Strong Supervision and Macro-Prudential Considerations
Remarks by Superintendent Julie Dickson
Office of the Superintendent of Financial Institutions Canada (OSFI)
to the
OSFI College of RBC Supervisors
Toronto, Ontario
Wednesday, February 4, 2009
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Jason LaMontagne
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www.osfi-bsif.gc.ca
Remarks by Superintendent Julie Dickson,
Office of the Superintendent of Financial Institutions Canada (OSFI)
to the OSFI College of RBC Supervisors
Toronto, Ontario
February 4, 2009
Strong Supervision and Macro-Prudential Considerations
Introduction
Welcome to the first OSFI supervisory college being carried out as a result of
recommendations made by the Financial Stability Forum (FSF).
I would like to acknowledge the foreign regulatory supervisors who have been
able to join us today. The sharing of experiences and contacts is incredibly
important to the work we all do in today’s multi-national world of financial
services.
OSFI agrees with the FSF that supervisory colleges are extremely important. We
chose Royal Bank for the initial college of this type, as it is Canada’s largest bank
and has an extensive international presence.
While this is the first college OSFI has sponsored based on the FSF
recommendations, we have previously hosted four primary, or 'core', colleges of
supervisors (in 05/2005, 04/2006, 02/2007 and 11/2007) which discussed Basel
2 implementation across Canada’s larger banks, and they involved supervisors
from the UK, US, Ireland, Mexico, and Luxembourg. We have also had two
colleges aimed at regional supervisors in the Caribbean and Mexico (01/2007
and 11/2007), which involved supervisors from many jurisdictions.
We are also preparing to host a college focused on ICAAP (Basel 2 Internal
Capital Adequacy Assessment Process) issues later this year.
What do we hope to accomplish with these colleges? At a very basic level,
developing a relationship with other supervisors makes it far easier to
interact. Knowing who to call if you have a pressing issue means we can get
information from you more quickly, and vice versa. The more times we meet
face-to-face, the better -- that is why we plan to meet in person once a year, and
buttress that by communicating regularly.
There are higher goals as well. Supervisory colleges can help us to become
more efficient (so we are not both doing identical reviews on the same business
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at the same time). Supervisory colleges also allow us to develop a more robust
understanding of an institution as more views are put on the table.
Updating OSFI’s Supervisory Framework
As you know, supervisory colleges are only one piece of the puzzle. There are
a host of other areas being worked on by the FSF, G20, Basel Committee, and
other international bodies. But here at OSFI we are also contemplating our own
corner of the world and making some changes at home that we think will make
us better supervisors.
Of note is our work in taking some of the lessons from the global financial turmoil
and updating the OSFI supervisory framework. The framework was introduced in
1999, and describes our process for assessing the safety and soundness of
financial institutions. While we believe that this framework has served us well and
has withstood the test of time, we have learned valuable lessons from the global
turmoil, and the supervisory framework should be updated to reflect that.
We spend a lot of time assessing the inherent risk at an institution and the
controls to manage those risks. But we have seen that the inherent risk of an
institution can change extremely quickly, far more quickly than we have seen
historically (i.e. risks embodied within the business). Controls at an institution
tend to be more static, so we are targeting ways to identify changes in inherent
risks through methods such as stress testing individual business lines more
frequently.
We also think we could place greater emphasis on the identification of risks (or
combinations of risks) that could be a material threat to the capital allocated to
individual business lines. Currently the framework only requires an assessment
of capital adequacy at an aggregate, or top-of-the-house, level. By first assessing
the seriousness of the threat (using techniques such as stress testing) to the
capital in an individual business, we can make determinations of the seriousness
of the risks even more quickly. This would help ensure that individual risks are
not obscured by comparing them to the institution’s entire capital base.
The current framework also makes clear that OSFI’s assessments include our
current perception of the direction of net risk -- is it going up, is it stable, or is it
decreasing? This is all about determining the future direction of risk. The
challenge is to ask whether we can go further. While determining the direction of
risk can be difficult because there are many variables, we are trying to increase
the robustness of this analysis, and the supervisory response to it, so we are
able to be even more forward looking.
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Macro-prudential regulation
OSFI is also interested in the burgeoning international debate about macroprudential regulation, a debate in which the Federal Government's budget noted
Canada's leadership role in the G20. This includes Canada’s Department of
Finance co-chairing the G20 working group on Enhancing Sound Regulation and
Strengthening Transparency.
