OSFI faces three key challenges, superintendent of financial institutions Jeremy Rudin said today at an Economic Club of Canada event in Toronto.

They are:

#1. Restraining “excessive risk taking while encouraging responsible risk taking.”

Read: BLG’s roundup of summer OSFI initiatives

#2. Determining the best way to apply international agreements on credential standards, “while also respecting the needs and circumstances of Canada’s financial sector.”

#3. Promoting stability among all institutions under OSFI’s jurisdiction, which differ both in systemic importance and capabilities.

Challenge #1

Rudin says “we would be missing the point if we tried to stamp out risk-taking in general.”

OSFI will continue relying on a broad, principles-based approach. “To the extent possible, we stay away from detailed, prescriptive rules,” though “there are some ‘bright lines’ that institutions are not allowed to cross.”

Rudin notes three points of guidance on risk-management:

  1. institutions must develop their own capital targets above OSFI minimums;
  2. residential lenders must develop their own residential mortgage underwriting policies using OSFI principles; and
  3. institutions with sufficient data and systems may use their own risk models to determine part of their capital requirements.

Rudin acknowledges a problem with relying on institutions for risk estimates: they have a short-term incentive to understate. But “[they] understand that their long-term interest is to maintain credibility with their regulator.”

And it’s not as if OSFI’s blindly accepting what institutions report. “We follow the old Russian proverb famously translated by Ronald Regan: ‘Trust, but verify.’ ”

Challenge #2

Regarding international agreements, Rudin says OSFI “look[s] carefully at the Canadian situation and at Canadian needs before deciding how, and how closely, to adhere to each international standard.

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“At times, we have chosen to impose standards above international minimums. In principle, this can put our internationally active institutions at something of a competitive disadvantage. That can be the unintended, yet justifiable, consequence of doing what is necessary to protect financial stability in Canada.”

Rudin points to OSFI’s decision to exceed Basel I and II capital requirements. “Since then, it has become a truism that these decisions helped Canada to skate through the global crisis much better than countries that imposed only the minimum standard, if that.”

He emphasizes, however, that when there’s no advantage to exceeding international minimums, OSFI will closely follow agreements with global counterparts. For instance, OSFI’s set the leverage limit at the international minimum. “This is despite the fact that several high-profile jurisdictions will impose much stricter limits.”

He adds OSFI is “sometimes prepared to take a liberal reading of the standards when Canadian circumstances call for it. For example, subject to certain conditions, we accept preferred shares as Tier 1 capital, even though this is not consistent with a strict interpretation of the Basel III standard.”

Challenge #3

Rudin notes the increased regulatory burden since the crisis has had a bigger impact on smaller players. “Moreover, compared with our large banks, smaller banks using the standardized approach for their capital requirements have fewer options for managing the post-crisis increase in those requirements.”

To help address the special concerns of smaller firms, OSFI’s appointed Scott Knight to the new role of small bank advisor. Knight will be consulting with these institutions and “helping…calibrate supervision so that the regulatory burden…can be more closely fit for purpose.”

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