Appendix I. Focused Review of the Basel Core Principles—Summary
70. CP 14 (Liquidity risk). A regular review of liquidity risk is part of OSFI’s ongoing risk-based planning process, and clear guidelines have been issued. For the large banks, monitoring of liquidity is quarterly, and involves off-site monitoring and discussions with banks’ management. Stress-testing, modeling, and worst case scenarios are regularly performed, as are reviews of internal controls. For smaller institutions, the process is lighter: OSFI monitors liquidity mainly on the basis of verified banks’ reports, and also checks that contingency plans and internal monitoring are in place. For all banks, OSFI intensifies its supervisory activities as warranted. It also appears that OSFI is exercising its supervisory functions in the current turmoil in ABCP and money markets.
71. CP 15 (Operationalrisk). Operational risk analysis is an integral part of OSFI’s supervisory framework. All banks are required to comply with the Basel Committee’s document on Sound Practices for the Management and Supervision of Operational Risk as well as OSFI’s own detailed guidance. OSFI has a specialized unit on operational risk that has elaborated a process and specific methodologies (such as an information technology risk scoring algorithm). Although OSFI is compliant with the criteria established in the CP methodology, the heavy reliance on banks’ own reporting could be more systematically addressed in on-site examinations. Staffing in the operational risk area also seems to be relatively low in comparison with other advanced economies. However, considering the expected low adoption of the AMA method, it remains commensurate to the present needs.
72. CP 16 (Interest rate risk in the banking book). OSFI has issued a Guideline on Interest Risk Management that references the Basel Committee’s July 2004 document on the topic. Larger banks are monitored quarterly through off-site reporting, benchmarking, review of internal audit reports, and other techniques. OSFI also verifies board and senior management involvement and liaises with the banks’ asset and liability management committees. Risk management systems, models, and policies are reviewed. For smaller institutions, OSFI relies more on the reports made by banks themselves, with institutions warranting attention receiving a more detailed examination. OSFI is to be commended for its plans to make its interest rate risk assessments more forward-looking and quantitative.
73. CP 20 (Supervisory Techniques). OSFI has a well-balanced and fully articulated organization, robust processes, well elaborated documentation, sound and suitable methodologies, up-to date tools in line with the international best practices, adequate and competent staffing, and sufficient legal powers effectively used where appropriate. On-site, off-site, and oversight work are efficiently blended, with good communication within the organization. OSFI is risk-focused and “reliance-based,” seeking to leverage the work done within banks with a view to minimize duplication of effort and to control the regulatory costs levied on institutions. At the same time, the need to assess risk in a complex and evolving financial services environment would seem to warrant additional resources for cross-checking of the submissions provided by financial institutions, including in on-site inspections.
Appendix II. The Structure of Securities Regulation in Canada—Background
74. A review of international experience shows a wide variety of institutional structures in financial regulation. Certain trends have emerged, mainly towards fewer separate agencies, and towards more integrated arrangements. However, there is no single model that all countries are converging to, or that could be considered best practice. Among advanced countries, some have opted for a fully unified regulator (England); others for a twin peak approach where prudential regulation is assigned to one regulator and market conduct regulation to another (Australia, and partially, Italy and Portugal—although the latter two could also be characterized as specialized regulators); and yet others for specialized regulators (United States). The division of labor between central governments and states or provinces also varies. In some advanced countries, the state regulators retain some role in securities regulation (Germany, United States). Effectiveness and efficiency are the ultimate criteria for the choice of regulatory structure: are the objectives being met, and are they being met without imposing unnecessary costs on consumers and regulated firms?
75. The structure of securities regulation in Canada has been the subject of considerable analysis. The most recent task forces include the Five Year Review Committee, the Wise Persons Committee, the Crawford Panel, and the Allen Task Force.26 There is also considerable academic research, much of it in response to the work of the task forces, which have also elicited comments from regulatory agencies and market participants.
76. By and large there is agreement that the current structure has provided Canada with an effective system of regulation,27 although enforcement is in need of further improvement.28 This in fact has been a principal conclusion of the IOSCO Principles assessment. Arguably, the current system has responded to the specific characteristics of its capital market, such as allowing for a large presence of small issuers, and the concentration of certain industries in specific provinces. The drawback of multiple regulation is that it requires market participants who want to raise funds or provide services in more than one province to comply with different sets of regulations, with correspondingly higher costs.29
77. There is thus scope to rationalize Canada’s system and make it more efficient. The main issues relate to the need to harmonize laws and regulations; expedite policy development; simplify registration processes and oversight arrangements for market participants (issuers, registrants, exchanges and SROs), reduce costs, and strengthen enforcement. Under the umbrella of the CSA, the provinces have taken several initiatives to address these issues. Significant progress has been made, but important concerns remain:30
Harmonization of regulations: significant progress has been made via the adoption of national instruments. Particular efforts are needed on securities intermediaries.
