpose. The new framework will also help us refine our risk evaluation methods and navigate today’s evolving risk landscape more efficiently.
• The notable changes to our Supervisory Framework are:
  • An expanded 8-point rating scale with greater disclosure about risk drivers and earlier warning to regulated institutions about OSFI’s level of concern;
  • Linkage to OSFI’s risk appetite through new tier ratings reflecting size, complexity, and potential for contagion;
  • Introduction of new risk categories including business risk and operational resilience;
  • Integration of climate risk considerations; and
  • Creation of additional capacity for risk-based supervisory work.
• The new supervisory framework is designed to enable quick responses and provide greater transparency to financial institutions about the outcomes we expect to see.
• To that end, we'll continue to facilitate frank, open, and direct communication with our stakeholders. We'll also provide more information to regulated institutions to help them understand what our key concerns are and address them in a timely manner.
• The new supervisory framework will become effective in April 2024, and it is worth noting is that this is the most significant change to OSFI’s supervisory framework in 25 years.

Commercial Real Estate

Moderator: Where does CRE stack up in your list of concerns? Discuss the purpose and scope of the CRE Risk Management Guidance – key areas of focus

Superintendent Routledge:

• The Commercial real estate (CRE) lending was identified as a top risk in the fall update to OSFI’s 2023-24 Annual Risk Outlook.
• The Commercial real estate (CRE) regulatory notice responds to the heightened risk environment by reinforcing our expectations regarding sound risk management of CRE lending. The notice is not exhaustive. Given recent observations through our supervisory work, it focuses on:
  • governance and risk management
  • prudent underwriting and account management
  • portfolio management
• While lending institutions are currently well capitalized and have proven to be financially resilient in previous downturns, the higher interest rate environment has prompted us to monitor for indications of increased borrower defaults, fraud, and credit losses, especially in residential real estate secured lending (RESL), CRE, and corporate loan markets.
• We are currently engaged with industry to enhance CRE-related data collection to increase reporting granularity. This will improve tracking of CRE, including monitoring of ratings, forbearance actions, and collateral valuation.

Climate risk

Moderator: We understand the risk clearly from the perspective of P&C insurers. How does it fit into the regulation of banks and life insurance companies?

Superintendent Routledge:

• For OSFI to fulfill its purpose, we must ensure Canadian financial institutions manage the risks that could impact their safety and soundness, and of course climate change is one of those risks - increasing physical risks from weather events, and risks from the inevitable transition to a low-carbon economy. Both types of climate-related risks intersect with more traditional financial risks such as credit, market, insurance, and operational risks.
• Climate change impacts financial Institutions’ safety and soundness because it will alter the cash flows generated by some financial assets and businesses. Stronger and more frequent natural disasters are changing the economic fundamentals in some insurance segments. As the world shifts away from GHG-emitting energy sources, the Canadian financial system will have to finance business’ transition to a low carbon economy.
• Over the last year, OSFI has made significant progress in helping regulated financial institutions advance their competence in managing the physical and transition risks associated with climate change.
• This has included setting our expectations through Guideline B-15: Climate Risk Management, launching the Climate Risk Forum to create a platform for dialogue, and initiating consultations on a draft Climate Risk Returns and Standardized Climate Scenario Exercise (SCSE). We plan to publish the final version of the climate risk returns and part 2 of the SCSE consultation in the next few months.
• We at OSFI ultimately see Climate Risk through the same lens as all other prudential risks that have emerged since the financial crisis of 2008-09. And we will approach it based on the same risk management principles.