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The buffer is intended to act as a cushion of extra capital amassed in good economic times, to be used if there is an economic shock or downturn.Adrien Veczan/The Canadian Press

Canada’s banking regulator raised minimum capital levels for large banks for the third time in the past year, nudging banks to build up reserves that they can draw on to continue lending in a downturn.

Since last December, the Office of the Superintendent of Financial Institutions has gradually increased its “domestic stability buffer,” or DSB, citing “elevated” risks to the banking sector from high household and corporate indebtedness, as well as imbalances in housing markets. The buffer is a capital requirement that OSFI imposes over and above other elements used to set minimum capital ratios.

The buffer is intended to act as a cushion of extra capital amassed in good economic times, when credit conditions are healthy and Canada’s economy is performing well. If there is an economic shock or downturn, OSFI can lower the required buffer, freeing up capital to keep banks lending.

On Tuesday, the regulator added another 0.25 per cent to the buffer, effective April 30, bringing it to 2.25 per cent of a bank’s total risk-weighted assets. It is capped by OSFI at 2.5 per cent, leaving room for only one more increase. When OSFI first publicly disclosed the existence of the buffer last year, it stood at 1.5 per cent.

“Right now we’re at the best part of the credit cycle so this is the time to build up your capital buffers if you want to go against the cycle," said Jason Mercer, a senior analyst at Moody’s Investors Service Inc. “The question that [banks] may have for the regulator now is when do they pull the trigger to start drawing them down?”

OSFI pinpointed the same set of vulnerabilities to banks on Tuesday as it did when it previously raised the buffer in June, although the regulator said some of the risks “show signs of increasing.” For instance, Canada’s ratio of household debt to disposable income remains high, at 177.5 per cent. And the regulator has noticed a "renewed pick-up in mortgage credit growth and housing prices in some regions.”

OSFI also warned in a statement that low interest rates, trade tensions and rising global leverage “could increase the chance of a spillover of external risks into the Canadian financial system."

This latest increase to the buffer comes days after Canada’s largest banks reported disappointing fiscal fourth-quarter earnings, and set aside more money to cover potential loan losses amid increasing signs of economic stress. Higher capital buffers are seen as an effective hedge against future risks to the banking sector, but they come at a cost to investors: The more capital banks have to hold, the less flexibility they have to return excess cash to shareholders.

“It will certainly dent their return of capital to investors, their plans related to dividends and share buybacks," said Robert Colangelo, a senior vice-president at DBRS Ltd. And it may force banks eyeing acquisitions to narrow their focus to those “that don’t have a significant capital impact” for the time being, he said.

The near-term impact of OSFI’s decision should be minimal, as all six of Canada’s largest banks have capital ratios well above the new minimum threshold. Banks will need to maintain a common equity Tier 1 (CET1) capital ratio – a key measure of a bank’s financial strength – of 10.25 per cent or more. The banks had CET1 ratios ranging from 11.1 per cent at Bank of Nova Scotia to 12.1 per cent at Royal Bank of Canada and Toronto-Dominion Bank, as of Oct. 31.

RBC spokesperson Maria McGee said the bank’s capital management practices “are unchanged” and consider “multiple factors, including OSFI’s latest DSB requirement.” Other large banks declined to comment.

The cumulative effect of raising the buffer is becoming apparent, as Canada’s banks are “maintaining a much higher level of capital,” Mr. Colangelo said. Unless OSFI sees clear signs the sector’s vulnerabilities are easing, he expects the regulator will raise the level again next June “and then keep it at the max until they feel that that downturn does occur.”

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