OSFI, Basel III, and Capital Floors

Check against delivery

Thank you Vanda for the kind introduction. Before I begin, let me first acknowledge that we meet today on the traditional land of the Mississaugas of the Credit, the Anishinaabeg, the Chippewa, the Haudenosaunee, the Wendat peoples and the home to many First Nations, Inuit, and Métis peoples. Earlier this week, we commemorated the National Day for Truth and Reconciliation, and we remain mindful of the Truth and Reconciliation Commission of Canada’s 94 calls to action.

Well … 2024 has turned out to be an interesting year for the institution I serve. We continue to garner much attention in the areas of mortgage underwriting, the Integrity & Security component of our mandate, climate risk management, and the prospects for financial system resilience in an era of intensifying uncertainty. And I know Sonia and I will discuss some of these topics in a few minutes. But, I must say the intensity of attention is new to OSFI and gives us an opportunity to communicate more clearly to Canadians about how we serve them.

One area that garnered an extraordinary amount of attention is OSFI’s implementation of the 2017 reforms to the Basel III framework for the prudential regulation of banks (2017 Basel III reforms). We were not alone in attracting this attention. In a neighboring country, earlier this year one could find a great deal of public attention on the 2017 Basel III reforms, most peculiarly on television advertisements and airport billboards. Thus, as regulators, we have a new audience with whom to communicate, populated by thousands of well-intentioned, curious inquisitors about how bank regulators might affect their businesses and economic opportunities.

For this reason, I thought it might be helpful to address our approach to the 2017 Basel III reforms.

In 2017, we committed to implementing a series of post-crisis regulatory reforms to the Basel III framework alongside supervisors from the 20 participating jurisdictions. We made this commitment to make the Canadian banking system safer and to signal our willingness to contribute to international financial stability.

And so we set about diligently making good on our commitment … and, because Canada has a principles-based regulatory framework, we are nearly finished with the commitment while some of our peer signatories to the 2017 Basel III reforms have further progress to make. Observers can track Canada’s implementation lead at the Basel Committee for Banking Supervision (BCBS)’s website. I would note that a number of our peers have re-affirmed their intent to fully meet their commitments to the 2017 Basel III reforms but with timelines that extend to the later years of this decade and the early years of the next.

Given the widening of Canada’s implementation lead, OSFI slowed the implementation of the last element of the 2017 Basel III reforms, the legendary capital floor. As announced in July 2024, OSFI announced a one-year delay to the increase of the capital floor level. As a result, the minimum floor for risk-weighted assets (RWA) calculated by those banks approved for internal ratings-based (IRB) approaches to risk-weighting (as opposed to a standardized approach) will rise more slowly than initially anticipated. Presently, the capital floor mandates that a bank’s RWA calculated with internal models must total at least 67.5% of risk-weighted assets calculated under the standardized approach. That floor will rise to 72.5% in 2027 on the current schedule (including the aforementioned one-year delay). Of note, only Canada’s six domestic systemically important banks (DSIBs) have approval to use IRB approaches to calculate RWAs.

In the course of arriving at our one-year delay, we received a great deal of interest and argumentation regarding the impact of this technical change to a complex regulatory capital ratio. We were surprised by the stakes in which some observers set their argumentation. Some argued that OSFI’s decision on this technical calculation method would have a consequential and negative impact on economic growth, arguing that dramatically rising capital requirements would slow lending and then economic growth. We welcome that challenge and believe it important to constantly test our thinking to ensure our well-intentioned efforts to enhance resilience in the Canadian banking sector do not lead to unintended consequences. In that spirit, I offer a few observations on this question.

The 2017 Basel III reforms do not have a material effect on DSIB capital

Based on our estimates, the implementation of the 2017 Basel III reforms in Canada is expected to be capital neutral, even at the fully phased-in level of 72.5%. While there are many moving parts in the full suite of Basel III reforms, the two most impactful components of those reforms on bank capital levels were (i) the removal of the 1.06 scaling factor that was previously applied to modelled RWA; and (ii) the inclusion of the capital floor discussed above. According to public disclosures, aggregate modelled RWA of the DSIBs was roughly $1,500Bn as of Q2 2024, which suggests the removal of the 1.06 scaling factor provided immediate relief of roughly $90Bn in RWA (6% of 1,500 Bn), ranging from $4.8Bn to $23.4Bn for the DSIBs.  