Policy development: the process of adoption of national instruments is protracted, since national instruments need to be individually adopted by each province. Depending on the jurisdiction, ministerial approval may also be needed.28 In addition, while provinces are committed to harmonizing their regulatory framework, they retain full authority to adopt a local standard.
Issuers and intermediaries registration: the Mutual Reliance Review System for issuers and the National Registration System for intermediaries have streamlined the registration process. However, opt-outs make the process longer and more uncertain.
Costs: A system of multiple regulators entails additional costs for market participants, including additional direct costs, since participants have to pay fees to all the regulatory authorities of the provinces/territories where they want to raise capital or provide services; there are also compliance costs and opportunity costs caused by longer review procedures.32 In addition, there appears to be room for efficiency savings at the regulatory level.
Authorization and oversight of exchanges and SROs: improvements have been made through the adoption of a “lead regulator” for exchanges and a “principal regulator” for SROs. The system for SROs needs further improvement, since the principal regulator only acts as a coordinator. The process of approving regulations developed by exchanges and SROs is protracted, since all the provinces have a role.
Enforcement: the CSA created a committee on enforcement that has improved coordination of enforcement actions by the provinces.33 Increasingly, provinces are conducting join investigations and to some extent joint hearings, and a few provinces have been given powers to reciprocate orders. While these steps have alleviated the problems posed by the limited jurisdiction of each provincial regulator, they do not eliminate them. In addition, a system of provincial regulators makes coordination with the criminal enforcement authorities more challenging.
78. The passport system represents an improvement over the current system but does not address many of the inefficiencies listed above. It will further rationalize the registration process for issues and intermediaries; a participant (issuer or intermediary) will only deal with the regulator of its home province; and decisions taken by this regulator will automatically apply to the rest of the provinces and territories, with no provision for opting out. In addition, further harmonization of regulations for both issuers and securities intermediaries will come into effect along with the passport system. However, the passport system does not address the remaining challenges listed above, and the delegation of powers that it entails will require a system of oversight.
79. Even so, many market participants see advantages in a single regulator.34 The 12 provinces that have joined the passport system acknowledge some of the problems mentioned above, in particular the challenges in policy development and the existence of a separate system of fees.35 However, their position is that they can find solutions to these problems that do not involve creating a single or national regulator.
Annex I: Observance of Financial Sector Standards and Codes––Summary Assessments
The annex contains summary assessments of two international standards relevant for the financial sector. The assessments were undertaken in the context of the FSAP in September 2007 and have helped to identify the extent to which the supervisory and regulatory framework is adequate to address the potential risks in the financial system in Canada.
The following detailed assessments of financial sector standards were undertaken:
The assessments were based on several sources, including:
Compliance with the Financial Action Task Force 40 Recommendations for Anti-Money Laundering and 9 Special Recommendations on Combating the Financing of Terrorism were assessed by the Financial Action Task Force in March 2007, using the mutual assessment process. The associated ROSC will be distributed separately, once it has been finalized.
Hedgeweek, “Toronto Hedge Fund Services 2007” (May 2007), hedge fund press releases, and discussions with prime brokers.
Given that Canadian banks have pursued international expansion mainly in the United States, Latin America, and the Caribbean, their sensitivity to the common shocks affecting the broader region is accentuated.
OSFI is approaching the implementation of Basel II cautiously to forestall any undue decline in banks’ risk buffer.
The five largest Canadian banks have on average, exposures above 53 percent to the mortgage sector.
EL are defined as EL= PoD x Exposure x LGD, where PoD is the probability of default and LGD is the lossgiven default of each loan in a bank’s portfolio. While it is important to estimate EL, estimating UL is fundamental to the effective management of credit risk. Economic capital should be available to cover UL.
Percentages of floating/fixed interest rate exposures vary across banks and portfolios. Information provided by the banks indicates that on average, more than 50 percent of loan exposures have flexible interest rates.
