Strengthening Fundamentals and Adapting to a Dynamic Risk Landscape - Fostering the Foundations of Sound Supervision

OSFI’s Assistant Superintendent, Regulatory Response Sector, Tolga Yalkin participates in a panel discussion titled “Strengthening Fundamentals and Adapting to a Dynamic Risk Landscape - Session 3: Fostering the Foundations of Sound Supervision” at the 23rd Annual International Conference on Policy Challenges for the Financial Sector

Moderator:

The banking sector in Europe and the United States experienced significant upheaval in 2023, including the failures of major banks such as Silicon Valley Bank (SVB), First Republic, Signature Bank, and Credit Suisse. What lessons do you think these events provide, especially in the context of international cooperation?

Assistant Superintendent Tolga Yalkin:

• While there are several lessons that can be drawn from this experience, there are few that are worth underscoring.
• First, timely and decisive intervention can prevent the roots of crises from establishing, and when crises do emerge, prevent them from escalating. In other words, delays in addressing identified vulnerabilities can contribute to failures. Proactive and prompt actions are necessary to stabilize institutions before issues become critical. Regulators would be well served by enhancing their surveillance and intervention mechanisms to act swiftly in the face of identified and emerging risks.
• To make this happen, supervisors must have the determination and authority to take decisive actions when early signs of trouble emerge. This includes having the “will to act and impact” and the capability to engage promptly with financial institutions to identify and mitigate risks before they escalate. Rapid and decisive action can help stabilize institutions and maintain market confidence.
• Ensuring thorough follow-up on identified issues and corrective measures is crucial for effective supervision. Supervisors must maintain comprehensive records of their findings and actions, regularly monitor the implementation of corrective measures, and pursue continuous improvement in supervision practices. In short, diligence drives stability.
• Second, robust stress testing and scenario analysis are vital. Banks should regularly conduct stress tests that consider a range of extreme but plausible scenarios, such as rapid interest rate increases, severe market downturns, or increasingly, geopolitical events. This helps ensure they are prepared for adverse conditions and can maintain resilience.
• Supervisory authorities should enhance their monitoring capabilities and stress testing frameworks to account for a wide range of scenarios, including off-balance sheet commitments and potential drawdowns during stressed conditions. This proactive approach, while not necessarily preventing a failure, can help ensure financial institutions maintain adequate capital and liquidity buffers to withstand shocks.
• The need for strong international cooperation was underscored by efforts between Canadian and US and Swiss regulators during these events. Establishing clear communication channels and collaborative crisis management frameworks can enhance readiness and response to global financial disruptions. Regular international crisis simulations can help build resilience and improve coordinate responses. 
• Building and maintaining strong relationships with other regulatory bodies and international counterparts is essential. Effective supervision requires regular communication, trust, and collaboration across borders to manage what can be global financial risks. Regular crisis simulations and preparedness exercises involving multiple jurisdictions can help build resilience and improve coordinated responses.
• Finally, governance matters. Deficiencies in risk management and accountability at the executive level are often the root cause of what become bigger issues. Supervisors should prioritize the implementation of stronger governance structures within financial institutions. This includes senior managers regimes to hold officers accountable for their decision and actions, ensuring transparent and effective risk management practices, and fostering a culture of responsibility and integrity. Supervisors must also regularly engage with senior management to monitor governance practices and enforce corrective actions, where necessary, thus preventing governance failures that can lead to systemic risks.

Moderator:

Reflecting on the Canadian experience, how important is it for international frameworks to allow for adaptability while supporting consistency and predictability?

Assistant Superintendent Tolga Yalkin:

• We rely on and are an active participant in the development of international frameworks when it comes the regulation of financial institutions. The development of international standards is a force multiplier for us: it allows us to work with other jurisdictions around the globe to develop comprehensive standards that reflect our domestic concerns and international consensus.
• This said, like other regulators around the globe, we have a statutory mandate that is unique in some senses. For example, in addition to protecting the rights and interest of depositors and creditors, we also need to have due regard to the need to allow financial institutions to compete effectively and take reasonable risks.
• Moreover, there are often factors touching on the risks affecting Canadian banks that may be unique to those which we regulate or manifest in different ways, militating in favour of taking a slightly different approach.
• So, while we are supportive and rely, to a large extent, on the development of international frameworks, it is key that those frameworks allow for adaptability. How though, can they allow for adaptability, yet support consistency and predictability?
• First, while sometimes there is value in international frameworks beings prescriptive, focusing on high-level principles provides a degree of consistency and predictability while allowing for national adaptation. This allows jurisdictions like Canada to adapt these principles to their specific regulatory environments and unique contexts while maintaining a consistent overarching framework globally.
• Frameworks can then be accompanied by detailed guidance and best practices, helping jurisdictions interpret and apply the standards consistently while adapting them to their local needs.
• Second, they can provide a baseline standard that can be augmented by individual jurisdictions. Often referred to as a building block approach, this ensures a minimum level of consistency and safety while allowing for additional requirements to address local risks and conditions.
• Third, they can provide for phased implementation, allowing jurisdictions to gradually adopt new requirements. A phased approach supports consistent adoption while providing flexibility to tailor implementation to fit local regulatory landscapes, economic conditions, and contemporary developments.
• Below are three examples where we have adapted international standards while respecting the objectives of consistency and predictability.
• We maintained a 35% standardized approach risk weight to mortgages with loan-to-value ratios (LTVs) between 70% and 80% to account for mandatory mortgage insurance in Canada. This adjustment removes the offsetting impact of higher weights for LTVs greater than 80%, demonstrating an increase in capital requirements to ensure better risk management.
• We lowered Credit Conversion Factors (CCFs) for credit cards based on data collected from our domestic systemically important banks (DSIBs), decreasing the risk weight for transaction accounts as an offsetting deviation. This example shows a reduction in expectations, making the capital requirements less stringent for certain assets based on available data.
• We also used a higher correlation factor for income producing residential real estate. This adaptation reflects the higher linkage to economic conditions, showing how regulatory expectations can be tailored to specific market dynamics rather than just increasing or decreasing requirements.
• As prudential regulators, it is important to adopt adjustments to international frameworks with care and precision. In adapting these standards to local circumstances, it is essential to implement only the changes that are necessary. By carefully balancing the need for regulator adaptation with the goal of maintaining stability and consistency, regulators can fulfil their mandate while fostering a resilient financial system domestically and globally.

Moderator:

How do the revised BCPs help foster the consistency and effectiveness of supervision for banks and non-bank financial institutions (NBFIs)?

Assistant Superintendent Tolga Yalkin:

• First, the revised BCPs set out clear and adaptable rules. Clear and well-defined rules are essential for ensuring that everyone knows what is expected and how to comply. This transparency helps build trust and accountability within the financial system.
• For example, the revised BCPs provide enhanced guidelines for leverage ratios, countercyclical capital buffers (CCYBs)—which in Canada we refer to as the Domestic Stability Buffer (DSB), and leverage limits. These standards ensure that financial institutions maintain adequate capital and leverage ratios, which form the fundamentals of financial stability.
• They also include new standards for operational resilience, climate-related financial risks, and business model sustainability. Standardizing these emerging risks across all supervised entities ensures that institutions are prepared for modern challenges and maintain resilience in the face of evolving threats.
• Second, they underscore the importance of effective communication between regulators for managing risks consistently and effectively. They emphasize the importance of sharing data on financial institution risk exposures, operational resilience, and compliance with regulatory standards.
• They encourage supervisors to regularly communicate and coordinate, within the confines of their own legal constructs. This continuous exchange of information helps in maintaining a more uniform approach to supervision.
• Third, the BCPs highlight the necessity of collaborative supervisory assessments and joint inspections, particularly for cross-border financial institutions. By working together, international supervisors can ensure that supervision is comprehensive and consistent across jurisdictions.
• While not directly related to the BCPs, we are mandated to regulate not just banks but also federally regulated insurance companies, both life and property and casualty, and pension funds, not to mention much of the broker-dealer system in Canada is owned by banks, which brings these entities under our purview.
• Moreover, our new supervisory framework employs the same approach, process, and system across the three sectors we are responsible for—banking, insurance, and pensions, ensuring a unified approach that promotes consistency and effectiveness in supervision while allowing for customization to meet the risks particular to these different sectors. We have built our consistency and effectiveness by implementing dynamic and robust internal governance to vet the conclusions that we reach.
• Added to this, we have regular contacts with provincial regulators involved in securities regulation and supervision of credit unions, as well as the Bank of Canada, which has an overall financial stability mandate and looks at many parts of the NBFI sector, including pensions, capital markets, and financial market infrastructure.
• All this said, when it comes to effectiveness, it is often the intangible qualities of supervisors that make the difference, such as a willingness to act and a sense of urgency. While standards and data are essential, they are only effective if supervisors are proactive and decisive in their actions.