Supervision of Canadian Financial Institutions

1
Supervision of Canadian Financial Institutions
James Dennison
2
Agenda

• Regulatory Capital 101
• The Basel Accord
• OSFI

3
Regulatory Capital 101
4
Regulatory Capital

• Capital is
• a measure of a financial institutions net worth.
• Regulatory capital is
• net worth as defined by rules adopted by a
  regulatory agency (e.g. OSFI).
• designed to require financial institutions to
  hold enough capital relative to the risks they
  are taking.
• calculated using financial statement and other
  relevant data.
• different for deposit-taking institutions, life
  insurance companies and property casualty
  insurance companies.

5
Regulatory Capital

• Regulatory capital for deposit-taking
  institutions consists of two key rules
• 1. Asset-to-Capital Multiple (ACM)
• 2. Risk-Based Capital Ratio

6
Regulatory Capital

• The Asset-to-Capital Multiple (ACM)
• is simply a measure of a financial institutions
  leverage.
• is calculated by the using the following
  equation
• ACM Total assets
• Total capital
• is a measure of a financial institutions
  leverage.
• is compared to the prescribed regulatory limit
  (e.g. 12x, 20x, 23x)

7
Regulatory Capital

• The Risk-Based Capital Ratio
• is a measure of how much capital a financial
  institution is holding, relative to the amount of
  risk it is taking.
• is calculated by the using the following
  equation
• Risk-Based Capital Ratio Total capital
• Sum of risk-weighted assets
• is compared to the prescribed regulatory limit
  (e.g. 8)

8
Regulatory Capital

• Total capital has 3 primary considerations,
  including its
• permanence.
• being free of mandatory fixed charges against
  earnings.
• subordinated legal position to the rights of
  depositors and other creditors of the
  institution.
• Total capital includes
• Tier 1 (core capital) highest quality.
• Equity capital
• Disclosed reserves (share premiums, retained
  earnings and general reserves)
• Tier 2 (supplementary capital) lower quality.
• Undisclosed reserves/hidden reserves
• Asset revaluation reserves
• General provision/loan loss reserves
• Hybrid debt capital instruments
• Subordinated term debt

9
Regulatory Capital

• Risk-weighted assets has several components.
• Credit risk (on-balance sheet) conversion factors
• 0 cash OECD governments
• 20 Canadian banks, OECD banks, non-domestic OECD
  public sector entities
• 50 residential mortgages
• 100 all other claims
• Credit risk (off-balance sheet) conversion
  factors
• 100 direct credit substitutes (e.g. credit
  lines)
• 50 transaction related contingencies (e.g. bid
  bonds, performance bonds, etc)
• 20 short-term, self-liquidating trade-related
  contingencies
• 0 unused portions of commitments with original
  maturity of one year or less.
• Market risk conversion factors
• On-balance sheet assets held in trading book
  subject only to market risk requirements.
• Derivative instruments held in trading books
  subject to both market credit risk reqmts.
• On-balance sheet assets held outside trading book
  and funded by another currency and unhedged for
  f/x exposure are subject to both market and
  credit risk requirements

10
Regulatory Capital

• Example ABC Bank
• Only one asset - 300,000 residential mortgage
• Total capital of 15,000
• Risk-weighted assets 300,000 x 50
• 150,000
• Risk-based capital ratio 15,000
• 150,000
• 10
• Conclusion 10 gt 8 regulatory minimum
• ? Compliant with regulatory requirements

11
MCCSR

• MCCSR Total Capital
• Required Capital
• Minimum 120
• Target 150
• Required capital includes charges for
• Asset default
• Mortality, morbidity and lapse risk
• Interest rate risk
• Segregated fund guarantee risk

12
The Basel Accord
13
The Basel Accord

• The Basel Committee
• was established in 1974 by the central bank
  governors of the G-10 countries (Belgium, Canada,
  France, Germany, Italy, Japan, Luxemburg, the
  Netherlands, Spain, Sweden, Switzerland, the UK
  and the US.
• was created to provide a forum for regular
  cooperation between its member countries on
  banking supervisory matters.
• sets the standards for the regulation of capital
  and capital adequacy for internationally active
  financial institutions.
• does not have supranational authority, therefore
  the Basel Accord does not have any legal force.
• satisfies its mandate by influencing national
  regulatory bodies to implement supervisory
  standards and guidelines, and best practice
  recommendations.

