Preserving confidence in Canada’s financial system

Superintendent Peter Routledge delivered keynote speech at the 24th Annual Scotiabank Financials Summit

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Date: September 7, 2023

Good morning, everyone.

Thank you, Raj, for your kind words and warm welcome to this summit.

I would like to acknowledge we are on the traditional territory of many nations, including:

• the Mississaugas of the Credit,
• the Anishnabeg,
• the Chippewa,
• the Haudenosaunee and the Wendat peoples
• and the home to many diverse First Nations, Inuit and Métis peoples.

In the two years I have served as Superintendent, I have learned to exist in the tail – severe but plausible downside scenarios for our economy and financial system.

Paradoxically, this experience has reinforced the value of optimism. My job may oblige me to stand in the shadows but, from there I can always see the sunlight.

So … let me start with some optimism … Canada’s economy and financial system have exhibited extraordinary resilience in the face of the most significant tightening of monetary policy in a generation. Financial system capital remains high and credit losses low. If credit losses expanded materially, we believe the institutions we regulate would weather that storm.

Hundreds of thousands of bright, hard-working people seek to make Canada their home each year. We are a magnet country. This bolsters our economy, the health of our social insurance system, and our housing market. Although we have work to do as a nation in ensuring housing development keeps up with household formation, I would rather have that problem than the myriad of other problems facing countries that lack Canada’s magnetic pull.

Innovation targeted at helping economies respond to the threat of climate change continues apace. According to the Financial Times, scientists in the United States recently generated net energy gains in a fusion experiment. While this success remains a nascent and uncertain breakthrough, it does offer hope for carbon-free power sources in our children’s or grandchildren’s lifetimes.

But … alas … the Superintendent is paid to worry in the shadows so worry I must. Today, I would like to speak to you about four key worries. These are:

• housing finance,
• the digitalization of financial services,
• climate change, and
• insurance resolution.

There is an upside as well as a downside to rising uncertainty. We at OSFI have recently articulated a risk appetite to capture this reality. We believe that by acting in support of our mandate early, we lessen the incidence and severity of downside events and enable our regulated constituents to drive towards the upside.

Housing finance

Across Canada, with high house prices, and a steep climb in interest rates and inflation, many Canadians face rising financial pressure in servicing their mortgages and other debts.

This year, and over the next three, we anticipate that many Canadian mortgagors will renew their contracts at appreciably higher interest rates. Fortunately, OSFI and the Department of Finance have had a mortgage stress test in place for many years and that test helped prepare Canadian mortgagors for this outcome. The health of Canadian residential mortgage credit in 2023 is testament to that.

As effective as that stress test was, it was not perfect. During the pandemic years, when interest rates fell to historic lows, many mortgagors took out variable-rate, fixed-payment mortgages (VFM). With this product, monthly payments remain fixed as the variable interest rate changes. We estimate that mortgages such as these total C$369 billion outstanding in a mortgage market of C$2.1 trillion. Banks offering these products have reported that approximately C$260 billion of this total have 35+ year transient amortization levels (more on this in a moment).

When interest rates rise, these VFM loans reach a “trigger rate” when the fixed payment only covers the interest and none of the principal. If rates rise beyond the trigger rate, the fixed payments do not cover the interest payments and mortgage principal outstanding grows.

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. While there are ways to reduce this shock – early voluntary paydowns and refinancing to name a few – I think the housing finance system would produce better outcomes for borrowers and lenders alike if this product was less prevalent.

We are looking at this problem – and other opportunities for improving housing finance – through the prism of our residential mortgage underwriting guideline, Guideline B-20.

In fact, we are conducting a comprehensive review of Guideline B-20. The review focuses on enhancing credit quality and mortgage underwriting, expanding the scope of the guideline, and incorporating recent supervisory insights. As part of that review, we consulted with industry stakeholders earlier this year on debt serviceability measures. Later this month, we aim to share our “What We Heard” report from stakeholders.  We have also consulted with our peers in other jurisdictions, for example the United Kingdom, that have innovated in the residential mortgage space to better protect their housing finance systems through good times and bad. 

In October we will share additional information in the semi-annual update and the “What We Heard” report.

I suggested earlier in this speech that the mortgage stress was imperfect; perhaps it is better to call it incomplete. Ultimately, we seek an integrated set of common-sense protections that work effectively both when interest rates are higher than normal, like today, and when interest rate are lower than normal, like during the COVID years.

Our primary aim is to ensure that Canadian homeowners can afford to service their mortgages in good times and hard times. As a secondary goal, we aim to ensure that OSFI’s measures impact our regulated constituents proportionately such that all lenders in the federal financial system, regardless of size, can compete and take reasonable risks.

Digitalization of financial services

Digital innovation is transforming how we transact, manage money, and think about value. 

But it presents risks to our financial system – like heightened liquidity risks, market conduct risks, or cyber threats.

Events in the crypto space have taught us the danger of unregulated financial innovation. And virtually all the extraordinary losses in the crypto space over the past year have occurred at lightly regulated or unregulated financial players.

At OSFI, our research tells us that the benefits that digital innovation offers society will be best realized within regulated financial systems. Financial services innovations outside regulated systems not infrequently yield catastrophes.

Fortunately, earlier this summer, the Financial Stability Board (FSB) published a global regulatory framework for crypto-asset activities. The framework is based on the principle of “same activity, same risk, same regulation,” and consists of high-level recommendations for the regulation, supervision, and oversight of crypto-asset markets and activities and of stablecoin arrangements.

To the extent countries develop their local regulatory frameworks in a manner consistent with the FSB’s recommendations, they will harness the potential of digital innovation in financial services and constrain the risks.

