Superintendent Peter Routledge participates in a fireside chat with Sonia Baxendale, President and CEO of the Global Risk Institute at the 2024 Global Risk Institute Annual Summit

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Moderator: Sonia Baxendale:

I find it interesting that prudential regulators are placing as much emphasis today on this notion of economic growth versus bank resilience and that feels like something I haven't historically heard prudential regulators talk about. When I was in an active bank role, I recall that provincial regulators didn't really care much about economic growth, and it was all about resilience.

I'm interested in the change in tone and how we should interpret what that means in terms of a bank making a case for economic growth, particularly in times where you might consider the environment to be challenging and may want capital constraints to be tightened potentially.

Superintendent Peter Routledge:

It's a great question, and the question itself is a product of the success we've had since the global financial crisis. As evidence of that success, we got through 2023. That was a pretty major shock, and we had significant bank failures on both sides of the Atlantic.

There was no recession, no real spike in unemployment, and the system held in really well. Even going back beyond that we operated quite ably through the initial shock from COVID-19 and the March 2020 flash crash. We're imperfect, but I think we achieved a lot over the last 15 years following the financial crisis.

There's this natural tendency to want to do more. Someone giving me advice when I first took the job said, you know the superintendent is there to take the blame if a bank fails. I don't really believe that and it was said in jest so I don't want to overstate that, but there is that natural tendency as a regulator to think, if I'm not on it and I let a financial institution fail, it's all my fault so therefore I have to do everything I can to prevent that.

As we moved our buffers up over the course of the last 15 years, in addition to creating resilience, we began to press into the growth dreams, ambitions, and strategies of the institutions we regulate. These institutions have begun to say enough is enough. If you keep going further, we may not be able to lend as much as you would have liked, or maybe our deposit gathering or funding strategies will have to change in a way that harms economic growth.

An enlightened bank regulator knows that the prudential health of a system is enhanced dramatically by a healthy economy that grows through economic cycles.

Moderator: Sonia Baxendale:

Thank you. Let me lean from there into something I know is uppermost in many of our members' minds and that's the housing market and mortgages.

With the loan-to-income ratio, which will come into effect in the first quarter of 2025, intended to backstop the MQR and given this new requirement and the expectations of financial institutions, how are you viewing this in terms of its effect on the housing market and the MQR going forward?

Superintendent Peter Routledge:

On the MQR and the loan-to-income test, I'd like to start with the MQR. We've had it in place since about the start of 2018. It has certainly added a bit more discipline to underwriting in the form of testing household income resilience to rising interest rates.

However, there are two challenges with respect to the MQR. The first is that it really didn't stop a very substantial build-up in mortgages with very high loan-to-income ratios, which I define as 450% loan-to-income and greater.

Unfortunately during COVID that big block of very highly leveraged mortgages also happened to be weighted towards variable rate products that had fixed payment components to it, which we see as a manageable but serious risk concentration. For all the work we put in the MQR, I would have rather had that risk concentration not emerge. That’s the first challenge.

The second challenge is by virtue of the way it is implemented, which is at the institution-to-borrower level. It feels to the borrower like it's OSFI regulating them individually. It's not the intent; I could read out B-20 and argue that we actually only regulate institutions and not the borrowers but if you're walking into your branch down on Main Street on a Saturday afternoon to talk about renewing a mortgage or getting a new one it feels like OSFI is regulating you and that is not the intent Parliament has ever set for OSFI.

OSFI's job is to regulate financial institutions, not Canadians. But the MQR creates that perception and I think that’s a challenge to it. With those challenges in mind, stealing from our peer regulators and other jurisdictions, particularly the United Kingdom, we looked at this loan-to-income test.

The loan-to-income test is pretty simple. It says every quarter a bank or a lender can only lend 15% of their mortgages in that quarter to borrowers with loan-to-incomes higher than 450%. That is a very effective ceiling that stops the build of risk concentration.

