Thriving in Uncertainty: Don’t Just Plan for the Future, BUILD IT!

Speech by Peter Routledge, Superintendent of the Office of the Financial Institutions, Economic Club of Canada, September 8, 2022

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Document PropertiesThank you for that kind introduction. I would like to acknowledge that we meet today on the traditional land of the Mississauga New Credit, the Haudenosaunee, the Huron-Wendat and other nations.

While land acknowledgements are part of the important journey of reconciliation our nation is on, they remind me also of the interconnected and interdependent nature of the world, underscoring the fact that we are but stewards of the land and resources from which we benefit.

Interdependence is an important word for a financial regulator: it implies common opportunities, but also the common risk that if one player in our economic system deteriorates, it could lead to unexpected losses or costs for many.

So, what are those risks?

In prior speeches, I have characterized the first 20 years of the 21^st century as an era of great uncertainty and corresponding financial system volatility. I pointed to geo-political disruptions, financial and economic disruptions, and those risk best characterized as unknown unknowns – events or phenomena that appear suddenly on the horizon, without much advance warning, like the global pandemic of 2020-2022.

No such list is complete without mentioning the intensified economic and financial risks stemming from the green-house-gas driven warming of our planet. One need only look at the impact of extreme heat and dryness in Europe, North America, and China this summer to appreciate this danger.

More recently, an abrupt emergence of inflationary pressures globally has caused central banks to tighten their monetary policies. Rising policy interest rates will lead to higher debt servicing costs which, combined with heightened inflation, will pressure Canadian households.

Former Bank of Canada governor Stephen Poloz wrote in his book, The Next Age of Uncertainty, that “… we should expect even more volatility in the years ahead, not less.” He points out that volatility goes both ways, meaning outcomes could be either better or worse than expected. In other words, volatility and uncertainty offer as much opportunity as danger.

In my view, to maximize the opportunities and contain the risks from this next age of uncertainty, financial institution regulators must recognize that the strategies and tactics that worked in the past—even the recent past—may not work as well in the future. Certainly, some principles have served us well and will continue to do so. But our mindset in confronting this new age must start with the question: how do we adapt our strategies and tactics to meet our moment and contribute to public confidence in the Canadian financial system?

In this speech I will argue that we must emphasize early actions and responses to emerging risks in our environment. When evaluating supervisory or regulatory strategies, OSFI must accept the risks of acting early to minimize the costs of acting too late.

I will speak today about how OSFI will apply this approach in the year ahead, highlighting five key actions we will take:

1. OSFI will count on boards of directors at financial institutions to continue to play their crucial role in the financial system;
2. OSFI will remind our regulated institutions that periods of greater uncertainty require greater margins of safety;
3. OSFI will intensify its focus on residential mortgage underwriting due to prevailing conditions in housing finance;
4. OSFI will finalize its climate risk management guideline by the end of our fiscal year; and
5. OSFI will develop regulatory and supervisory approaches for digital assets based on the principle of same activity, same risk, same regulation.

At the start of this century, Canadian financial institutions, particularly the largest ones, led the way globally in splitting the positions of board chair and CEO. This may seem normal now, but only because those institutions took action to make their corporate governance practices more effective.

Despite the uncertainty and volatility of the last 20 years, Canadian federally regulated financial institutions, or FRFIs, have outperformed many of their global peers in capital resilience, liquidity resilience, and resilience to non-financial risks. These outcomes—effective corporate governance and extraordinary resilience—are not coincidental. Canadian boards deserve praise for this track record.

Today, those boards of directors still have a special responsibility and duty to protect their institutions when risks intensify. Their job is to protect the underlying franchises so that they have the resources to withstand more dangerous times and then prosper through periods of growth.

At OSFI, we rely on boards of directors to fulfil the important role as insightful, watchful stewards over their institutions’ franchise values, especially when risks intensify. We count on them to focus intently on the long-term, and to realize that a dollar applied to capital or liquidity safety margins today is not a cost, but an investment in the long-term sustainability of franchise value.