As part of that effort, Canada will be making recommendations to support a
macro-prudential orientation for regulatory frameworks. A macro-prudential
approach takes a system-wide view of how government regulation and other
interventions in the financial sector affect business cycles and the broader
economy.
I know that this is increasingly a source of discussion internationally.
In the United Kingdom, on January 21st at The Economist's Inaugural City
Lecture, Adair Turner, Chairman of the UK Financial Services Authority, said:
"Regulators were too focused on the institution by institution supervision of
idiosyncratic risk; central banks too focused on monetary policy tightly defined,
meeting inflation targets. And reports which did look at the overall picture, for
instance the International Monetary Fund (IMF) Global Financial Stability
Report .., sometimes simply got it wrong, and when they did get it right, for
instance in their warnings about over rapid credit growth in the UK and the US,
they were largely ignored. ... Central banks and regulators between them need to
integrate macro-economic analysis with macro-prudential analysis, and to identify
the combination of measures which can take away the punch bowl before the
party gets out of hand."
I noticed also that Jose Maria Roldan, chair of the Basel Accord Implementation
Group (AIG), said recently that perhaps analysts, as well as supervisors and
banks, should pay closer attention to financial stability issues when undertaking
their assessments. He asked, “How many of us asked ourselves whether it was
ever realistic to expect the banking system to regularly deliver returns on equity
in excess of 20 per cent, without taking excessive risk?”
The question posed by Jose Maria, in his reference to financial stability, is a good
one. Such questions were arguably something that supervisors should have
always been asking, and many were. Making the need to ask such questions
more front-and-centre would clearly be of benefit.
However, the macro-prudential debate goes further than that. The issue is about
realizing that everything in this world is connected. For example, bank
regulations can have impacts on banks, as well as on the macro-economy. Just
as government and central bank policies can have impacts on the economy as
well as on financial institutions.
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Regulators, central banks and policymakers have always worked together
closely, but the macro-economic debate suggests the need to ask questions
about bank regulations that have not typically been asked before. The best
example of course is the question of whether bank capital rules are too procyclical and should in fact be "anti-cyclical" – in other words whether capital
requirements should go up in booms and go down in downturns.
I focused on that issue in a speech on January 8, 2009. I talked about the fact
that regulators did a lot to make those rules cycle-neutral, and that more can be
done via through-the-cycle estimates versus point-in-time measures. I said that
we also need to study whether having anti-cyclical capital rules is a concept that
can actually be employed, recognizing that this is a very complicated area on
which there is much debate.
We need to ask these questions, while recognizing that we are mere
mortals. Very smart people have tried to moderate the real economic costs
imposed on society by phenomena such as business cycles, uncontrolled
inflation, and the collapse of asset bubbles. We have had some success
but unfortunately, in spite of the best efforts of macro-economists, we have not
repealed the business cycle, nor have we escaped the problems associated with
it.
While macro-economists are working hard to better understand the business
cycle and the relationship between the financial sector and the macro-economy,
studying the extent to which bank regulations are part of this equation is a natural
frontier to be explored.
Prudential Regulation
As a bank regulator, OSFI is very focused on the solvency of the banks we
regulate. That focus has paid dividends in Canada. A part of our process is to
look at the bigger picture, and then relate that understanding to what we are
seeing in the particular financial institution we are reviewing. We instituted an
emerging risks process in spring 2007 to hone that even more.
A second part of our focus is to analyze and take action at the industry-wide
level. Usually we develop a regulation, or equivalent measure, that banks must
follow where we do not see risk adequately handled on an industry-wide basis.
Capital rules are a key part of that rule book.
At the same time, we have never made across-the-board changes to regulatory
rules to respond to swings in macro-activity. Across-the-board changes in OSFI
rules reflect three key factors: changes in risk management techniques (we raise
the bar for banks as better risk management techniques are brought forward);
changes in the activities undertaken by banks (new activities often result in new
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supervisory requirements); and new risks as they appear, such as in the area of
securitization.
As examples, the decision in 1999 to require banks to meet a 7 per cent tier 1
target reflected the new risks OSFI was seeing. The decision to maintain the
leverage ratio when Basel 2 was agreed upon also reflected OSFI's views about
the risks. This is the foundation of our work and must be done well.