When we looked at that and tested it out, we learned that a single 15% ceiling or 20% ceiling across the industry wouldn't work. We determined we would do it on a bespoke model. We would go institution by institution and calibrate it to those business models.

Our back testing on that method tells us that it would have eliminated or at least severely blunted this risk concentration I mentioned earlier, and it does not involve the borrower at all. It is a direct regulator to financial institution metric.

We're going to test it next year and if it works the way we want, and we'll probably have to tighten or loosen the bolts here and there, we expect it be a legitimate alternative or a legitimate complement to the MQR. We'll make that decision after we have a full year of testing to make sure if we do anything, we do it right.

Moderator: Sonia Baxendale:

I have a little bit of a follow-up on that. If the feeling is that it's too negatively impacting the end consumer, the borrower, is that a factor that you will take into account in terms of re-evaluating whether it's working or not working? If it's affecting the housing market in that way, is that a criteria that you will use to assess it?

Superintendent Peter Routledge:

It won't be the direct criteria. The direct criteria we'll assess is whether underwriting remains sound. However indirectly, enlightened self-interest would tell us overall value of collateral, if you had a sudden and volatile shift down in the overall value of collateral that would weaken credit quality and weaken capitalization in the system.

We should consider that reality and make informed decisions primarily focused on our mandate directly, but not blind to the indirect factors that can affect the MQR or the application of sound underwriting to the mortgage industry.

The way Canadians feel OSFI's presence through the MQR is a factor. To cite an example, we recently (through too much fanfare) stopped requiring institutions to apply the mortgage stress test or MQR when uninsured borrowers switch their mortgages straight from one lender to another. In other words, the amortization doesn't change, and the mortgage loan owing doesn't change. It's a straight switch.

When that happens, lenders need no longer apply stress tests to uninsured lenders, at least as far as OSFI is concerned. They may still choose to do that. We did that because, straight switches before the MQR came in were two to six percent of renewals. After the MQR came in in 2018, they were two to six percent varied. Ninety-five percent of Canadians don't switch their mortgages so it wasn't a huge prudential issue.

But if I were a Canadian and I had a variable rate mortgage with a fixed payment and I was going to get it renewed in a year and my mortgage balance was higher because it's negatively amortizing and the mortgage rate was going to be higher and therefore I was going to be stress tested at a much higher level, I'd feel like the presence of the OSFI stress test would bar my ability to get a mortgage and that did make a difference in our decision making.

Even though it was only going to be a limited number of Canadians, I don't think that that's OSFI's role and purpose. I think doing that or accepting that does undermine confidence in our institution and that was a factor.

My lesson learned over the first three years is that institutions with unelected public servants who serve a government elected by the populace must stay within their mandate outlined by Parliament and must be very careful not to go out it lest they undermine confidence in their institution.

Moderatorr: Sonia Baxendale:

Let me move to the macroeconomic environment and financial resiliency. If we look at the current set of circumstances, the Bank of Canada reduced its rate by 75 basis points so far in the last few months, more to come likely.

At the same time consumer spending is weak, unemployment is inching up slowly, job gains are primarily in the public sector, and the business investment sector is not strong. Given all of these macro conditions, how are you viewing the resilience of the financial system as a whole? How does this fit in and how do you think about this in the context of your ‘2024-25 Annual Risk Outlook?

Superintendent Peter Routledge:

We just issued our update to our semi-annual update and the risk didn't change, residential mortgage risk, commercial real estate, liquidity and then integrity and security in a world of intensifying geopolitical risk.

What we're seeing is globally and locally a successful lowering of inflation which is a long-term economic threat to our ability to sustainably grow as an economy. That's really good news and I think achieving that will have a confidence-building effect and when I don't have my Superintendent hat on I’m quite optimistic about the future.

When I put my Superintendent hat on, I'm paid to be, if not pessimistic, at least healthily paranoid. The areas where I feel a little bit of appropriate caution and even fear are areas that we don't see as well into, our risk areas where our view into those risks are more opaque.

