Banking Sector 18. The banking sector’s performance is strong, with solid profitability and sizeable capital buffers (Figure 8, Table 6). ...
Banking Sector 18. The banking sector’s performance is strong, with solid profitability and sizeable capital buffers (Figure 8, Table 6). Banks have steadily improved their capitalization, benefiting from their robust revenue-generating capacity based on universal banking even in the low interest rate environment. Credit-related impairments have been remarkably low. Large banks have established their footprints overseas, particularly in the United States, and thus become exposed to macrofinancial conditions in those markets. Going forward, the sector’s ability to continue growing domestically while maintaining high profit margins and low capital charges from mortgage lending could be more difficult given market saturation. Banks’ funding appears diversified, largely comprising retail and wholesale deposits. However, banks have increasingly relied on foreigncurrency funding (slightly more than half of total funding) mainly to fund their international operations and to a smaller extent their domestic activities. Derivatives-related liabilities are sizeable and have contributed to volatile liquidity profiles. 0 1 2 3 4 5 6 7 8 0 10 20 30 40 50 60 70 Increase in the adverse scenario (2020) Latest (2016) Household Debt-at-Risk (In percent of total debt)
Debt-at-risk, not covered by assets (in percent; right scale) Debt-at-risk (in percent; left scale) 0 2 4 6 8 10 Current situation (2018) Adverse scenario Current situation (2018) Income shock Funding cost shock Adverse scenario (combined shocks) Others Energy Materials (inc. mining) Utilities Corporate Debt-at-Risk (In percent of total debt; based on firms with publicly available financial statements) Increase due to shock(s) Sources: Statistics Canada, Survey of Financial Security; and IMF staff estimates. Note: Financially weak households are defined as households whose debt-servicing obligation is larger than 40 percent of disposable income. Debt of these financially weak households is considered at risk. The sensitivity analysis assumes a decline in income by 15 percent, an increase in interest rates up to 230 basis points (depending on the renewal profile of borrowers), and a decline in house prices by 40 percent. Sources: CapitalIQ; and IMF staff estimates. Note: Financially weak firms are defined as firms whose earnings before interest, tax,
depreciation and amortization (EBITDA) is less than interest expense (including capitalized interest). Debt of these financially weak firms is considered at risk. The sensitivity analysis assumes income shock (i.e., 25 percent decline in EBITDA) and funding cost shock (i.e., 5 percentage points increase). CANADA INTERNATIONAL MONETARY FUND 17 19. Smaller deposit-taking institutions show some vulnerabilities. Some banks rely on less stable brokered deposits. Credit unions’ loan books are concentrated in residential mortgages, and hence could be hard hit following a significant decline in house prices. 20. D-SIFIs appear resilient to severe macrofinancial shocks (Figure 9).2 Based on the stress tests that covered six domestic systemically important banks (D-SIBs) and Québec’s D-SIFI, the solid revenue-generating capacity would contribute to an upward trajectory of capital ratios in the baseline. In the adverse scenario, the aggregate common equity tier-1 (CET1) capital ratio would decline by 4.8 percentage points to 7.4 percent in 2020 before recovering to 9.6 percent in 2021. During the stress testing horizon, most entities would tap into capital conservation buffers, therefore subject to dividend restrictions. By 2021, all entities would meet the regulatory minimums (including D-SIFI capital surcharges). Larger credit-related impairments, lower net interest income and noninterest income, and increased risk-weighted assets would contribute to a larger capital depletion in the adverse scenario than in the baseline. Staff stress test results are largely aligned with BOC results. 21. The capital dynamics would be largely driven by credit risk. In the adverse scenario, cumulative credit-related impairments would reduce aggregate capital ratios by 4.4 percentage points. Underlying credit quality would also deteriorate significantly, raising risk-weighted assets and thus reducing aggregate capital ratios by 0.8 percentage points. 22