Nonetheless, such activities may expose banks to market and credit risks, as exemplified by the losses suffered by one institution on commodity trading in early 2007. However, in this particular instance, losses were absorbed by profits, which might not be sustainable in the event of a systemic shock.
On average, banks do not appear to run material foreign exchange (FX) trading positions; and their nontrading FX risk usually arises from investments in foreign operations, which is actively managed. In most developed economies, banks dynamically hedge such positions, so that even a substantial exchange rate shock has only a limited impact on capital adequacy. OSFI confirmed that banks’ exposure to FX risk is modest.
The June issue of the Financial System Review contained a detailed discussion of stress-testing.
The $65 billion of Canadian “term” ABS excludes MBS issued by government-guaranteed Canada Mortgage and Housing Corporation, of which about $128 billion were outstanding.
Some conduits reduce the need for liquidity protection by issuing extendible paper, which allows them to extend maturities by up to 365 days in the event of rollover difficulties. However, this option comes at a cost (about 10 basis points); and it has not been broadly popular with investors.
Only the multi-seller conduits sponsored by the Royal Bank of Canada and Bank of Nova Scotia (with $11 billion and $7 billion outstanding) offered global-style protection prior to August 21.
For unconditional facilities with maturities over one year, North American and European regulators uniformly imposed a 50 percent CCF, as does Basel II.
The required regulatory capital on a liquidity facility is calculated on the product of the CCF and the highest risk weight assigned to any of the underlying individual exposures covered by the facility.
Certain dealer bank asset providers and other investors have agreed in principle to participate, and several of the large Canadian banks have indicated an interest in participating.
They had already made such a change to their criteria for structured credit product-backed programs in January 2007, although this change grandfathered existing programs.
However, these stress tests do not seem to consider an interruption of financing, a decline in asset prices, or the cost of holding “bridge loans” that would have otherwise been financed in the money markets.
ABCP represented about half of the outstandings in the corporate short-term paper market. Of the C$ 223 billion short-term corporate paper outstanding on August 31, 2007, C$ 115 billion was ABCP, C$ 58 billion was bankers’ acceptances, and C$ 50 billion was direct corporate issuance. However, of the C$ 115 billion ABCP, C$ 32 billion was issued by the “Montreal Proposal” conduits.
The BSI conceptualizes the banking system as a “portfolio of banks.” Using individual banks’ market measures of PoDs, the mission modeled the portfolio multivariate density (PMD), which is used to estimate the banking system’s joint probability of default (Goodhart and Segoviano 2007). The PMD embeds both linear and nonlinear default dependence, and allows for the change of default dependencies over time (reflecting the fact that dependencies among financial assets increase in periods of distress). The approach is statistically robust and requires only a limited dataset.
With the exception of two Additional Criteria, which have in the meantime been addressed. Canada thus remains fully compliant with the 1999 version of the BCP.
Under current policies, partial assessments of the BCP (or other standards) do not result in issuance of a formal Report on the Observance of Standards and Codes or preparation of a Detailed Assessment. A summary of the assessment is provided in Appendix I.
The provinces have regulated capital markets using their jurisdiction over “property and civil rights” set out in subsection 92 (13) of the Constitution Act, 1867.
See Crawford Panel, Blueprint for A Canadian Securities Regulator, June 7, 2006.
For example, the Caisse des Dépots, a crown corporation that manages Quebec public pension and insurance funds, acquired large exposures to third-party ABCP conduits.
Encouraging the establishment of larger, multi-employer pension plans, and facilitating the access of pension plans to the (re)insurance market where instruments are been developed to manage extreme risks, are possible ways to address this risk management challenge. In the same vein, forms of a possible affiliation with, or outsourcing to, sophisticated money managers or large pension plans may be possible. However, implementing some of these steps is likely to be difficult as there are many aspects that would require negotiation, such as contribution rates, benefit accruals, and so forth.
Reviewing the Securities Act (Ontario), Five Year Review Committee, March 2003; It’s Time, Wise Persons Committee to Review the Structure of Securities Regulation in Canada, December 2003; Blue Print for a Canadian Securities Commission, Crawford Panel, June 2006; Canada Steps Up, The Task Force to Modernize Securities Legislation in Canada, October 2006; One Year On: Seeing the Way Forward, Crawford Panel, June 2007. Much of the relevant academic research is cited on the respective Web sites of these task forces. In addition, see Jean Marc Suret and Cécile Carpentier, Securities Regulation in Canada (2003) and Proposal for a Single Securities Commission: Comments and Discussions (September 2007). The authorities also provided the FSAP team with a background paper: Briefing Note: Canada’s Securities Regulatory Regime, August 16, 2007.