For our part, OSFI’s job is to lower the likelihood and cost of disruptive failure through supervision and regulation and, in so doing, support FRFIs’ long-term franchise values. In this way, prudential concerns are well-aligned with those of boards of directors.

In the context of the next age of uncertainty, we expect the financial institutions that we regulate to exercise vigilance and heightened prudence in their capital management practices with a view to increasing margins of safety, thereby increasing resilience.

Here again, boards of directors are critical, but they cannot do it alone—we at OSFI must do our part and remain committed to acting early and predictably to support the stability of the regulated financial system as risks intensify.

For example, in June, when we reaffirmed the Domestic Stability Buffer, or DSB, at its upper range of 2.5 percent, we also announced a review of its design and range. The DSB represents an additional Pillar 2 capital buffer that domestic systemically important banks should maintain. During times of economic difficulty, it can be released to make more credit available. That is why it is a valuable tool, and why we are currently reviewing it to ensure it continues to fulfil its role as a shock absorber for systemic risks.

Building on its review of the DSB, OSFI is also undertaking a comprehensive review of the Pillar 2 capital framework which addresses idiosyncratic risks that are not already captured by the DSB or by banks’ Pillar 1 capital requirements and buffers.

While OSFI can always act to increase capital and leverage requirements commensurate with an institution's individual risk profile, our review is intended to improve transparency and predictability around OSFI’s Pillar 2 capital framework and ensure that it remains fit for purpose given the intensifying risk environment.

Perhaps more importantly, this work will provide us with better tools to continue to verify that individual banks’ capital levels are robust to their unique risk profiles while considering their allowances, capital assessments and plans, and stress testing results.

Given present circumstances, all OSFI-regulated institutions should maintain capital and liquidity buffers well above their through-the-cycle averages. We believe this is the appropriate, prudent thing to do, and we constantly scrutinize the boards of directors of financial institutions to ensure their risk appetites are fully aligned with the overriding goal of resiliency. The market will not impose great costs on financial institutions that maintain large, plentiful, and safe buffers; in hard times, the market will, however, impose severe costs on those financial institutions that fail in this regard.

As I mentioned earlier, Canada’s financial system is fortunate to have advanced, prudential corporate governance standards. At OSFI, we are comfortable with placing a large measure of trust and confidence in the boards of directors at the financial institutions we regulate. We know they will apply diligently the principle of resiliency when making decisions around acquisitions, executive compensation, and distributions to shareholders, and build long-term franchise value.

Now, to housing. Since the global financial crisis of 2008-9, OSFI has called on the lending institutions we regulate to maintain very high underwriting standards for residential mortgages. This helps ensure credit quality in housing finance, which in turn helps maintain the availability of housing finance.

OSFI’s Guideline B-20, which governs residential mortgage underwriting practices and procedures, is another important tool that helps ensure sound underwriting, especially during periods of excessive exuberance or undue pessimism in the housing market. Its benefits can be seen in the historically strong credit quality metrics observed in Canadian residential mortgages over the past several years.

We know that the pandemic brought with it a rise in housing valuations across the country. More recently, robust inflationary pressures have led to higher interest rates. In Canada, the increase in mortgage interest rates heightens the risk of a correction that could affect asset valuations and repayments.

The uncertainty and anxiety caused by a rising interest rate environment have, understandably, caused some Canadians to advocate for a loosening of the underwriting standards in Guideline B-20. Let me reassure those of you who oppose a loosening of underwriting standards that OSFI will not do that.

Accordingly, we tightened underwriting standards in June of this year, when we issued new expectations for the treatment of innovative residential real estate lending products, including reverse mortgages, mortgages with shared equity features and combined loan plans, or CLPs. For CLPs, we tightened our expectations so that lenders will have to ensure their residential, uninsured mortgage clients with loan-to-value amounts above 65 percent do not repeatedly borrow against their principal or the price appreciation on their homes, which would sustain their indebtedness.

Because Guideline B-20 touches home ownership, it gets an extraordinary amount of public attention – at least relative to all our other regulatory guidelines. We accept this reality – housing is crucial to all Canadians and Guideline B-20, whether we at OSFI like it or not, matters to Canadians. And so, our job is to address concerns with B-20 transparently and forthrightly.