Using information from DSIBs’ Q2 2024 public disclosures, along with regulatory data publicly available on our website, we estimate the increase in RWA due to the fully phased-in capital floor to be approximately $85Bn. This has an impact on banks’ Common Equity Tier 1 (CET1) capital ratios ranging from 0 basis points (bps) and 86 bps for the DSIBs. A detailed outline of our calculation of the capital floor can be found in a technical note published on our website today. 

In other words, the capital floor impact on a gross basis (i.e., the impact ignoring the prior capital relief), at $85 Bn, is many multiples lower than some estimates and is negligible on a net basis.

The benefits of healthy surpluses in bank capital have outweighed the costs

Underlying criticisms of banking regulators seeking to add to banks’ capital surplus is an argument that high and rising capital requirements increase the cost of lending which in turn slows economic growth. I think it important that OSFI always keeps this argument in the forefront of our minds when we make technical decisions about bank capital calculations, lest we trigger the unintended consequence of damaging economic growth through an excessive concentration on financial resilience.

A colleague from the Bank of England, Sarah Breeden (Deputy Governor for Financial Stability), presented a speech this fall in which she

• reminded colleagues that the purpose of bank regulation is to ensure that the banking system provides vital services even as shocks occur, and …
• warned that bank regulators must avoid the “stability of the graveyard”, taking care to respond to opportunities to increase growth potential without undermining financial stability

We think this is a great articulation of the proper risk appetite for bank regulators. There is an optimum level of bank capital – one that lessens the likelihood that a financial shock damages the economy but avoids the “stability of the graveyard” in which economic growth is unnecessarily slowed by an excessive aversion to financial system risk.

Central bankers and academic researchers have found fertile ground for studying this trade-off since the Global Financial Crisis of 2007-2009. This has included researchers from multiple federal reserve banks, the Bank of England, the Bank for International Settlements, and many universities. While there are still legitimate research debates, there is a general consensus that:

• The benefits of rising capital requirements after 2009, in reducing the probability of financial system shocks, have outweighed the costs of slower lending as capital requirements rose.
• There is an optimum level of Common Equity Tier 1 capital relative to RWA that runs in the range of 10% to 15%, if banking systems have advanced systems for bank resolution and contingent capital available for conversion to common equity in a crisis.
• Increases in bank capital requirements should occur gradually to avoid more serious unintended consequences on economic growth.
• When capital requirements do rise, those banks with thinner capital surpluses to regulatory capital minimums tend to lose market share while those with higher surpluses tend to gain share.
• This market share transference tends to lessen a system-wide drop in credit availability during periods of gradually rising bank capital requirements.

The capital floor adds model risk discipline and competitive balance to Canadian banking

IRB approaches to risk-weightings incorporate an individual bank’s own historic losses. But past performance is no guarantee of future performance and, as the Global Financial Crisis teaches, decades of strong loss performance can evaporate suddenly. Moreover, periods of low loan losses result in higher calculated capital ratios in good times and lower capital ratios in bad times as losses rise and are incorporated into internal models. A capital floor will cause banks to more regularly investigate, challenge, and improve the assumptions in their internal models lest the standardized floor becomes binding. In this way, the capital floor introduces more model risk discipline into the banking system.

The capital floor also has the benefit of reducing the difference between capital requirements for banks using IRB approaches versus standardized approaches to risk-weighting. This will tend to add competitive balance, all else equal, which will ultimately benefit Canadian businesses and households looking to finance their futures.

Conclusion

So I am sure some observers may wonder what this argument means for the schedule OSFI pursues in regards to the capital floor. The honest answer is that we don’t have to make that decision now, so we will not. I expect sometime early next summer, we will announce our path forward, with or without changes to the schedule. But I will say that, despite Canada’s demonstrated commitment to the 2017 Basel III reforms, we cannot extend the implementation lead we share with a small number of fellow signatories.

The 2017 Basel III reforms will strengthen banks’ ability to withstand financial shocks and support economic growth while enabling them to compete and take reasonable risks. Key to these reforms’ success is full, timely, and consistent adoption and implementation across BCBS jurisdictions so that competitive balance prevails throughout the international banking system.

We will continue to measure implementation progress of the 2017 Basel III reforms across jurisdictions with a focus on both competitive balance in banking and the soundness of Canada’s capital regime.