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Earlier this month, the Office of the Superintendent of Financial Institutions (OSFI) announced it had decided to delay adoption of a key element of the global bank capital rules for one year. When that new measure is finally adopted, banks will likely have to add capital or shed assets, says Morningstar DBRS.
In a new report, the rating agency reviewed the impact of the planned increase in the output floor under the Basel III capital regime — a move that’s designed to reduce the disparity between the internal ratings-based approach and the standardized approach to calculating banks’ risk-weighted assets (RWAs), which OSFI decided to push back until 2027.
As it stands, the big Canadian banks generally use internal models to calculate risk-weighted assets, and use the standardized approach for other aspects of their capital calculations, the report noted, adding that the internal approach results in much lower RWA calculations.
For example, DBRS estimates that aggregate RWAs for the Big Six banks under the internal approach are about $2.59 trillion, but would be $3.85 trillion under the standardized approach. This implies that, under the revised output floor, the banks would have to increase capital by about $27 billion to keep their capital ratios at current levels.
While OSFI has now pushed back final implementation of the revised floor to the first quarter of 2027 (from the previous timeline of Q1 2026), when the new provisions do take effect, the big Canadian banks will either have to boost their capital levels, or reduce risk-weighted assets to maintain their existing capital ratios, DBRS said.
“The Canadian banks will likely use a combination of various tools to manage heightened capital requirements” such as raising equity, curbing dividends, selling non-core assets, or optimizing their balance sheets through synthetic/credit risk transfers and loan sales, the rating agency said.
Among the Big Six, Scotiabank and the Bank of Montreal would face the largest impact on their capital ratios from the new floor, the report said, while TD Bank would feel it the least.
“The adoption of the revised output floor without any capital raise or balance sheet optimization strategies would result in a significant reduction in several [big banks’] capital buffers,” the report said. Although, even then, the banks would likely be able to remain above the current regulatory minimum.
Despite the expected impact on the banks’ balance sheets, DBRS said the higher floor should enhance the banks’ safety and stability.
“Despite potential implementation challenges, the adoption of the revised output floor will further strengthen Canadian banks’ ability to withstand financial shocks,” the report noted.
OSFI’s decision to delay the adoption of the higher floor comes in the wake of signals that regulators in the U.S., Europe and the U.K. are also delaying implementation of certain elements of the Basel III regime in their markets.
While the regulator said it’s still committed to fully implementing the latest edition of the global capital rules, which were overhauled in response to the financial crisis, it also indicated that it will “continue to monitor the implementation progress of the Basel III 2017 reforms across jurisdictions, considering both competitive balance in the banking sector and the soundness of Canada’s capital regime.”