Were regulators too focused on idiosyncratic, or institution-specific, risk -- paying
too much attention to what could happen to a particular bank? Would more focus
on macro-prudential issues have saved us from this turmoil? I do not know the
answer to the second question, on which many are placing much effort and
thought.
I do, however, know the answer to the first question. Regulators globally did not
pay too much attention to institution by institution supervision of idiosyncratic
risk. Otherwise we would not have as many global banks on life support.
But I do agree that regulators need to focus on the forest as well as the
trees. Prudential regulators do have, as part of their job, a mandate to look at
system wide issues. We ask banks to consider scenarios ranging from
idiosyncratic problems in their own specific portfolios, to problems in the
economy as a whole and the consequential impact on bank balance sheets.
We also ask banks to consider situations where there is a herding effect
(everyone heading for the exits and trying to unwind positions or sell assets at
the same time). We talk to banks about the impact unregulated players have on
their own risk taking. We have to be concerned with how banks or insurers as a
whole operate. So a focus on system-wide issues is incredibly important, but it
cannot substitute for a strong focus on what each bank is doing.
Many thought that securitization would reduce risks for individual banks, by
passing credit risk to a diversified set of end investors, and that this would reduce
risks for the whole system. In the years prior to summer 2007, when the global
financial turmoil erupted, work was being done to assess this.
Some felt that system risk was reduced because the risk was widely distributed;
others felt that it was too hard to determine because they were not sure where
the risk had gone. Not many were saying that, while these system wide
considerations were interesting, you had better be sure that the core players
creating the risk exposures and transferring the risk know what they are
doing. Also key was whether supervisors had taken steps to force prudent
securitization practices to begin with.
So, in my mind, discussion about macro-prudential regulation and system-wide
views, is not, and should not, be about diluting the supervisory focus on
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individual bank risk. A sound banking system is made up of sound banks. The
optimal path to a sound financial system is sound risk management by individual
financial institutions. This is done bank by bank -- and each institution is
different. They have different business plans, different appetites for risk, different
approaches to management, and more.
While monetary and fiscal policy can be “broad-brush”, OSFI’s regulatory
approach must be fine-tuned to individual situations.
While we need to study how and whether various regulations could affect macrofinancial stability -- just as globally we are always studying how fiscal and
monetary policy affects stability -- we already know certain things. Weak
oversight and supervision of banks, combined with weak rules, is a recipe for
instability and bigger problems.
Regulators have to work to ensure that they do not create problems, and that
they "get" the lessons from the current turmoil. Some of these lessons are still
being sorted out. For example, consider Jose Maria's comment that regulators
should think more about financial stability in doing their work. It is impossible to
disagree with this and many would say that this consideration was always
present (otherwise the suggestion is that regulators don't care about system
stability).
But financial stability means different things to different people. If bank
regulations keep bank risk under control, but that leads to a growing unregulated
sector, does financial stability suggest that bank regulators should be less
conservative and entice more people into the regulatory net? Should OSFI cut
institutions some slack in the interest of financial stability -- like diluting regulatory
requirements in these tough times even if we don't think it is warranted by the risk
at hand? Should regulators avoid taking control of institutions in the name of
system stability, even where governments are not prepared to step in?
OSFI’s legislated mandate takes us to a clear answer on all such questions -- the
answer is no.
OSFI’s mandate tells us to stay the course, because robust regulation and
supervision are key ingredients in creating financial stability. This does not mean
that OSFI should have tunnel vision and not see the bigger picture -- quite the
contrary. Indeed, we need to share our views about banks, and the wider system,
and we need to be receptive to views about the impact of our rules on the wider
system. We need to discuss whether these impacts mean that the rules should
change or that something else should change. The point is that the core job -robust supervision and regulation of financial institutions under OSFI’s purview -needs to be done and there are no short cuts to financial stability.
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So this all boils down to one major point, that a response to the global financial
turmoil is necessary. Given the scale of the crisis, a sense of urgency is key. But
we need to be very careful, as changes in financial system regulation can have
major impacts that are hard to predict in advance. It is important to analyse
and try to understand those impacts early.
Conclusion
To conclude, and to get back to why we are here today, a supervisory college is
something concrete that we can all use to improve the quality of supervision, a
central part of a sound financial system.
More information, better information, sharing of experiences, all contribute to
more effective regulation. We need to continue to maintain our focus on
individual institutions, while also adding our expertise to the important
international debates that are occurring on ways to enhance financial stability
and on macro-prudential regulation.
Thank you.
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