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Canada’s banking regulator has raised the capital cushion that the biggest banks must hold, increasing the guardrails against high household and corporate debt levels, rising borrowing costs and increased global uncertainty over fiscal and monetary policy.

The Office of the Superintendent of Financial Institutions (OSFI) said Tuesday that it will increase the domestic stability buffer (DSB) – a capital reserve that banks build to soften the blow of an economic downturn – on Nov. 1, hiking it to 3.5 per cent from 3 per cent of a bank’s risk-weighted assets. The move is the second increase in the past six months as OSFI ramps up “insurance” against mounting risks to the financial sector.

The regulator last increased the potential range of the buffer in December to somewhere between zero per cent to 4 per cent of a bank’s risk-weighted assets. OSFI also raised the buffer itself to 3 per cent from 2.5 per cent, which had been the top end of the range since the DSB was introduced in 2018.

“Today’s decision reflects our assessment that financial system vulnerabilities remain elevated and, in some cases, have continued to increase,” OSFI superintendent Peter Routledge told reporters Tuesday. “We are in a period of rising interest rates and home prices have begun to climb again. Households and corporates remain highly leveraged, making them more vulnerable to economic shocks.”

While OSFI can change the DSB any time, it announces a decision to change or hold the level twice each year. The buffer applies only to financial institutions that are considered systemically important, including Royal Bank of Canada RY-T, Toronto-Dominion Bank TD-T, Bank of Nova Scotia BNS-T, Bank of Montreal BMO-T, Canadian Imperial Bank of Commerce CM-T and National Bank of Canada NA-T.

A change in the DSB also prompts an adjustment in the minimum capital levels that a bank is expected to hold. The common equity tier 1 (CET1) ratio – a measure of a lender’s ability to absorb losses – will increase to 11.5 per cent from 11 per cent. The hike means that the banks will have to hold billions of dollars in excess capital.

All six banks currently exceed the minimum threshold: TD holds the most excess capital, with 15.3 per cent, and CIBC has reserved the least, with 11.9 per cent.

When the economy is strong and loan losses are lower, banks are expected to build capital reserves. The regulator can later allow banks to release capital to help them absorb losses if the economy sours.

With the threat of a recession looming, OSFI said it “will not hesitate” to lower the buffer to allow banks to access their capital reserves.

Mr. Routledge said he is closely watching for an increase in bad loans and delinquencies, as well as employment data. The banks have yet to see a significant rise in loans that have gone bad, and Canada’s unemployment has remained low despite concerns over a weakening economic outlook.

Requiring lenders to hold onto more money means they have less capital to invest in growth opportunities or to give back to shareholders through dividend increases or share buybacks. The change could also weigh on loan growth, which is a key source of revenue for the banks, during a time when high interest rates are already dampening demand for borrowing.

Holding onto too much cash also drags on a bank’s return on equity (ROE) – an industry metric that measures profitability – which can affect the valuation of a company’s share price.

“The higher capital levels are intended to reduce lending capacity/loan growth and will serve as an ROE headwind for Canadian bank investors,” Bank of Montreal analyst Sohrab Movahedi said in a note to clients.

The higher bar could be a new permanent fixture in the sector as global risks mount. Some analysts said that, barring an economic downturn, the odds are high that OSFI will increase the buffer again at the end of the year.

“In the long run, we see OSFI moving to the upper end of the range (announcing another increase) in December all else equal as likely,” Royal Bank of Canada analyst Darko Mihelic said in a note to clients.

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Tickers mentioned in this story

Study and track financial data on any traded entity: click to open the full quote page. Data updated as of 24/05/24 4:00pm EDT.

SymbolName% changeLast
TD-T
Toronto-Dominion Bank
+2.25%77.28
CM-T
Canadian Imperial Bank of Commerce
+0.3%66.39
BNS-T
Bank of Nova Scotia
+0.45%65.27
RY-T
Royal Bank of Canada
+0.17%143.92
NA-T
National Bank of Canada
+0.66%114.71
BMO-T
Bank of Montreal
+0.47%130.48

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