The changing geopolitical environment is creating new risks that we're not familiar seeing. Even when we do see them they're hard to look into and sort through. Cyber risk would be a good example: how do I measure the likelihood that a financial institution will be hit by a cyber attack? I can measure how well they've built their defences, but I can't determine how effective the cyber attacks will be until they actually happen.

Anti-money laundering risk isn't only a problem related to the proceeds of crime in a local context, it’s a problem that has a transnational factor associated with it. It's a risk that is more significant than I appreciated three years ago when I started the job.

The final risk is hard to see and it's probably the biggest one. It’s the risks that come from non-bank financial institutions. One of the consequences of stronger, more resilient banking systems is the emergence of non-bank financial institutions that provide intermediary services. Some are highly regulated like life insurance companies or other insurance companies, and some are not very highly regulated, for example, hedge funds, private equity funds, or private credit funds.

Usually when you get fast growth in a lightly regulated space in the financial services corner there's a crisis and an accident that undermines broader systemic stability. I'm not predicting that but I'm worried about it.

Moderator: Sonia Baxendale:

We just had a breakout session on private credit, and I think what I heard is there are no risks, there's no reason to regulate and no reason to look in our direction. How do you react to that?

Superintendent Peter Routledge:

It sounds a lot like securitization of subprime mortgages in 2005.

Moderator: Sonia Baxendale:

Would OSFI contemplate removing the stress testing requirement totally if, when they introduce the new loan-to-income potential concentration requirements along with all other regulatory requirements? Is that something you anticipate going away?

Superintendent Peter Routledge:

The honest answer is I don't know, that's what we need the next year to figure out. We designed the LTI to be either a complement or an alternative to the MQR and we need a year to really put it in place and then measure whether we're getting the effects we want. That's the responsible way to do it.

Moderator: Sonia Baxendale:

Compared to many other markets, we haven't had as many financial institutions but we've seen consolidation, HSBC, Canadian Western Bank, we have lots of very small organizations, but in terms of that second tier, the medium tier, it's shrinking quite significantly, credit union consolidation.

How do you view this in terms of this growing market share and the growing dependence on fewer institutions and arguably less competition in the Canadian market? Is that a concern?

Superintendent Peter Routledge:

It is, and a lot of the argument I just made about the capital floor, part of it may be better to say than a lot, part of the argument I made about the capital floor was if the capital floor, or as it comes into force it does rebalance relative capital, relative risk weightings between systemically important banks on the internal based, ratings-based approach and smaller banks on the standardized approach.

There is a fairly significant difference in risk weightings between those two approaches that all else equal, if you talk to standardized banks, disadvantages standardized banks and advantages internal ratings-based banks.

When you have those imbalances left unaddressed, they can produce adverse selection in terms of risk. Even though we don't have a competitive mandate, a prudential mandate still merits thinking about that imbalance and trying to level it and there are multiple ways to do it. The standardized floor is one, and the other way to do it is to consult with our regulated constituents who are on the standardized approach to see how we might put in place a made in Canada improvement in the standardized approach that maybe also helps level that playing field.

Moderator: Sonia Baxendale:

From your point of view, do you think we've gone too far, or do you think we've gone far enough? Do you think we're in the right place? Do you have a view on future consolidation?

Superintendent Peter Routledge:

Any views I'd give to the Minister is advice to Minister and it would undermine my responsibility if I have to really be transparent on that.

I think Canada's system as it stands now with six systemically important banks, which is a lot for a country our size, certainly a lot more than some other systems, and I recognize the consolidation pressures but there are still really cool, innovative, challenging institutions in the market that are competing and generating good capital return. I like the industry structure prudentially, I think that in the last 30 years bears it out, we haven't had a bank failure. I like the status quo prudentially.

Moderator: Sonia Baxendale:

Let's move to integrity and security, a new mandate for OSFI. You've mentioned a number of times that this is a more material issue than you had originally thought and I think we're seeing evidence of the challenges in relation to this. Do you view it as it’s going to make Canada’s banking system more competitive or less competitive?