OSFI will do its part to help Canada develop policies that accord with the FSB’s high-level recommendations by the end of 2025. That said, most of this work is taking place through the 2025 financial legislative review, led by the Department of Finance, with collaboration from our office and other regulators.

So, what else is OSFI doing on the digitalization risk forefront?

As announced in our Annual Risk Outlook and 2022 Digital Innovation Roadmap, OSFI is developing digital innovation-related guidance applicable to FRFIs.

For example, we’re looking at developing a policy response to ensure FRFIs are prepared to manage risks posed by Fiat Referenced crypto assets (FRC) arrangements and activities.

Also, in July, we published two draft guidelines on the regulatory capital and liquidity treatment of crypto-asset exposures – one for federally regulated deposit-taking institutions (DTIs) and another for insurers.

The new guidelines, which reflect industry input and international standards, will eventually replace the interim advisory from August 2022 and come into effect in the first quarter of fiscal 2025.

A public consultation seeking feedback on these draft guidelines is currently underway and will remain open for public consultation until September 20, 2023.

Climate change

From Hurricane Fiona to the worst wildfire season in our nation’s history, Canadians are feeling the effects of climate change. And financial institutions are no exception.

Not only are they facing increasing physical risks from weather events, they also face risks from the inevitable transition to a low-carbon economy.

Most experts predict more, rather than fewer, natural catastrophes in the future. This may speed up the market-driven transition towards a low-carbon economy. Both these forces increase the likelihood of system‑wide and institution-specific financial stress.

My job is to ensure Canada’s financial system is thinking ahead and taking concrete steps to manage both types of climate-related risks in a manner that supports public confidence in the Canadian financial system.

As most of you know, back in March, we published Guideline B-15 on Climate Risk Management. And over the summer, OSFI launched its first Climate Risk Forum.

This forum is a consultation on draft Climate Risk Returns in partnership with the Bank of Canada and the Canada Deposit Insurance Corporation. The consultation period will run through September 30.

The returns will collect climate-related emissions and exposure data directly from federal financial institutions.

This will greatly help OSFI carry out evidence-based policy development, regulation, and prudential supervision as it pertains to climate risk management. 

There are also two projects we will be publishing this fall.

The first item is a draft 2024 Standardized Climate Scenario Exercise methodology. It will encourage financial institutions to build their capacity to conduct scenario analysis.

The second item we will be publishing later this fall, in partnership with the Bank of Canada, is results from a study of the financial impact of flood risk across Canada.

In addition, Budget 2023 made progress on flood insurance and we look forward to further measures to address earthquake risk.

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 exactly the same risk management principles. In other words, OSFI’s mandate today forms a durable platform to foster sound management of climate-related risk throughout the Canadian financial system.

Insurance resolution

This uncertain risk environment has a particular impact on the insurance industry.

In Canada, the existing insurance resolution framework has successfully navigated the very few insurance insolvencies that have occurred over the last 30 years.

But gaps remain despite recent work done by the Property and Casualty Insurance Compensation Corporation (PACCIC) and Assuris (the independent, not-for-profit organizations that protect Canadian policyholders if their general insurance or life and health insurance providers fail) - particularly in terms of the rising scale of potential events.

For example, last year, a wildfire destroyed the entire town of Lytton, BC – a quiet town of 1,500 souls or so where my family would go whitewater rafting back in the day.

The Insurance Bureau of Canada reported $78 million of insured damage.

Now just imagine if a catastrophic event affected a larger metropolitan area. Consider if you will the impact of a catastrophic earthquake in British Columbia or Quebec.

As a proactive regulator, OSFI recognizes the urgency of getting ahead of these challenges.

While federally regulated property and casualty insurers have, to date, been able to manage the financial cost of the most likely natural disasters, we have an opportunity to refine our insurance resolution framework so that it can help manage through a scenario in which extraordinary insured losses arise from large-scale catastrophes.

Since 1967, Canada banking system has benefited from the existence of a specialized resolution authority, the Canada Deposit Insurance Corporation. Canada’s insurance system might also benefit from a similar resolution toolset available to the government should risk events overwhelm insurers’ capital capacity.

In the interim, we are making good progress on insurance resolution planning. For example, we engage regularly with senior management of PACCIC and Assuris to facilitate operational and transparency and effectiveness in resolution planning. 

OSFI has required recovery planning of internationally active insurance groups (IAIGs) and is expanding this to include resolution planning and the establishment of Crisis Management Groups for IAIGs. 

OSFI also recently established the Crisis Readiness Team in Supervision as a centre of excellence on recovery and resolution. This team is responsible for managing the relationship with the compensation associations.

But the opportunity to bolster the insurance resolution regime in Canada is well within our grasp, today.

Closing

Our risk environment is intensifying not slowing down. We must prepare to manage risks as if they will crystallize tomorrow.

OSFI’s new Risk Appetite Statement will guide how OSFI will make decisions amidst intensifying uncertainty.

It states that we have a high appetite for early action to address risks, and that we would rather be criticized for being too quick on the trigger than for being asleep at the wheel.

We won’t shy away from taking any action we deem necessary to contribute to public confidence in the Canadian financial system.

And in line with our new risk appetite, we’re building a new supervisory framework, which will be in effect in 2024. This will be the first in-depth revision in the last 25 years.

Now we know that not all institutions have the same risk profiles, the same size, the same operational complexity. And the supervisory framework is meant to be proportional to that reality. Our regulated constituents and Canadians will hear more about this in 2024.

There’s no question that the risk environment is growing more complex. But we can’t – and won’t - slow down. This is our new normal.

Thank you.