Low Rates Can Raise Risks at Canadian Banks, Dickson Says

Julie Dickson, Canada’s banking regulator, said the current period of low interest rates threatens to increase risks for the country’s lenders and that it has become an issue she’s closely monitoring.

Bank regulation and supervision need to be a “strong line of defense” against the consequences of sustained low interest rates, which could include falling margins and increased reliance on higher-yielding assets, Dickson, 55, said in a speech today at the Bloomberg Canada Economic Summit.

The regulator “is very focused on how banks are reacting to current conditions,” said Dickson, who heads the Ottawa-based Office of the Superintendent of Financial Institutions. “The longer the low interest-rate environment persists, the more interest-rate risk can be built up.”

“When low interest rates first appeared, OSFI saw that the impact was most noticeable on pension plans and insurance companies,” Dickson said. “A sustained low interest-rate environment, especially combined with a flat yield curve, affects the banking sector as well, largely through squeezing net interest margins, which negatively affects revenues.”

The effect of low interest rates has become manifest in the nation’s housing market, a “significant area of focus” for the regulator, Dickson said. The agency, for example, is conducting reviews of bank mortgage lending portfolios as well as the models lenders use to calculate capital charges for uninsured home loans, she said.

Mortgage Dependence

Canadian banks have been increasing their dependence on real estate lending in recent years to drive earnings, with residential and non-residential mortgage assets totaling C$955 billion ($929 billion) at the end of March, or 26 percent of total assets, according to OSFI data. That’s up from C$521 billion five years earlier, which represented 20 percent of assets at the time.

Dickson also defended her decision to make the nation’s banks meet new capital standards ahead of global peers, saying it helps the industry maintain its status as one of the world’s soundest and will protect Canada’s lenders from any sudden shocks such as a spike in interest rates.

Canadian banks held four of the top 10 spots in Bloomberg Markets magazine’s annual ranking of the world’s strongest banks, released this month. The industry has also been ranked the world’s soundest for the past five years by the Geneva-based World Economic Forum.

Basel Rules

OSFI is requiring Canadian lenders to comply with capital requirements stipulated by the Basel Committee on Banking Supervision this year, even though the nation can have six more years to implement the standards. OSFI also has introduced requirements for “contingent capital” that would help banks cover future losses and limit the need for taxpayer bailouts.

Banks have been losing favor with investors. Royal Bank of Canada, Bank of Nova Scotia and six other large Canadian lenders are trading at the lowest premium to U.S. bank stocks in more than two years.

The spread between the Standard & Poor’s/TSX Commercial Banks Index and the KBW Bank Index of 24 U.S. lenders is at its narrowest since January 2011, based on price to tangible book value per share, according to data compiled by Bloomberg.

‘Quite Resilient’

Canada’s financial system continues to be “quite resilient” and banks are stronger today than they were six years ago, Dickson said during a question-and-answer period.

“In 2013, the system is far sounder than it was in 2007,” she said. “I would say that the external environment, though, is more dangerous today than it was in 2007.”

Banks should be fine to take on more risk as long as they have the controls in place and are doing stress testing, Dickson said.

“There are huge incentives right now to go out the risk curve,” Dickson said. “Banks exist to take risk, but if you’re going to go out the risk curve, you better be on top of it, and be talking to your boards about your strategy and enhancing your risk management at the same time.”

Canadian banks are “relatively well-situated” if there’s a sharp increase in interest rates, Dickson said.

“I’m relatively comfortable with Canadian banks,” she said. “It’s the impact on consumers, as well, who might not be so well-situated to deal with a rapid increase in interest rates, especially the marginal borrower.”

Dickson also said she’s not seeking another seven-year appointment as the country’s bank regulator, and will step down when her term ends in July 2014.

Dickson, the first woman to hold the job, built on a tradition of emphasizing safety over growth in six years as head of OSFI.

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