Superintendent Peter Routledge:

Our mandate has been changed, a little bit out ahead of some, and probably more than other global regulators, certainly on integrity and security.

The upside of it is if we do it smart and we do it well, Canada's banking system will be healthier and safer, and all else equal, that will be a net benefit to the country and a healthier banking system means probably a more fertile environment for financing economic growth. We can screw it up though.

If we overreact to certain challenges we can do more harm than good. I think any regulator needs to have that humility and calibrate the positive outcomes you seek against the potential downside costs of what you're doing.

Every regulation has a cost. The question for a financial system regulator is the benefits you get to the system. Are you confident that they will outweigh the costs? If you're not, you should probably take a minute and get to a point where you can have that confidence before you do anything. Particularly a system like Canada's where the track record is pretty good. First do no harm isn't a bad mantra.

Moderator: Sonia Baxendale:

To build on that, how do we mitigate against that risk? I'm not thinking so much from a regulation point of view in terms of what you do, but from a financial institution now feeling a need to overreact. This is a new regulation, and it's principles-based. We now have to use judgement to determine what that means.

I think there is probably a fair amount of concern and worry that you fall short of the threshold and if you fall short of the threshold what are the implications of that? How do we mitigate against financial institutions going too far?

Superintendent Peter Routledge:

There are probably three things you can do. The first is hold on to this principles-based approach to regulation. We produce guidelines, we do not produce rules. When we ask institutions to apply those guidelines, we ask them to hold to the principle and adapt their application of that principle to their business model. Both institutions and regulators have to be alive to that opportunity.

The second is we as regulators have to count on boards of directors. I think my colleague and the Deputy Superintendent, Ben Gully, gave a great speech a couple of months ago about just that. We count on boards to do the work to protect their franchise values of the institutions that they govern.

There is a line we have to respect where we aren't dictating to boards. We are showing where in our evaluation, policies, and procedures may not be up to where we would hope given our principle, but then engage with boards and senior managers in longer term intelligent discussions about the best way to achieve the principle. The role of the board in that is crucial and OSFI has to know its limits in dealing with boards.

The third is internally to OSFI My job as Superintendent is to make sure that my colleagues are facing out into the risk environment, facing out to their regulated constituents and having an enlightened view on how to apply our principles-based guidelines and listen to who it affects and change based on good arguments from those constituents.

The board is one side of the street, and the other side of the street is OSFI being diligent, responsible, and empathetic how we deal with their regulated constituents.

Moderator: Sonia Baxendale:

There's been a lot of talk about board governance both from the regulator lately in terms of the role of the board and even as we see new guidelines coming out, frequently with some of these non-financial risks, we're seeing some reasonably clear expectations of the board in some of these things.

Are we in a new era of boards and does the role of the board need to change? Are the boards fit for purpose today in your view? These risks are more complex, I mean just the reality of it is mostly we used to deal primarily with financial risks and if you put some good accounting and business leaders on your board, they could cover them all.

But now you've got cyber risk, climate risk, and integrity and security. It's a complex myriad of risks that we're asking boards to weigh in on, be accountable for, govern, challenge, etcetera. Have we got it right for the new era of organizations and risks that they face?

Superintendent Peter Routledge:

I think the basic structure where shareholders hire boards of directors to hire managers, particularly the CEO, and that the board serves as the crucial oversight of the managers they hire. We don't need to change that and there's the old nose and fingers out, that's a pretty good principle to uphold.

What's changed is the risk environment and boards have to change their composition to match up against the risk environment. This isn't on OSFI's initiative, it really is on the boards that we work with on their initiative. They're recognizing these risks and they're bringing in a wider array of members who understand risks in a more technical level.

You'll get cyber risk experts or operational experts who may understand issues like AML a little bit better to go along with traditional creditors who borrow from banks or traditional financial specialists who understand the economics of banks. You need to broaden your skillset on boards.