. However, additional losses could materialize due to Canada-specific features that were not fully captured in the abovementioned results. The sizeable undrawn exposures in the banking book, including HELOCs, could be drawn at time of stress, resulting in additional creditrelated impairments of Can$18.5 billion (0.9 percent of risk-weighted assets) according to sensitivity analysis. Similarly, if lenders adopt a more dynamic risk-based pricing of mortgage spreads by charging larger spreads for financially weaker borrowers, additional credit-related impairments would amount to around Can$14.5 billion. 2 See Appendix III for the methodological details for all stress tests (banks, insurers and investment funds). 7.9 7.4 9.6 12.2 13.4 14.3 15.2 6 8 10 12 14 16 2018 2019 2020 2021 Adverse scenario Baseline scenario Common Equity Tier-1 Capital, 2018-21 (In percent of risk-weighted assets) Source: IMF staff estimates. 4 6 8 10 12 14 16 -12 -9 -6 -3 0 3 6 9 12 2018 2019 2020 2021 2019 2020 2021 Others Dividend payout Taxes Market risk Credit risk Operating expense Non-interest income Net interest income CET1 (right scale) Contribution to Common Equity Tier-1 (CET1) Capital, 2018-21 (In percent of risk-weighted assets) Source: IMF staff estimates. Baseline scenario Adverse scenario CANADA 18 INTERNATIONAL MONETARY FUND 23. D-SIFIs appears to hold sufficient liquidity buffers to withstand sizeable funding outflows. The cash-flow analysis identifies small liquidity shortfalls for some entities under severe scenarios,3 with aggregate shortfalls amounting up to Can$91 billion. The exercise suggests that a large funding outflow would be needed to generate a liquidity shortfall. The Liquidity Coverage Ratio (LCR) tests confirm similar findings. D-SIFIs would be able to manage large outflows from either retail or wholesale funding segments separately, including by significant currencies. However, certain vulnerabilities exist. Counterparty risk could be material given the sizeable repo books and derivatives exposures (e.g., currency swaps and total return swaps); the latter, potentially associated with complex bank-specific risk profiles, was not assessed due to data limitation. Insurance Sector 24. The insurance sector’s performance has been strong even in a low interest rate environment (Figure 10, Table 6).4 Return on equity remains stable for the life and mortgage insurance sectors but has declined for the property-and-casualty insurance sector in recent years. Overall, insurers in all sectors maintain strong solvency positions, holding some capital buffers in excess of the supervisory targets. Following the expansion of their business abroad, the three large life insurers have increasingly relied on earnings from their overseas operations (more than half of their net premiums). 25. Large life insurers are somewhat exposed to financial market stress and lower interest rates. The stress tests covered the five largest life insurers and assessed the sensitivity of their solvency to macrofinancial conditions in 2019Q3 (most severe financial market stress) and 2021Q4 (lowest interest rates) in the adverse scenario. In 2019Q3, the aggregate core capital ratio would decline by 34 percentage points to 61 percent, largely driven by the impact of widening credit spreads and falling equity prices. Essentially, life insurers hold a sizeable amount of low-rated and unrated bonds. Some entities would see their capital ratios below the regulatory minimums. In 2021Q4, the aggregate core capital ratio would fall marginally by 5 percentage points. However, life 3 The horizon of stress events would be 3 months. Under the most severe scenario, funding outflows would amount to Can$1.1 trillion (nearly 20 percent of total assets).
4 The discussion only covers federally regulated insurers. -1,500 -1,000 -500 0 500 1,000 1,500 Reverse repos Securities held Cash Committed facilities Repos Maturing debt issued Wholesale outflows Retail outflows Net CBL Counterbalancing Capacity and Funding Outflows, 2018Q3 (In billions of Canadian dollar) Mild Severe Severity of scenario Source: IMF staff estimates. 60 70 80 90 100 110 120 130 140 Scenario-3 (combined) Scenario-2 (wholesale funding outflows) Scenario-1 (retail funding outflows) Starting point (2018Q3) Liquidity Coverage Ratio (LCR), 2018Q3 (In percent) Source: IMF staff estimates. Total LCR LCR - U.S. dollar LCR - Canadian dollar CANADA INTERNATIONAL MONETARY FUND 19 insurers’ solvency would be hit harder in a more sustained low interest environment. For example, a downward parallel shift in the risk-free yield curve by one percentage point would reduce the core capital ratio by 40 percentage points. 26. Mortgage insurers are vulnerable to severe macroeconomic downturns with significant house price declines. Based on the stress tests that covered all three mortgage insurers, cumulative insurance claims would amount to Can$25 billion, consistent with credit losses of banks’ insured mortgage portfolios, in the adverse scenario. Mortgage insurers would need additional capital of Can$15 billion to meet the supervisory solvency target, half of which is for one insurer. 27
. Required capital for insured mortgages may not sufficiently reflect potential deterioration of credit quality during severe downturns. The seven D-SIFIs currently have capital buffers for insured mortgage exposures equivalent to 0.17 percent of outstanding insured mortgages. Accounting for mortgage insurers’ required capital for insurance risk, system-wide capital buffers would amount to 1.96 percent. In adverse scenario, these buffers should go up to 4.32 percent. This would imply additional capital need of Can$28 billion to cover expected and unexpected losses for insured mortgage exposures
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