14
The Basel Accord

• The first version of the Accord
• was first released in July 1988.
• was introduced to address the need for a
  multinational accord to strengthen the stability
  of the international banking system and to remove
  a source of competitive inequality arising from
  differences in national capital requirements.
• was limited in focus to credit risk and provided
  a framework for the implementation of a minimal
  capital standard of 8 by the end of 1992.
• was amended in 1996 to incorporate market risk.

15
The Basel Accord

• The first version of the Accord has several
  shortcomings
• Inadequate differentiation between credit risks
  does not allow for varying levels of credit
  quality.
• Securitization banks have securitized high
  quality loans, thus leading to a deteriorating
  loan book.
• Credit mitigation techniques does not recognize
  the benefits of techniques such as collateral
  guarantees, netting and use of credit
  derivatives.
• Diversification does not consider portfolio
  risk and completely ignores the benefits derived
  from diversification.
• Operational risk does not consider operational
  risk into calculation of required capital.

16
The Basel Accord

• The second version of the Accord is based on 3
  pillars
• Minimum Capital Requirement
• to cover credit, market and operational risk (new
  risk category under Basel II)
• financial institutions have a wider choice of
  models to calculate risk charges
• Supervisory review process
• supervisors (e.g. OSFI) have an expanded role,
  including ensuring financial institutions have a
  process in place to for accessing capital in
  relation to risks, and that they operate above
  the minimum regulatory capital ratios.
• Market Discipline
• Basel II emphasizes the importance of risk
  disclosures in financial statements by setting
  out disclosure requirements and recommendations

17
The Basel Accord

• Financial institutions can now choose from
  numerous approaches to calculating required
  capital

18
The Basel Accord

• Choices regarding credit risk include
• Standardized Approach uses credit ratings from
  external rating agencies together with risk
  weights applicable to each rating category to
  calculate the credit risk capital charge.
• Foundation Internal Ratings Based (IRB) Approach
  use internal estimate of creditworthiness,
  subject to regulatory standards. Under this
  approach, institutions estimate the probability
  of default (PD) and together with inputs provided
  from the standardized approach, is used to
  determine the credit risk capital charge.
• Advanced Internal Ratings Based (IRB) Approach
  builds on the Foundation IRB approach, by adding
  other inputs such as loss given default (LGD) and
  exposure at default (EAD) to further refine the
  credit risk capital charge calculations.
• Note in order to use either the Foundation or
  Advanced IRB approach, regulatory approval of
  credit models must be obtained.

19
The Basel Accord

• Choices regarding operational risk include
• Basic Indicator Approach institutions using
  this approach must hold operational risk capital
  equal to the average over the previous three
  years of 15 of positive annual gross income.
• Standardized Approach institutions using this
  approach are required to divide its activities
  into eight predefined business units and apply a
  predefined factor to each business line to
  determine operational risk capital. The total
  operational risk capital charge for the
  institution would be the three year average of
  the sum the charge for each business unit.
• Advanced Measurement Approach the operational
  risk capital charge is generated by the
  institutions internal operational risk
  measurement system using quantitative and
  qualitative criteria specified in the accord. Use
  of this method is subject to supervisory
  approval.

20
Operational Implications

• Bank business line/group impacts
• Key Risk Indicators
• Operational Losses
• Operational Risk Modelling
• Financial Regulatory Returns
• Independent Assessment (Internal Audit)

21
OSFI

22
Mandate

• The Office of the Superintendent of
  Financial Institutions (OSFI) is the primary
  regulator of federally chartered financial
  institutions and federally administered pension
  plans. OSFI's mission is to safeguard policy
  holders, depositors and pension plan members from
  undue loss. OSFI supervises and regulates all
  banks, and all federally incorporated or
  registered trust and loan companies, insurance
  companies, cooperative credit associations,
  fraternal benefit societies and pension plans.

23
Organizational Structure
24
Supervision Processes

• Quarterly monitoring process
• On-site examinations
• Cross-industry reviews
• Ad-hoc analysis and project management

25
Supervisory Tools

• Quarterly monitoring process
• Stage Ratings
• (Stages 0 to 4)
• Supervisory Framework
• FI Ratings
• (Low, Moderate, Above Average, High)

26
RMCF Characteristics
Overall Assessment
ONR
Stage Rating
27
Questions

• ?