Looming risks and long-term resilience

Speech by Superintendent Peter Routledge, Economic Club of Canada, Toronto, Ontario, April 27, 2023

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Date: April 27, 2023

Thank you for the invitation to speak to you today. Before I begin, let me first acknowledge that we meet today on the traditional land of the Mississauga of the Credit First Nation, the Haudenosaunee, the Huron-Wendat and other nations. I am grateful to have the opportunity to be present in this territory. 

Re-asserting OSFI’s will to act

Today I would like to speak with you about how risks facing Canada’s financial system have shifted and heightened the need for OSFI, as a prudential regulator, to act early in response to uncertainty.

The need to act early, or the will to act, lies at the core of OSFI’s origin story. Parliament established OSFI in 1987 in response to several failures of medium-sized banks in the mid-1980s. The Royal Commission that investigated these failures – called the Estey Commission – stated in its “essential recommendation”^{Footnote 1} that a Canadian financial regulator’s true north must be "... a will to respond when the signals of trouble …”^{Footnote 2} arise.

Since I began my tenure as Superintendent, I have taken a personal accountability to re-assert and re-install a will to act at the institution I lead. I assumed leadership of an OSFI that possessed justifiable confidence in its track record over the first 20 years of this century. A remarkably small number of serious financial institution failures characterized this track record and led to an understandable lack of alertness to the risk that inertia can follow such success.

To signify my underlying intent, I titled my first public speech as Superintendent The Fierce Urgency of Now. In that speech, and in all my subsequent public remarks, I have endeavoured to reach back to OSFI’s origin story and re-affirm our True North, or our will to act when faced with signals of trouble, to paraphrase Justice Willard Estey, the head of the Royal Commission that led to OSFI’s creation.

Signals of trouble

Since I began my service as Superintendent, I have pointed OSFI towards a variety of trouble signals – climate change, the digitalization of financial services, and risks in the housing market to name a few.

More recently, the global financial system has provided us with other signals of trouble. Three banks in the United States failed this winter. One of the failed institutions – Silicon Valley Bank – had a branch here in Canada. Further afield, a globally systemically important bank, Credit Suisse, foundered shortly after U.S. regional banking problems arose and required extraordinary assistance to facilitate a takeover by its largest domestic competitor.

These very sudden signals arrived in the midst of a risk environment already well-populated by the aforementioned signals of trouble. This prompts the question from our regulated constituents of how OSFI will respond in an environment of accumulating signals of trouble.

OSFI’s true north will guide us

Our True North compels us to sustain and enhance our will to act. To that end, we have and will continue to do three things.

First, when confronted with weakening financial institutions, we will take swift and decisive action to protect the interests of depositors and creditors.

Second, we remain clear-eyed and transparent about the risks to the financial sector, a principle we followed when we published our Annual Risk Outlook (ARO) on April 18.

Third, we continue to advance key regulatory policies necessary to promote public confidence in the Canadian financial system.

Today, I will talk about each of these things.

One can detect OSFI’s renewed will to act in our response to the failure of Silicon Valley Bank (SVB) and the crisis at Credit Suisse.

The troubles at these banks ignited public anxiety about the health of our financial institutions. The global financial system is deeply interconnected; contagion is always a threat, so problems in one part of the system ripple across the globe at light speed.

In the case of SVB, when it was clear over that first weekend that the bank was failing, we swiftly took control of the assets of its Canadian branch and applied to the Ontario Superior Court of Justice for a winding-up order. That was granted and a court-supervised process, overseen by a court-appointed liquidator, is now underway to restructure the branch.

Our reaction was rapid, expedient, and collaborative. We worked late into the night and over the weekend, engaging with fellow regulators to cross all our t’s and dot our i’s so that Canadian creditors’ interests at SVB’s Canadian branch would be protected. This rapid reaction reflects what can be done quickly if there is a will and the leadership to activate that will.

It will likely come as no surprise that we were also paying close attention to the Swiss regulator’s handling of the challenges at Credit Suisse. While the risks were different than SVB, we watched with great interest the market’s reaction to the contractual terms of Credit’s Suisse’s Additional Tier 1 instruments which called for a write-down of the full principal of the notes on the occurrence of a viability event.

We recognized immediately the impact such an event could have on market perceptions about Canadian bank capital instruments. We took immediate steps to remind investors that Canada’s capital regime preserves creditor hierarchy if a viability event were to occur here.

We quickly issued a statement to reinforce the reality that if a Canadian deposit-taking institution reaches the point of non-viability, OSFI’s capital guidelines require Additional Tier 1 and Tier 2 capital instruments to be converted into common shares in a manner that respects the hierarchy of claims in liquidation. This results in significant dilution to existing common shareholders, which we believe meets the reasonable expectations market participants have for bank capital instruments.

Both of these cases illustrate the importance of transparency and urgency in contributing to financial stability.

Secondly, we’ve also taken steps to enhance confidence in our supervision by publishing our Annual Risk Outlook, or ARO, every spring with an update in the fall. We issued our 2023-2024 edition just last week.

This important document helps us remain clear-eyed about the risks we face as the supervisor of federally-regulated financial institutions (FRFIs) in Canada. It encapsulates OSFI’s view of the risk environment at a given point in time and provides an early warning for those emerging risks that lay further out on our horizon. It tracks current threats and provides transparency around our view of risk. The ARO adds ​an important dimension to our contribution to public confidence in the Canadian financial system. We want the institutions we regulate, other stakeholders, and the public to know the nature of the risks we face and what actions OSFI will take to address them.

