John R.V. Palmer Superintendent of Financial Institutions
A NEW MANDATE FOR OSFI
Chairman: Catherine Steele
President, The Empire Club of Canada
Head Table Guests
George L. Cooke, President and CEO, The Dominion of Canada General Insurance Company and Past President, The Empire Club of Canada; The Reverend Dr. Robert Pierson, Rector, St Philip's Anglican Church; Anders Sorensen, Honour Student, Etobicoke Collegiate Institute; Sarah J.E. Iley, President and CEO, The Council for Business and the Arts in Canada; Lillian Morgenthau, Canadian Association for the Fifty-Plus (CARP); George Anderson, President and CEO, Insurance Council of Canada and Director, The Empire Club of Canada; Charles C. Black, Senior Advisor, Insurance Operations, Canadian Life and Health Insurance Association; and Kelly Shaughnessy, Vice-President, Banking Operations, Canadian Bankers Association.
Introduction by Catherine Steele
It is my privilege to introduce to you now our guest speaker, John Palmer, Superintendent of Financial Institutions.
Created in 1987 by an Act of Parliament, the Office of the Superintendent of Financial Institutions, also known as OSFI, has a mandate to safeguard depositors, policyholders and pension plan members from undue loss, and to advance and administer a regulatory framework that contributes to public confidence in a competitive financial system. A financial system which includes banks, property and casualty insurers as well as life and health insurers.
In the competitive financial world, this role of watchdog on behalf of consumers is no small task. And achieving a balance between the role of regulator while fostering competition, innovation and growth among financial institutions is also a challenge.
Canadian consumers have been rather fortunate when it comes to our financial institutions. We haven't suffered major collapses and by world standards our institutions respond well to change and to the needs of consumers.
It is logical to think that public confidence in Canada's financial institutions is based on knowledge and personal experience. Knowledge of their financial institution, its performance and policies, and how it compares to other institutions, enables consumers to make informed choices about where to invest their hard-earned money and in whom to place their trust.
John Palmer was appointed to the position of Superintendent of Financial Institutions in 1994. Born in Halifax, Mr. Palmer became a chartered accountant in 1969 and was made a Fellow of both the Ontario and British Columbia Institutes of Chartered Accountants.
He joined the firm now known as KPMG in 1966 serving with it and an affiliate in London, England, Vancouver and Toronto. In 1983, he became National Executive Partner. In 1989, he was appointed Deputy Chairman and Managing Partner before leaving that position to become Superintendent.
Mr. Palmer has served two successive federal ministers of national revenue and served on the panel of senior advisors to the Auditor General of Canada and as a Governor of the Canadian Comprehensive Auditing Foundation. He is currently one of three Canadian representatives on the Financial Stability Forum.
Mr. Palmer has been a director of a number of charitable and community organisations, and is currently a Director of the Canadian Council for Business and the Arts. His visit with us today is very timely, given that the long-awaited financial services legislation is expected to be introduced next week.
Ladies and gentlemen, please welcome John Palmer to The Empire Club of Canada.
For those of you who haven't previously dealt with the Office of the Superintendent of Financial Institutions, or OSFI as it is affectionately known, let me take a minute to explain what we do.
We are the primary regulator and supervisor for all federal financial institutions and pension funds. That includes all banks operating in Canada, whether Canadian or foreign-owned, as well as federal trust companies, life insurance companies and property and casualty insurance companies. We are responsible for about 500 institutions in total, and about 1,100 federal pension plans.
We are what is called a ""prudential"" supervisor. That means that we focus on the financial health of institutions and pension plans and the protection of your savings.
In 1995, when I last spoke at the Empire Club, I had been Superintendent of Financial Institutions for less than one year. The Canadian economy was just coming out of a difficult period and between 1989 and 1994, a total of 139 federal financial institutions went out of business, including:
• 15 small banks;
• 17 trust and loan companies;
• 33 life insurance companies; and
• 74 property and casualty insurance companies.
And those numbers did not include companies like Royal Trust that retained their identity but which were taken over by other institutions.
The financial institution failures and near failures of the early 1990s led to a reappraisal of the changes which Canada had made to its financial-sector legislation at the beginning of the decade, and a decision to further strengthen the regulation and supervision of federal financial institutions.
OSFI was given a legislative mandate, which made it clear that it had a responsibility to protect the savings of depositors and policyholders of federal financial institutions. Importantly, the mandate also made it clear that OSFI's responsibilities did not extend to preventing the failure of financial institutions. Instead, OSFI was expected to become more interventionist in its supervisory approach, detecting potential problems earlier, and moving faster to ensure a resolution of the problems, either by requiring the institutions to fix them or by closing the institutions before further erosion took place in the savings of depositors and policyholders.
This mandate, which was passed into law in 1996, has been driving OSFI's activities since that time. At the risk of lapsing into immodesty, I can tell you that we have fundamentally transformed OSFI, as a result.
We have developed a new approach to supervising financial institutions which includes closer attention to the key risks which institutions are taking on and the quality of the institutions' own risk management systems. Our new approach also requires us to intervene more quickly and decisively when problems become evident.
As part of our new approach, we have been encouraging institutions to increase capital levels and strengthen their reserves for losses.
We have also played a more active role in shaping legislation than was the case before I became Superintendent. While we do not shape financial-sector policy, we do develop recommendations for amendments of a more technical nature which will permit the legislation to achieve its objectives and ensure that OSFI can accomplish its prudential mandate.
