After last decade’s financial crisis, regulators introduced several new measures to reduce systemic risk in the financial system. How are the new safeguards working? What are the implications for future balance sheet structure?
The CFA Society Toronto convened a panel of three experts on November 25, 2020, to discuss the new regulatory capital and liquidity frameworks and how they are reshaping the way Canadian banks approach the market. The webinar, including a Q&A session, was moderated by Nigel D’Souza, Investment Analyst, Veritas Investment Research.
“There’s no doubt the financial crisis changed balance sheets,” said Bruce Choy, Managing Director (Former Risk Consulting Practice Leader) at PwC Canada. As an example, he pointed to the Liquidity Coverage Ratio (LCR), a global minimum liquidity standard that is part of Basel III. The LCR, and what can be counted as a high-quality asset, has changed. Nowadays, in the current health crisis, “we are fairly resilient,” he said. “Banks have stayed fairly strong.”
“Liquidity is not infinite, so the response to a crisis must be firm and timely,” said Svilen Petrov, Managing Director, Enterprise Balance Sheet Risk, Royal Bank of Canada. Models have been revamped considerably.
Before 2007, banks were capitalized in a way that made it difficult to understand liquidity and asset worth. Troubles within Bear Stearns and Lehman Brothers spread to the banking system because they did not have the asset quality that people thought they did. Central banks became the lenders of last resort.
“Although there was damage and consolidation, the biggest banks were saved,” said John Shaw, VP, Head of Investment Grade Credit, Signature Global Asset Management. “Canadian banks were left in a relatively good position.”
An important regulatory change was the “quantity and quality of capital that needed to be stress tested,” Shaw said. “The results of stress testing had to be publicly viewable and [the scenario] was made harder each time.”
Shaw drew a striking comparison between two periods of crisis. During the worst 13 months of the financial crisis, the credit spread went from 100 to 300 bps.
During the most financially unstable 13 days during the Covid-19 pandemic, the same size of spread occurred. Liquidity in the system became a worry, but the central banks responded quickly, adding liquidity where needed. “The regulatory process has increased the trust in the market system,” he said.
“Liquidity will always be the Achilles’ heel,” Shaw said. “We need to know the central bank will be there.”
Choy said the economy is on life support at the moment. “Giving money will not get more people in restaurants.” He did not see the pandemic transforming the economy because some industries (food service, airlines) are simply “on pause” – not obsolete.
“Credit risk models are based on historical information,” he said, “so there will be some delay while they adjust to changes” in the economic environment.
“The majority of Canadian banks took a provision for credit losses,” Petrov said. “Banks will need to reassess existing portfolios” because the new economy is asset-light. He noted the downturn in GDP at the outset of pandemic lockdown “is recovering, although it will take some time to get back.” Well diversified banks will do better.
All in all, the regulatory changes mean “central banks have shown they are ready to act faster,” Petrov said. “The resilience of the system has increased over time.”
When it comes to the interplay between regulatory policy and public policy, Choy said, the Canadian banking system differs from the U.S. system because it is an oligopoly. “It’s all about soundness and stability.” The Canadian corporate culture is that “we’re all in it together.”
Give the unprecedented nature of Covid-19, investment decision-making has changed. “There were a couple of weeks in March when it was harrowing to be a bond investor,” Shaw said. “In March 2020 corporates were looking for liquidity. It caused an incredible squeeze on liquidity.” The Canadian government and the Office of the Superintendent of Financial Institutions (OSFI) worked together “but they were a little slow in understanding just how tight the market was.” At the outset, the government programs covered a three-month period because “we were confident this would pass.”
D’Souza asked panellists if they had ideas where the next crisis might lie. Choy said he thought it would have less to do with liquidity and more with cyber risk. “That’s because so many are working from home, using less secure electronic channels.” He has only seen one scenario analysis and stress test that considers the threat of cyber risk.
“Canadian banks are generally profitable,” Shaw said. “OSFI and the banks and Basel 3 regulators have been working on preparedness. IFRS 9 accounting allows for future charge-offs. They have a real playbook.” ♠️
The webinar presentation was recorded by CFA Society Toronto.
The second graphic is from Clearrisk.com. Permission pending.