July 16, 2018

IMF published its staff report and selected issues report on the 2018 Article IV consultation with Canada. Directors emphasized the importance of close coordination and information exchange between federal and provincial regulators to mitigate risks to financial stability. Gaps identified in the AML/CFT assessment will need to be addressed. Directors looked forward to the upcoming FSAP for a comprehensive assessment of the financial sector. Directors concurred that current macro-prudential measures are appropriate and appear to have contributed to a cooling in the housing market. If housing vulnerabilities continue to rise, the authorities should consider introducing additional measures.

The staff report reveals that financial indicators of the six largest banks (D-SIBS), accounting for 93% of banking system assets, appear strong. The D-SIBs have employed different strategies to support earnings growth, including acquisitions abroad and expansion in wealth management and capital markets businesses. 5 The return on equity of D-SIBs is about 15% and it remains well above the average of G-SIBS. The NPL ratio is low at 0.5% of total loans in the first quarter of 2018. The D-SIBs draw about 50% of their total funding from wholesale sources. The average Core Tier 1 capital ratio rose to 12.9% in the first quarter of 2018, with a leverage ratio of 4.2%. In November 2017, Royal Bank of Canada became the first Canadian bank to be added to the list of global systemically important banks (G-SIBs). However, the banking system has a large exposure to household debt and is vulnerable to a sharp reversal in house prices, but other exposures also merit attention in a low interest rate environment.

The federal government has introduced a raft of macro-prudential measures over the last ten years to preempt complacency regarding risk-taking by financial institutions and to tackle growing housing market imbalances that could undermine financial stability. The measures were initially aimed at the insured market and helped reduce the government’s exposure to the housing sector. In early 2018, OSFI tightened the underwriting requirements for low-ratio mortgages to stem rising risk in the uninsured market. Low-ratio mortgages are now subject to a new stress test for mortgage interest rates; loan-to-value (LTV) measures and lenders’ internal limits that reflect housing markets risks; and restrictions on combining mortgages with other lending products that could circumvent LTV limits. Overall, these measures have kept mortgage credit growth at moderate levels and slowed the pace of house price inflation.

 The upcoming Financial Sector Assessment Program (FSAP) will conduct a more comprehensive assessment of the financial sector. The assessment will focus on these emerging risks and the quality of prudential regulation and supervision. The authorities are of the view that the existing informal macro-prudential and crisis management frameworks and supervisory approaches are appropriate. They acknowledge the risk of regulatory fragmentation but argue that the current delineation of responsibilities between federal and provincial regulators is appropriate, where each jurisdiction OSFI has updated several regulatory initiatives in the areas of liquidity and capital requirements. The implementation of the Net Stable Funding Ratio was postponed from January 2019 to January 2020, based on implementation progress at the international level. OSFI is studying potential adjustments to the capital regime with the view to increase transparency in Pillar 2 capital buffers. The objective of OSFI is to increase the likelihood that the capital that is already built up will be drawn as intended in case of a stressed event in the future.

The selected issues report reviews and suggests possible improvements to the business taxation system, examines balancing of financial stability and housing affordability, and takes a closer look at labor productivity in Canada.

 

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Keywords: Americas, Canada, Banking, Article IV, FSAP, Financial Stability, OSFI, IMF

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