This is a shortened version of an article that is reprinted with permission from Rotman Management, the magazine of the University of Toronto's Rotman School of Management.
The effectiveness of any economy depends, in large part, on how well its financial sector functions. Which elements of the Canadian system have enabled it to rise to the top?
There are many factors at play, but I'd like to start off by noting that the fiscal situation in Canada was very good prior to the crisis, which was a unique feature, globally. Aside from that, one can look at the activities of the OSFI [Office of the Superintendent of Financial Institutions Canada] and the activities of the financial institutions themselves. From OSFI's perspective, our review would show that some of the things that really mattered included the capital requirements and leverage ratios that we imposed. There was also an international accord – Basel II – that we implemented literally as well as in spirit. These things proved to be very important.
Aside from that, we had the fundamental of good supervision in place, including a mandate. We were one of very few regulators in the world with a well-crafted mandate in the statutes. Its focus was on the safety and soundness of banks and on acting quickly when any problems were identified, and it did not suggest that we should be promoting any particular city as a financial centre. To us, effective supervision includes providing independence and freedom to act – to take tough decisions when necessary, and to have adequate resources at hand. The institutions need to be able to hire people who are skilled in areas of risk management and oversight. We began a building process for all of this around the year 2000, which paid dividends.
Your approach to keeping the Canadian system in check includes implementing 'stress tests.' What does this entail?
'Macro stress testing' is something most regulators in the world are doing these days. It involves spending time thinking about some of the very negative scenarios that could unfold. This doesn't mean you believe they will unfold, but you're trying to see how resilient the banking sector is to some very negative scenarios. So, we could say to the institutions, "Assume GDP growth falls to X," or, "Assume unemployment rises to Y." We change the variable each time, and then ask the banks to run a test to see how they would fare. We then compare their results, one against the other, and sometimes, we notice things that lead us to ask questions and follow up. This provides us with an understanding of what each institution would do in each scenario – what they assume about it and what they don't assume. The more we do this, the more we learn from it.
We also run stress tests on particular portfolios. Instead of running a macro stress test, we test particular economic variables and how the economy would fare. We might say, "Assume in this portfolio that your lapsed rates go up by X," and see what they come back with. Stress testing has been a feature of regulation for some time; it's just been enhanced since the global financial crisis began.
If you woke up tomorrow and found yourself running a European version of the OSFI, what would be the first thing on your agenda?
Firstly, I think I would want to have assurances that the prerequisites for good supervision are in place, and I talked about those earlier. But I would want to be very focused on the mandate – whether the supervisory agency is independent and has the freedom to take what could be very unpopular decisions; whether it has the ability to act very quickly; whether it has the resources and the ability to hire the skills it needs. These are things that, no matter where you are, you must have in place.
Assuming these things are accounted for, as head of the organization, I would want to spend a lot of time understanding what supervisors from around Europe are actually doing. Globally, supervisors are doing very different things; I know that because I chair a group called Supervisory Intensity and Effectiveness, where we discuss approaches to risk and what supervisors are actually doing on the ground. Through these discussions we are seeing that there are some very different approaches out there. Sometimes, that can be a good thing, but sometimes it reflects not having enough resources, not doing enough 'drilling down,' or not doing enough comparative reviews across the sector, whereby you compare all your banks and the risk management practices to find out what 'leading practice' is. I would spend a lot of time on this, because I'd want to ensure that all of the supervisors in Europe are doing roughly the same thing. I would probably also have to spend a bit of time with the banks that we would be overseeing, because they would likely have been subjected to very different supervisory practices and expectations up to this point. Clearly, this would be a huge job.
While everyone wants the same thing – safer, more liquid banks – globally, there has been a lack of uniform regulatory approaches. What is your take on this diversity of approaches?
I think some diversity of approaches is fine, but sometimes, global institutions complain about it. They'll say, 'In this country I'm allowed to do this, and in that country, I'm not.' A good example is the Volcker Rule in the U.S., which has been put forward by the U.S. government, not by regulators, per se. A diversity of approaches is a fact of life; what is more troubling is when global agreements are reached – for example, agreements on capital – and they are not implemented. We are now waiting to see exactly how members of the G20 and the Basel Committee implement Basel III. It's a very important issue, and one that will be quite troubling if, at the end of the day, countries don't implement it in the same way.
Some in the financial community believe the measures put in place to date have already 'fixed' the problems that led to the global financial crisis. Do you agree?
No, and in fact, I don't believe we will ever be done, because financial institutions are constantly evolving and developing new products. As supervisors and regulators, we have to stay on top of that and react quickly if we see that existing capital rules are not addressing the risk. In addition, we can't assume that the rules that have been proposed and implemented won't have unintended consequences; that's another aspect of our job. We constantly have to be looking at whether something we've done is leading to unintended results.
This is not to say that we haven't accomplished a fair bit, in the sense that we have agreed to Basel III; but there is still more work being done on things like resolution planning – 'living wills' is another term that is used for that. This basically requires banks to prescribe how their operations could be dismantled in the event of a crisis. That has to come to fruition. And the whole exercise of ensuring that supervisors are enhancing their methods, and being intrusive or intensive, especially with respect to systemically-important financial institutions – that is still very much a work in progress, globally.
Julie Dickson is Superintendent of the Office of the Superintendent of Financial Institutions, a post she assumed in July, 2007.