Thus, the views expressed in the FSAP are not entirely at odds with those of the Chair of Canada’s Council of Ministers, who has noted that independent studies have found Canada’s system to be one of the best in the world. Even so, the studies he quotes are not comprehensive assessments of the Canadian system. Rather, they focus on specific aspects. In addition, in all cases, their findings are mostly based on surveys of law firms, viz. World Bank, Doing Business Indicator, Djankov Simeon et al, The Law and Economics of Self Dealing (2006), and Organization for Economic Cooperation and Development, Economic Policy Reforms, Going for Growth (2006). Similarly, the AMF cites De Serres, Kobayakawa, et al, Regulation of Financial Systems and Economic Growth, Organization for Economic Cooperation and Development (OECD) Economics Department Working Papers, No 506 (2006). Both OECD papers are based on the World Bank’s “doing business indicator.”
Enforcement has been the subject of much research. See, for example, Charles River Associates, Securities Enforcement in Canada: the Cost of Multiple Regulators, commissioned by the Wise Persons Committee; Jackson Howell, Regulatory Intensity in the Regulation of Capital Markets: A Preliminary Comparison of Canadian and U.S. Approaches; Peter de Carteret Cory and Marilyn Pilkington, Critical Issues in Enforcement; Utpal Bhattacharya, Enforcement and its Impact on Cost of Equity and Liquidity of the Market. All of these studies were commissioned by the Allen Task Force.
See Wise Person’s Committee, It’s Time, p. 19–24.
In June 2003, a steering committee of provincial ministers in charge of securities regulation released a discussion paper for comments, Securities Regulation in Canada: An Interprovincial Framework, in which they summarize the main concerns expressed by market participants. See also Wise Persons’ Committee, It’ Time.
The Crawford Report noted that the implementation of a CSA multilateral instrument takes a minimum of 18 months.
In their submissions to the Wise Persons’ committee, participants expressed concerns about the increased costs caused by a system of multiple regulators. See Wise Persons Committee, It’s time, pages 33–37. Research carried out by Charles River Associates provides evidence that a system of provincial regulation adds significant costs to both intermediaries and issuers. Research by the Canadian Bankers Association provides additional evidence for issuers. Anita Anand and Peter Klein concluded that registrants are more likely to incur material incremental costs than issuers; but that case study participants uniformly reported significant incremental opportunity costs. Jean Marc Suret and Cecile Carpentier concluded that there is little evidence that the present structure greatly penalizes the country. See Charles River Associates, Estimating the Incremental Costs of Multiple Securities Regulators in Canada, 2003; Canadian Bankers Association, The Impact of Multiple Regulators on the Cost of Raising Capital for Small and Medium Size Businesses, February 2007. Anand, Anita and Klein, Peter, The Cost of Compliance in Canada’s Securities Regulatory System, 2003; Suret Jean Marc and Carpentier Cecile Securities Regulation in Canada, 2003 and Proposal for a Single Securities Commission: Comments and Discussions, September 2007.
In addition, the Royal Canadian Mounted Police has created integrated market enforcement teams.
See Crawford Panel, Blueprint for A Canadian Securities Regulator, June 7, 2006. Of the 77 submissions that make specific recommendation on the best regulatory structure for Canada, 74 percent recommended a single regulator and 13 percent recommended a passport system; ibid, page 10.
The AMF has acknowledged that members of the CSA recognize that there are delays in policy development. This issue is at the forefront of future initiatives to guarantee a more streamlined process. The Council of Ministers has already asked the CSA to analyze and make recommendations on the fee system.
An IOSCO assessment was conducted in 1999; however at that time a methodology to assess the level of implementation of the Principles had not been developed. In addition, significant reforms have been brought about by the creation of the CSA. Therefore, a decision was taken to conduct a full assessment rather than an update.
The provinces have regulated capital markets using their jurisdiction over “property and civil rights” set out in Subsection 92 (13) of the Constitution Act, 1867. Legal opinions commissioned by the Wise Persons Committee concluded, however, that nothing in the Constitution prevents the federal government from regulating this area.
The equity marketplaces are the Toronto Stock Exchange (TSX), TSX Venture Exchange (TSXV), Canadian Trading and Quotation System—the new Canadian stock exchange, and the several alternative trading systems (ATS).