The response to the global financial crisis should not lead regulators to take their eyes off the task of ensuring individual financial firms are sound, says the head of the Office of the Superintendent of Financial Institutions.

Speaking to the OSFI College of RBC Supervisors in Toronto on Wednesday, Superintendent Julie Dickson noted that OSFI has learned valuable lessons from the global turmoil, and that the supervisory framework should be updated to reflect those lessons.

For example, she noted that, “We spend a lot of time assessing the inherent risk at an institution and the controls to manage those risks. But we have seen that the inherent risk of an institution can change extremely quickly, far more quickly than we have seen historically. Controls at an institution tend to be more static, so we are targeting ways to identify changes in inherent risks through methods such as stress testing individual business lines more frequently.”

She said that the regulator also thinks it could place greater emphasis on the identification of risks (or combinations of risks) that could be a material threat to the capital allocated to individual business lines. “Currently the framework only requires an assessment of capital adequacy at an aggregate, or top-of-the-house, level. By first assessing the seriousness of the threat (using techniques such as stress testing) to the capital in an individual business, we can make determinations of the seriousness of the risks even more quickly. This would help ensure that individual risks are not obscured by comparing them to the institution’s entire capital base,” she suggested.

In addition, Dickson noted that Canada will be making recommendations to support a macro-prudential orientation for regulatory frameworks. “A macro-prudential approach takes a system-wide view of how government regulation and other interventions in the financial sector affect business cycles and the broader economy,” she explained.

“The issue is about realizing that everything in this world is connected. For example, bank regulations can have impacts on banks, as well as on the macro-economy. Just as government and central bank policies can have impacts on the economy as well as on financial institutions,” she noted.

That said, she observed that there are limits to regulators, and policymakers, ability to limit the effects of economic cycles. “Very smart people have tried to moderate the real economic costs imposed on society by phenomena such as business cycles, uncontrolled inflation, and the collapse of asset bubbles. We have had some success but unfortunately, in spite of the best efforts of macro-economists, we have not repealed the business cycle, nor have we escaped the problems associated with it,” she said.

She also stressed that “discussion about macro-prudential regulation and system-wide views, is not, and should not, be about diluting the supervisory focus on individual bank risk. A sound banking system is made up of sound banks. The optimal path to a sound financial system is sound risk management by individual financial institutions. This is done bank by bank — and each institution is different. They have different business plans, different appetites for risk, different approaches to management, and more.”

“While we need to study how and whether various regulations could affect macro-financial stability — just as globally we are always studying how fiscal and monetary policy affects stability — we already know certain things. Weak oversight and supervision of banks, combined with weak rules, is a recipe for instability and bigger problems,” she warned.

“OSFI’s mandate tells us to stay the course, because robust regulation and supervision are key ingredients in creating financial stability. This does not mean that OSFI should have tunnel vision and not see the bigger picture — quite the contrary. Indeed, we need to share our views about banks, and the wider system, and we need to be receptive to views about the impact of our rules on the wider system,” she said. “We need to discuss whether these impacts mean that the rules should change or that something else should change. The point is that the core job — robust supervision and regulation of financial institutions under OSFI’s purview — needs to be done and there are no short cuts to financial stability.”

IE