The traditional best practices of boards with the right skillset is fit for purpose, which is poke your nose in and ask uncomfortable questions of management and hold them accountable when you're unhappy with the answer.

Moderator: Sonia Baxendale:

OSFI's scope of oversight has increased over the years. Where would you like to see it go in an increasingly complex environment?

Superintendent Peter Routledge:

We're already trying to correct this but with every new risk that props up that's threatening we put together a new guideline and we put it out, third-party risk management, cyber risk management, integrity, security and so on. Over the last 25 years, I don't think we've decommissioned any of our guidelines or advisories.

In November we are going to announce a first wave of decommissioning of guidelines and advisories that are really no longer relevant. Not a game changer for the regulatory environment, it's the easy part and we're going to do that in November.

Phase two will be looking at the ones that weren't so easy to decommission, but that we'd like to and try and figure out if we really need. If we only need a small part of it, maybe we can fit it into a broader guideline. As much as we add to our regulatory framework we'd like to be subtracting from it. Stay tuned in November, we'll get the first wave done.

That was the easy part and then we'll engage with our regulated constituents on where else we might be able to shrink it. It would be good discipline for us, and I hope over the next couple of years that we turn it into a regular repeating discipline.

Moderator: Sonia Baxendale:

We had a session earlier this morning with Ambassador Rice and it was a pretty comprehensive discussion about the geopolitical risks that we're facing. We don't have to look too far to see the implications of that. How do you think about the geopolitical risks from a prudential perspective in your regulating of financial?

Superintendent Peter Routledge:

I'm not a geopolitical scientist, and I'm not a foreign affairs expert, I'm just a simple bank analyst who's now a bank regulator. But I lived through the fall of the Berlin wall and the end of the Cold War and then this golden age of free trade and this theory that free trade, free markets ultimately leads to all nations of the world having common interests. A great dream, it might not represent where we are right now today.

What I perceive is a marked increase in geopolitical conflict. I think we had an example of that yesterday in the Middle East and we've certainly seen Russia's invasion of Ukraine as another example. Amidst these kinetic conflicts there are virtual conflicts going on in cyberspace all the time.

The mindset I've asked the boards of directors and the institutions that we supervise to adopt is one of thinking of their institutions as nodes in this virtual system that could come under attack by hostile players.

Many of Canada's financial institutions are national champions and so that positions them as unique receptors of geopolitical risk and I've asked boards to think about that in setting up defences to protect their organizations.

As is, is there a big wave of attacks on Canada's institutions that's not unique and extraordinary. But there is a persistent effort by some actors to attack financial institutions through cyber attacks or other means to benefit themselves and in so doing they risk harming the institutions we regulate.

I've asked boards to think of their institutions as having higher risks that might flow out of this different geopolitical environment and to think about how to protect their institutions.

Moderator: Sonia Baxendale:

I want to stay on the theme of the regulatory impact of some of the sessions we've had earlier today and this morning we had a speaker on AI and one of the comments that that speaker made was the pace at which AI is moving relative to the pace at which regulation moves and that by the time there's a regulation that relates to something to do with AI it's two years after the fact. They move in days and weeks and months and regulation does not. Is there a thought that we need to think about regulation differently or is this just a reality that we're going to live with?

Superintendent Peter Routledge:

I think you're right in discussing the rate of change in each sector. Regulations do change fairly slowly and advancements in AI will probably happen exponentially. Should we speed up the regulatory process for that? Maybe a little but not really. First do no harm.

AI has very significant risks, but also very significant opportunities. I think one risk that we have to accept is we will take a little bit longer to implement regulatory responses to AI and the risk that comes with that is what you just pointed out. AI could really take off and create risks we don't see and then create a crisis that'll cause us to react to it.

I think right now accepting that risk is intelligent while we begin to develop and build our understanding of the space and not knee-jerk into reactions that might otherwise harm the development of this technology.

