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Canada’s banking regulator is raising a key threshold for banks’ capital reserves above prepandemic levels, signalling confidence in an economic recovery and setting the stage to lift restrictions on dividends and share buybacks this year.

The Office of the Superintendent of Financial Institutions (OSFI) said Thursday that it will raise its domestic stability buffer to 2.5 per cent of risk-weighted assets starting Oct. 31 – the maximum level and a significant increase from the current, 1-per-cent buffer.

The move will rebuild a cushion that banks were allowed to use to soften the blow of the economic shock of the pandemic, giving them extra capacity to absorb potential losses and continue lending money throughout the crisis.

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By raising the level of the buffer now, when banks find themselves unusually flush with capital, OSFI is swiftly resetting a key regulatory defence against the next crisis. But it also sets expectations for how much capital banks must set aside and how much will be available to pay out to shareholders once current capital restrictions are lifted.

Banking analysts interpreted the move as a sign that OSFI believes the worst risks from the pandemic are over and that the likelihood of banks raising dividends and buying back shares this year is increasing.

OSFI officials cautioned that the course of the pandemic remains uncertain and that “key vulnerabilities such as household and corporate debt levels remain elevated – and in some cases have increased since March, 2020.”

At the same time, the regulator sees signs that an economic recovery is under way and that banks’ capital levels have proven resilient, rising to unusually high levels despite the pandemic.

“We always knew that there was a point we were going to make the decision to require institutions to rebuild those buffers … to reset for the next event,” said Jamey Hubbs, OSFI’s assistant superintendent in charge of supervising banks, on a conference call with reporters. “We have learned that preparing for the next shock when it materializes is too late. You need to act before that, so that is what we’re doing today.”

The domestic stability buffer is a tool designed to help offset the impact of economic shocks. In good times, the regulator raises the buffer’s level, compelling banks to hold more capital, and OSFI had steadily built it up to 2.25 per cent before the pandemic.

In March of last year, when the pandemic pushed Canada into lockdown, OSFI reduced the buffer to 1 per cent of risk-weighted assets, which are a barometer for the riskiness of a lender’s loan portfolios. In doing so, the regulator made a combined $300-billion in extra capital available for banks to use to cope with the expected economic upheaval. And it promised not to raise the level of the buffer again for at least 18 months – a moratorium that will expire in September.

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At the same time, to further bolster capital reserves, OSFI temporarily prohibited banks from raising dividends or buying back shares. Those restrictions are still in place, and OSFI has not disclosed when it will lift them. As a result, banks have had extra capital piling up, amplified by massive government stimulus to support businesses and households that has kept losses on loans much lower than they anticipated.

Although the decision to raise the domestic stability buffer pushes minimum capital thresholds higher, it should not put any pressure on Canada’s major banks. Each of them has capital levels well above minimum requirements, with common equity Tier 1 (CET1) ratios ranging from 12.2 per cent at National Bank of Canada to 14.2 per cent at Toronto-Dominion Bank .

Mr. Hubbs of OSFI said the regulator felt that the “sequencing” of resetting the buffer first was important. It is “useful for the banks to understand what our minimal capital expectations are and to give them time to adjust to that … ahead of any lifting of the temporary capital restrictions,” he said.

Investors are now eyeing an end to limits on payouts to shareholders in the coming months. “The short interpretation is that OSFI will likely make an announcement” about lifting the temporary restrictions on dividends and share buybacks “ahead of the release of [fiscal fourth-quarter] results,” said Paul Holden, an analyst at CIBC World Markets Inc., in a note to clients.

Canada’s largest banks will report earnings for the fiscal fourth quarter, which ends Oct. 31, starting at the end of November.

Once OSFI lifts the capital restrictions, Mr. Holden estimates that each of Canada’s major banks could announce dividend increases of 5 to 8 per cent and share buybacks equal to 1 to 2 per cent of outstanding shares – though there are indications that some lenders may buy back more shares, he said.

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Raising the domestic stability buffer may be one of the last major decisions made under OSFI superintendent Jeremy Rudin, who is set to step down when his seven-year term ends on June 28. His successor has not yet been appointed.

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