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Canada’s banking regulator has raised the ceiling on bank capital levels and ramped up the reserves the country’s largest banks must hold, citing rising risks posed by inflation, interest-rate hikes and household debt as reasons to expand a financial safety net designed to guard against economic shocks.

The Office of the Superintendent of Financial Institutions (OSFI) increased the maximum level of the domestic stability buffer Thursday. The DSB, which will now range from 0 to 4 per cent of a bank’s risk-weighted assets, is a store of capital built up in good times to be used to soften the blow when conditions turn sour.

OSFI also announced that it will set the buffer higher on Feb. 1, 2023, raising it to 3 per cent from its current level of 2.5 per cent, which had been the top end of the DSB’s range since it was formally created in 2018.

By requiring banks to hold more capital when business is good and credit losses are low, OSFI is building a surplus that it can then release when banks are under strain, in theory helping them absorb losses and continue lending money to customers in tough times.

Increasing the DSB and expanding its range, however, also puts a heavier burden on banks by reducing the amount of capital they can put to work. That can affect the decisions bank executives make about how much to lend or spend to expand their businesses, as well as the amount of capital they give back to shareholders through dividends and stock buybacks.

Factors that loomed large in OSFI’s decision included higher levels of household indebtedness relative to income, especially among homeowners, as well as high inflation and rising interest rates, which make it harder to service those debts.

The regulator also considered that businesses with high debt loads could be more vulnerable to higher interest rates; that sovereign debt is far higher than it was before the pandemic; and that the geopolitical landscape looks more uncertain. OSFI also looked at the results of stress tests that imagine the outcome of severe economic hardship on banks.

“Clearly, we are in a risk environment now where levels of indebtedness have grown,” said Angie Radiskovic, OSFI’s chief risk and strategy officer, speaking to reporters Thursday. “Our main objective … is really to protect the system” and, by extension, the banks’ depositors and creditors.

OSFI said a year ago that it would review the DSB’s design and range to make sure it continues to work as intended. The regulator concluded Thursday that, on the whole, it is still an effective tool. Yet the process OSFI went through to reset the DSB, ultimately choosing to expand its range, was very different than the one used to create it in 2018, Ms. Radiskovic said.

“This time we find ourselves in a completely different risk environment and we had the benefit of four years of experience with the DSB,” she said. “And in thinking through what the adequate range should be, we leaned into some of that historical experience and lessons learned.”

OSFI updates the DSB level at least twice annually and can adjust it at any time. Generally speaking, the regulator raises the buffer when it judges that conditions are good but risks are rising, and lowers the buffer – allowing banks to use some of that capital – when those risks turn into real losses and financial hardship.

Raising the DSB by 0.5 percentage points causes an equal increase in the minimum capital levels banks are required to hold. Starting in February, a major bank’s common equity Tier 1 (CET1) ratio – a key measure of a lender’s ability to absorb losses – will have to be at least 11 per cent, up from 10.5 per cent now. And OSFI still has room to increase the DSB by one percentage point within the new range, which would ratchet minimum capital levels as high as 12 per cent – a bump that could collectively add billions of dollars of capital.

The DSB only applies to six Canadian banks considered systemically important: Royal Bank of Canada RY-T, Toronto-Dominion Bank TD-T, Bank of Nova Scotia BNS-T, Bank of Montreal BMO-T, Canadian Imperial Bank of Commerce CM-T and National Bank of Canada. NA-T.

All six currently exceed the new minimum capital threshold, but three of them – RBC, TD and BMO – are awaiting approvals of major acquisitions of rival banks that would sharply reduce their stores of capital upon closing.

The bank facing the biggest impact from February’s DSB hike is likely to be BMO, which expects to complete a $17.1-billion deal to buy California-based Bank of the West by early next year. Analysts predict BMO’s CET1 ratio could be at or below 11 per cent at that time.

“We suggest there could be a potential for a small equity raise by BMO to help bridge the capital gap,” said Scott Chan, an analyst at Canaccord Genuity Group Inc., in a note to clients.

BMO’s share price fell 2.2 per cent to $125.72 on the Toronto Stock Exchange on Thursday – the largest decline among the six major banks.

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Tickers mentioned in this story

Study and track financial data on any traded entity: click to open the full quote page. Data updated as of 28/03/24 4:15pm EDT.

SymbolName% changeLast
RY-T
Royal Bank of Canada
+0.29%136.62
TD-T
Toronto-Dominion Bank
-0.63%81.75
CM-T
Canadian Imperial Bank of Commerce
+1.13%68.67
BNS-T
Bank of Nova Scotia
+0.94%70.07
BMO-T
Bank of Montreal
+1.13%132.25

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