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Canada's bank regulator allows dividends as pandemic tests capital regime

The Office of the Superintendent of Financial Institutions (OSFI), Canada’s federal bank and insurance regulator, is casting a vote of confidence in the safety and soundness of domestic systemically important banks (D-SIBs) in the country as well as its own unique approach to capital-adequacy rules.

The regulator has said it will allow large lenders to continue paying dividends to shareholders even as they draw down on regulatory capital buffers to weather financial stress related to the COVID-19 pandemic. OSFI’s decision will test the ingenuity of its bank capital regime, which has incorporated Canada-specific elements and has, at times, diverged from international practices.

Dividend payments to continue on soundness confidence

Departing from other jurisdictions such as the United Kingdom, New Zealand and Australia, which have asked banks to suspend dividend payments to shareholders, OSFI has said that Canadian banks can, and should, continue paying dividends as a way to support the domestic economy. Analysts from the Bank of Montreal estimate that 90% of the banks’ shares are owned by Canadian investors and about 40%-50% are retail investors.

OSFI justified this decision in a recent statement on Canadian bank capital and dividends. The statement outlines Canada’s approach to meeting capital adequacy standards set by the Basel Committee on Banking Supervision (BCBS) and said that large Canadian banks are capitalized beyond BCBS expectations. Due to flexibility in OSFI’s approach, the regulator believes that D-SIBS are in good position to withstand financial stress.

OSFI highlighted areas where it has implemented mechanisms to address Canada-specific risks while still respecting international standards.

The domestic stability buffer is one example where OSFI has added requirements beyond what is recommended by the BCBS. The countercyclical buffer, which OSFI reviews twice a year based on market developments and emerging risks, is meant to hold more flexible amounts of regulatory capital for banks to draw on in times of stress without having to reduce their lending.

In addition, since 2016, OSFI has imposed a surcharge for D-SIBs on the basis that their insolvency would hurt the Canadian economy. The surcharge requires large banks to hold an additional one percent of capital as a buffer, in addition to the domestic stability buffer and BCBS capital requirements.

D-SIBs are now drawing down on these extra buffers and OSFI thinks that there is flexibility to free up credit without compromising bank capital levels. Last month, OSFI lowered the buffer to 1.00 percent of risk-weighted assets for large banks, down from 2.25 percent. As a result, C$300 billion was made available in credit for financial relief from the novel coronavirus pandemic. OSFI encouraged the D-SIBs to use the capital from the domestic stability buffer, as well as additional liquidity buffers such as the surcharge, to lend to Canadian businesses and households.

OSFI will likely monitor how this reserve capital is used. It should be used to support the Canadian economy and should not be used to increase share distributions or undertake share buybacks, the regulator said, echoing previous guidance. OSFI said in 2016 that a welldesigned capital regime should reduce the likelihood that banks will try to de-leverage too rapidly during a crisis, thereby exacerbating financial stress on the economy.

In 2017, OSFI delivered a similar message, saying that a goal of its capital regime was to encourage banks to maintain capital in times of stress without having to drastically reduce lending or conduct a “fire sale” of assets.

Risk and compliance considerations

OSFI’s decision to allow large Canadian banks to continue paying dividends along with its expressed confidence in the safety and soundness of these financial institutions sets a high bar for risk and compliance.

Implicit in the regulator’s messaging is an expectation that banks keep a close eye on capital distribution, ensuring that freed funds are being used prudently to support the Canadian economy. Risk managers are advised to ensure that liquidity risks are identified and kept up to date with market developments. Liquidity modeling should also cover a range of scenarios, given that a degree of market uncertainty is expected to persist for at least the next several months, if not longer.

The impact of volatile markets, combined with a sharp increase in unemployment, and requests for deferrals on loan obligations are just some of the unpredictable factors that risk and compliance personnel will have to work around.

Client borrowing needs could also shift more permanently and should be factored into a bank’s longer term plans to re-capitalize. Although OSFI has said that it does not intend to raise the domestic stability buffer for another 18 months, planning and accounting for lasting economic fallout from the pandemic are important capital management considerations to address now.

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