Canada’s Bank Regulator Moves To Tighten Credit As Impaired Loans Surge

Canada’s bank regulator is growing increasingly concerned about a risk event. This morning the Office of The Superintendent of Financial Institutions (OSFI) raised the Domestic stability buffer (DSB) target 50 basis points (bps) to 3.5% of risk weighted assets (RWA). Banks subject to the buffer will have until November 1, 2023 to get it done. This comes after a similar-sized increase this past February, which saw the DSB hit 3x 2020-levels. Not only is the regulator increasingly worried about a risk event, but this is going to throttle credit and make borrowing more expensive. 

Domestic Stability Buffer 

The Domestic Stability Buffer (DSB) is money that major banks have to set aside for a rainy day. In the event a bank needs emergency cash, the regulator can authorize the use of the DSB, avoiding the need for a taxpayer bailout. Great, so why not raise it to 50%, and have taxpayers never hear the word “bailout” again? 

The impact of higher DSBs can cost you a lot more. As a risk event approaches, the DSB rate rises, meaning banks are setting aside more cash. This reduces credit liquidity, which means borrowers will have to compete for what’s left. Less credit liquidity results in more expensive credit, less credit, and/or harder qualifications. 

When the risk event passes, the DSBs are typically lowered to release the cash back into the system. This helps increase credit liquidity, and delivers more cheap credit to help with a recovery. 

DSBs are in addition to other regulatory capital buffers, and only apply to domestic systematically important banks (D-SIBs). D-SIBs is the technical term for a bank that’s vital for the operation of a country, and are better known in Canada as the Big Six. 

Canada’s Bank Regulator Will Significantly Decrease Loans 

The increase is one of the biggest signs that the age of low rates is over. At the end of 2022, OSFI raised the maximum DSB from 2.5% to 4.0%, to accommodate the current level. Prior to that, 2.5% was seen as the most extreme amount they may need to put aside. With the most recent announcement, these banks will have to put a share of capital aside that’s 40% larger than the max possible less than a year ago. 

It’s hard to nail down exactly how much the move will reduce the credit supply. Back in 2020, the DSB was cut from 2.25% to 1.00% of RWA, and generated $300 billion in additional lending capacity. This helped to drive the record low rates seen, in addition to the Bank of Canada (BoC) rate cuts. Now imagine a similar concept but in reverse, and banks have seen the value of their RWA surge, so the share is even bigger in dollar terms. 

Canada’s Overleveraged Households & Rising Delinquencies Contributed To The Decision 

The regulator cited both domestic and global concerns as the reason behind the change. “Current vulnerabilities, including high household and corporate debt levels, the rising cost of debt, and increased global uncertainty around fiscal and monetary policy, coupled with Canada’s financial sector showing strength throughout the winter and spring has presented the opportunity for OSFI to build more resiliency in the system,” read the regulatory announcement. 

Though, the change comes at the same time that Canada’s D-SIBs are extending mortgage repayment terms for much longer than typically allowed. Arguing that failing to extend the mortgages on overleveraged borrowers would result in a hardship, tying the regulators hands since they aren’t interested in forcing delinquencies. 

By increasing the DSBs, OSFI will be forcing the banks to become more conservative with their lending. It’s a total G move, reigning in reckless lenders leaning on their “too big to fail” status. 

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