With the ARO, we aim to communicate our evaluation of risk from the present day and into the future. With that evaluation in hand, our duty to Canadians in fulfilling our purpose obliges us to prepare the financial system to manage those risks.

So, we prepare supervisory and regulatory responses in order to promote public confidence in the Canadian financial system. And we do so with transparency, again via our ARO and public engagements such as this one. As such, I would like to outline our responses to three present and emerging risks: housing finance, climate change, and third-party risk.

First, risks in the housing market:

We have Federally-regulated Financial Institutiosn (FRFIs) to consider the impact of increased credit risk on their loss provisions and capital management decisions. In addition, they should have proactive account management practices to assist borrowers in times of stress, mindful of the Financial Consumer Agency of Canada’s proposed Proposed Guideline on Existing Consumer Mortgage Loans in Exceptional Circumstances.^{Footnote 3}

This work is in addition to our ongoing supervisory reviews and monitoring of mortgage asset quality for signs of credit deterioration.

We also continue to engage with industry members on combined loan plans to clarify their application of our B-20 guideline on residential mortgage underwriting practices.

In January 2023, OSFI launched the initial phase of a public consultation on Guideline B-20 on Residential Mortgage Underwriting Practices and Procedures, as we committed to in our ARO update last fall.

The level of household indebtedness in Canada is a vulnerability we take very seriously, and it is an area that we have been and will continue to monitor closely. That longstanding vulnerability is made riskier today with elevated mortgage interest rates and a potential economic downturn.

We are grateful for the many responses to the consultation and for the many responses outside the consultation in the public media. Sound mortgage underwriting and credit quality supports a well-functioning mortgage market and is critical to the financial wellbeing of Canadians.

In terms of next steps, we intend to publish a summary of the feedback received from stakeholders in the months ahead. We may also publish an advisory or interim guidance that gives a directional indication of where we might be headed and what the next steps look like.

The second risk I want to talk to you about is climate change:

I am an avid reader of the reports issued by the United Nations’ Intergovernmental Panel on Climate Change (IPCC), the most recent one out in March of 2023^{Footnote 4}. The IPCC indicates with very high confidence that climate change is a threat to human well-being, particularly if the world does not keep the increase in average global surface temperature to 1.5° Celsius (measured from the average temperature between 1850-1900).

Nations of the world have efforts underway to transition our economies away from green-house gas emitting energy sources and to adapt to and mitigate the impacts of an already warmer climate. As nations of the world mitigate the physical and transition risks produced by climate change, their responses could have a profound impact on Canada, its economy, and financial system. More to the point, Canada will be far more influenced by the climate-related actions taken by other nations of the world than it will influence the global movement towards climate change adaptation.

So OSFI’s responsibility in respect of climate risk is to ensure Canada’s financial system identifies the risks related to climate change and builds resiliency to those risks.

Our response to date centers on Guideline B-15: Climate Risk Management. This guideline aims to ensure that as the various forms of climate-related risk, including transition and physical risks, continue to manifest themselves in various forms, FRFIs and pension plans advance their governance and risk management capabilities accordingly.

To help build our own climate-risk assessment capabilities and those of FRFIs, we will collect, analyze, and disclose new climate risk data. We are also planning to develop a standardized, climate-scenario exercise that all FRFIs will undertake in 2024. This scenario exercise will incorporate learnings from two ongoing joint projects with the Bank of Canada, one on transition risk and another on a single-peril physical risk such as flooding.

The final risk I want to highlight is the use of third-party arrangements by the financial services industry. It, too, has made it into the 2023-2024 ARO.

The financial services industry’s increased dependency on external arrangements heightens the risk to FRFIs’ critical services. This dependence also intensifies the risk of compromised data. Third-party providers may also have external arrangements of their own, which creates additional complexity for oversight. The emergence of dominant technology service providers and the frequency and severity of cyber incidents have also increased the risk of a systemic event.

These third-party arrangements present considerable risks to our system. We cannot ignore them today nor can we assume that they will be static.

This week we issued Guideline B-10 which addresses Third-party Risk Management. It is our response to global regulatory trends and the expansion and complexity of the third-party ecosystem. B-10 applies beyond FRFI outsourcing to encompass a comprehensive scope of third-party arrangements.

We plan to work with industry to improve the consistency and quality of third-party risk data. As a first step, we participated in a third-party data submission pilot in 2022-23 with a group of FRFIs. What we learned from the pilot will be used to help improve data aggregation, analysis and reporting processes, and the ability to identify trends and vulnerabilities associated with third-party arrangements. This data will continue to help us adjust our guideline to respond to the dynamic realities of the industry we regulate.

Conclusion

I have said on many occasions that I am committed to transparency about how OSFI sees its risk environment and about its plans for adapting to it. I have also repeatedly underlined our bias towards action.

This combination of clear-eyed analysis of current and emerging risks paired with a predisposition to swift and decisive action is how OSFI will contribute to confidence in the Canadian financial system. That will to act remains our True North.

Just as a compass points toward a magnetic field, our True North pulls us to toward the purpose of our work. I think that this speech has laid out the evidence for the positive outcomes of publicly identifying risks and then acting swiftly and decisively to protect the interests of depositors and creditors.

And, I would argue, our True North gives Canadians reason to feel confident in our financial system.

Thank you.

I look forward to the discussion and your questions.