I'm not saying it's risk-free, I'm saying we're working diligently but quietly to understand it but it's going to be a while before we develop actual regulations or guidelines on this. I don't think we understand it well enough to do that.

Moderator: Sonia Baxendale:

We also just had a breakout session on open banking and that's been on the agenda for a while here in Canada and we do expect we'll receive new guidance on that later this year.

I think it's clear that the introduction of open banking introduces new risks to the system. It doesn't necessarily mean we shouldn't do it or that we should just mitigate for those risks or work within those parameters. What's OSFI's current engagement on this subject and role and expectations?

Superintendent Peter Routledge:

Open banking policy is developed by the Department of Finance and there's been a role stated in the most recent budget document for the Financial Consumer Agency of Canada. We're in support of it but we are observers to it and at present we're not seeing any step change in systemic risk as a result of open banking. If we did we would make our concerns known.

As open banking and the digitalization of financial systems continues to go forward product design, particularly in funding, will be a very, very important consideration for financial institutions.

The traditional stable demand deposit, sticky demand deposit, I think institutions should be continuously measuring how sticky their demand deposits are in an electronic world and then developing their product in the event that they believe that stickiness is weakening.

In Canada I don't see any evidence of a weakening in demand deposit stickiness, but I know that the institutions looking at open banking are keeping a good clean eye on that risk just in case it increases.

Moderator: Sonia Baxendale:

We haven't talked about climate, and I don't think we can go through a session without including climate. It felt like it was higher on the agenda from a regulatory perspective for a period of time. Where do you put it today in terms of the priorities coming out of coming out of OSFI at this moment?

Superintendent Peter Routledge:

We certainly made a lot more noise about climate three years ago than today because we were in building a capacity to begin to prepare the institutions we supervise to manage that risk. We've developed a guideline, we've developed a scenario testing capability, we've developed regulatory returns for climate risk exposure so we're through the initial lift.

From a visible standpoint and a public relations standpoint, the next three years will be much quieter because now we have to do the hard work of implementing B-15. Now we have to do the hard work of measuring climate risk exposure through scope one, scope two, scope three emissions. Now we have to do the hard work of processing regular scenario tests for different climate scenarios.

In so doing we are developing a maturity in measuring and understanding climate risk as a financial risk. We have to advance and mature our ability as do the boards of directors of the institutions that we supervise and it's going to take three or four years.

I equate it to market risk back in the 1980s, liquidity risk coming out of the great financial crisis. There is a multi-year process of getting smarter and more empirical around climate risk and that's what we have to focus on.

That will begin to answer the questions that are longer term which is, do we have enough capital for worsening or intensifying climate risk? If not, how's the best way to advance that? If so, that's one less thing to worry about. What do boards need to think about in terms of measuring climate risk and at what point should they disclose it to the market?

All those things require a couple of years of green eye shade, nose to the grindstone, empirical work to measure the risk more effectively, and it's important. This year, according to the Insurance Bureau of Canada, there was $7.5 billion in natural catastrophe losses. The previous high was $4 billion the year of the Fort McMurray fires.

Does anyone want to take the over-under in five years whether $7.5 billion will be the high? I'd take the over. Climate risk is first and foremost a financial risk that we haven't fully figured out how to measure in price. That's the job of the next three years.

Moderator: Sonia Baxendale:

We're just about at the end of our time so I'm going to leave you with one final question from our participants. Of the top risks banks face, which one is OSFI most concerned about?

Superintendent Peter Routledge:

We put out our Mount Rushmore top four and number one is still residential mortgage lending risk and the housing market more generally. That's where we find the largest allocation of risk in a bank's lending book. That has a fundamental link to consumer confidence and consumer spending which is two-thirds of our economy. OSFI has been saying this for 20 years but it’s the central risk to our system.

Moderator: Sonia Baxendale:

It’s good to be a consistent regulator. Peter, thank you very much, really appreciate you always coming. Thank you for your continued openness and transparency.

Superintendent Peter Routledge:

Thank you.