OSFI has committed to proactively reviewing our Guideline B-20. As we move forward, we will evaluate B-20 to ensure FRFIs’ residential mortgage underwriting meets high underwriting standards. One such standard relates to borrowers’ capacity to service their debt through economic cycles and calls on lenders to qualify uninsured borrowers at the contractual mortgage rate plus a buffer or a minimum floor rate. This is the Minimum Qualifying Rate, or MQR, commonly referred to as the mortgage stress test.

We are constantly evaluating the MQR to measure its efficacy in sustaining sound residential mortgage underwriting as well as the risks of pro-cyclicality.

For those of you familiar with the 2022 federal budget, you will note it set out the government’s expectations for addressing the challenge of climate change, including mandatory reporting of climate-related risks and attendant exposures. The budget noted that OSFI would consult with the financial industry on climate disclosure guidelines and requirements, in keeping with the framework set out by the international Task Force on Climate-related Financial Disclosures.

In May, we issued a draft guideline that sets out OSFIs’ expectations as to how FRFIs should manage climate-related risks. This is an area of inquiry that will affect not just the balance sheets of banks and insurers, but funding for energy and infrastructure projects as well as firms in virtually every sector of the economy.

Public consultations on our proposed approach to climate-related risks are open until the end of this month and, given the far-reaching nature of both OSFI’s draft guideline and the government’s action on climate-related risks, I look forward to receiving your feedback.

We at OSFI remain laser-focused on consulting with FRFIs on the unique risks facing Canada should our trading partners suddenly accelerate their adoption of non-greenhouse gas-emitting energy sources. Our joint scenario analysis with the Bank of Canada revealed the downside risks to the financial system of this scenario. And our job is to ensure Canada’s FRFIs can operate through a period of economic disruption triggered by a global move away from GHG energy sources.

That is a depiction of the risks of climate change. There are opportunities as well. We look with interest at the work being done to develop taxonomies for so-called green and transition assets, which could uncover new insights about their underlying risk profiles. We encourage FRFIs to share with OSFI their ideas on the underlying risk profiles of green and transition assets in this next age of uncertainty.

Digital assets—such as cryptoassets, so-called stablecoins, and decentralized finance applications and structures—are an area of rapid change. These products, which cannot yet be considered mainstream, require prudent and thoughtful approaches from institutions, which will no doubt be informed by the legislative review that the Department of Finance is leading.

OSFI is of course supportive of competition and reasonable risk-taking, but not at the expense of destabilizing the financial system or more importantly eroding Canadians’ trust in that system. Digital asset innovations are occurring within the system but also outside of it, and sometimes both simultaneously. OSFI believes that if digital asset innovations offer Canadians the same financial services and activities, with the same risks, then they should be subject to the same regulation.

In line with this, last month, OSFI published interim guidance on the treatment of cryptoasset exposures that complements OSFI’s existing guidelines. The advisory, which applies to all deposit-taking institutions and insurers, defines and categorizes cryptoasset exposures from the standpoints of regulatory capital, liquidity, and leverage requirements. It also covers the various forms of risk involved with such exposures.

I will note that this advisory does not endorse such digital assets; it merely acknowledges that institutions will hold them to varying degrees, and accordingly, provides guidance on their capital, liquidity, and leverage treatment.

These five areas—corporate governance, margins of safety, mortgage lending, climate change, and digital assets—only scratch the surface of the myriad areas in which institutions must actively navigate the risks they face.

How they go about this work, however, will have repercussions for not only their stakeholders, but the financial system writ large. Last decade, in an ocean of uncertainty, Canadians understood again the benefits of the enduring rock of financial stability. We at OSFI, and our colleagues at the boards of directors at the financial institutions we regulate, will not take for granted the value and importance of that rock.

While none of us can predict the future, we can “build it” to some extent by working together to lay a prudential foundation today that can withstand the uncertainty sure to follow in future years.

Thank you.