Bank regulator mulls higher capital requirements for banks as cushion against climate change risks

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Canada’s banking regulator could raise capital requirements for banks in the coming years to build up new buffers against risks from climate change and the challenging transition to a greener economy.

Peter Routledge, who leads the Office of the Superintendent of Financial Institutions (OSFI), said at a virtual conference held by Royal Bank of Canada on Wednesday that the regulator “will expect federally regulated financial institutions to build up their capital buffers in the 2020s.”

New capital buffers would be designed to guard against potentially higher volatility and risks to the financial sector as action to combat climate change ramps up, and especially if some of the tougher measures are put off past 2030.

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Banks’ minimum capital requirements won’t be raised this year, Mr. Routledge said. Rather, the regulator’s efforts to help shore up Canadian banks against risks from the climate transition “would be a multiyear effort” with extensive consultations.

But his signal that banks can expect to be required to hold more capital in reserve in future years comes just as major lenders have started putting tens of billions of dollars back into use through acquisitions and share buybacks.

“We will have to ask hard questions of the entities we supervise to ensure they have sufficient capacity – in the form of buffers, capital and otherwise, and risk management disciplines – to absorb intensifying physical climate risk,” Mr. Routledge said.

Banks must “build adequate capital buffers this decade” to be resilient in the 2030s, he added.

Currently, OSFI requires the country’s largest banks to keep in reserve high-quality capital equal to at least 10.5 per cent of its assets, as measured by the common equity Tier 1 (CET1) ratio – an important barometer for assessing a bank’s resilience. That is made up of a core capital reserve of 4.5 per cent plus additional buffers and a surcharge.

At Wednesday’s conference, RBC chief executive officer Dave McKay responded that the current capital regime protects the banking system. RBC keeps an “operational cushion” above the regulator’s minimums, setting its own floor at 11 per cent, Mr. McKay said, and if OSFI were to add new buffers that raised the minimum threshold, RBC would raise its own cushion accordingly.

Mr. McKay said the banking sector is “just learning” how to measure the greenhouse gas emissions tied to its loan portfolios, and working to understand the resulting risks. “This is an evolution,” he said. “We don’t even have a clear strategy in our country for how we’re going to make the transition to net zero [emissions].”

Yet he sounded a warning about the potential impact of raising capital requirements in Canada if regulators abroad don’t follow suit. “I do want to stress that maintaining competitive policies, competitive capital structures, competitive tax structures in this country is essential to maintaining a prosperous Canada,” he said.

As of Jan. 31, all banks exceeded OSFI’s minimum capital requirements by wide margins, in large part because temporary restrictions the regulator imposed early in the COVID-19 pandemic had prohibited dividend increases for their shareholders and share buybacks. That caused excess capital to pile up.

After OSFI lifted those restrictions in November, with Mr. Routledge urging banks to “act responsibly” with their surplus capital, the six largest banks announced dividend increases of 10 per cent to 25 per cent, and plans to buy back 2 per cent to 3.5 per cent of their shares. And in late December, Bank of Montreal struck a $20.9-billion deal to buy California-based Bank of the West, cancelling its plans to buy back shares.

The bank has said the deal, when it closes, will likely consume most of its extra capital, reducing its CET1 ratio from 13.7 per cent to about 11 per cent. But the bank will “build from there” to raise it again, CEO Darryl White said at Wednesday’s conference.

Toronto-Dominion Bank has the highest CET1 ratio, at 15.2 per cent, leaving it with billions of dollars in extra cash. CEO Bharat Masrani said the bank will continue to look at opportunities for acquisitions, but if none are available “then we will not be shy to buy back our shares.”

Bank of Nova Scotia repurchased 10.8 million shares in December and early January, completing nearly half of the buyback plan the bank announced at the end of November.

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