During this period, OSFI has undergone organisational changes to eliminate overlap and duplication and ensure that our activities are better focused on our objectives. We have created a conglomerates group to supervise our larger, more complex institutions and are building an internal consulting division staffed with specialists in such areas as value at risk models, securitisation, as well as experts in accounting and actuarial matters. This has been essential to help us keep up with the rapid changes taking place in the financial sector.
Well-qualified, well-trained and highly motivated people are the key to the success of any organisation, and some profound changes have occurred in OSFI's human resources over this period. We have experienced a staff turnover of about 50 per cent. Some of this was initiated by us, and some was unsought, as employees left for better-paying jobs in the private sector, a continuing challenge for OSFI. We have also been eliminating lower-value positions and adding higher-value ones as we sought to enhance our expertise.
Overall, our staff levels are down nearly 10 per cent since I became Superintendent, but at the same time, our salary expenditures have gone up by nearly 30 per cent, reflecting the upgrading in talent that has been taking place.
We have been working hard, too, to give our people the training they need to enhance their knowledge and skills. Training expenditures have quadrupled since I became Superintendent. Overall, our expenditures, which we charge out to the institutions we supervise, have increased by 25 per cent since I last appeared before this audience. While we are clearly out of step with other government organisations which have been attempting to reduce costs, I make no apologies for this. The industry we supervise has become more complex and our work has become much more difficult. During the same period in which our costs went up 25 per cent, the non-interest costs of the Big 6 banks increased by 68 per cent, and their total assets under administration increased by 70 per cent, even after deducting the impact of the massive securitisations which have taken place over the last couple of years.
We have been also attempting to develop information to track our own performance; information that we will soon make public. We are trying to track the impact of our more interventionist supervisory approach, monitoring the number of institutions on our watch list and how long they stay there. We are also tracking losses from financial institution failures to assess just how well we are protecting depositors and policyholders. And we are conducting surveys to find out how well our employees and our institutions think we are doing.
While we have been working hard to become a more effective and, in a quiet Canadian way, a more aggressive supervisor, as required by our legislation, what has been happening around us?
The recession of the early 1990s is well behind us and we are enjoying one of the longest expansionary economic cycles in history. In the United States the expansion has lasted for 110 months, the longest of any cycle since data was first compiled in the 1850s. The number of institutions on our watch lists has dropped, and there have been few failures. Indeed, many of the financial institutions we supervise are enjoying record profits despite the dire predictions we have been hearing since the bank merger proposals were turned down. In fact, many financial institutions, both in Canada and abroad, are targeting rates of return in excess of 20 per cent and achieving them, at a time when inflation is holding in the 2-per-cent to 3-per-cent range.
And as the last recession recedes from memory, the public debate concerning the financial sector has shifted away from prudential themes such as the protection of the savings of depositors and policyholders toward the challenge posed by technology and globalisation. Policymakers are now wrestling with questions of how to permit our institutions to compete with much larger foreign competitors and unregulated institutions while at the same time ensuring that the rights and needs of consumers are not overlooked.
In this environment, some might argue that OSFI is still fighting the last war-working busily to build and strengthen a prudential ""Maginot Line"" around our institutions, while bigger, stronger, more technologically advanced, and often foreign competitors sweep past our defences and mount their electronic blitzkrieg against our institutions, well beyond OSFI's reach. We have certainly heard this from some commentators.
Let me acknowledge that there may be an element of truth to this observation. We still see building prudential protection as the heart of OSFI's job. The government has given no indication of weakening OSFI's mandate to protect your savings, and we have not suggested this. OSFI has not forgotten about the last recession and those that preceded it. And while there are some who may believe that we have entered a new economic paradigm in which recessions are a thing of the past, we at OSFI are not convinced of this.
History tells us that all economic growth cycles eventually end. And sometimes they end with a bang, not a whimper.
When the boom in the 1980s came to an end, that bang was a big one. Banks in many countries incurred heavy losses, and lots of them failed. Repairing the damage was hugely expensive. Public outlays to repair their deposit-taking institutions amounted to nearly 3 per cent of one year's GDP in the United States and 5-per-cent to 7-percent GDP in some of the Scandinavian countries. In Japan, the economic cost has been many times greater, and the resolution of the banking problems in that country is still taking place.
And so, knowing what has happened in the past in Canada and other countries, we have to be scanning the horizon in search of any distant storms that might be brewing, even when the economic weather seems most sunny and promising.
And if we can't yet see storms, there are at least a few clouds that we have to be concerned about.
Those 20-per-cent rates of return that I talked about a few minutes ago are being achieved at a time when risk premiums are at very low levels. Thus, almost by definition, institutions have to be taking more risk to achieve these sorts of returns. And while market participants are taking on more risks, some cracks are beginning to appear. Standard and Poors reported that default rates were up last year to the highest level seen since the recession. There are reports of more fraud and creative accounting by borrowers, often symptoms of the end of an economic cycle. Some U.S. banks are beginning to tighten their lending conditions. Stock markets are increasingly volatile. The U.S. Federal Reserve is performing a remarkable highwire act, carefully tightening credit to discourage latent inflation in the system, without bringing this era of growth to an unpleasant end. In the past, similar initiatives have often brought about a recession.
And we shouldn't forget about the near miss that we in developed countries experienced two years ago during the financial crises which occurred in Asia, Latin America and other regions. These crises were successfully contained and the collateral damage, at least in the developed world, was slight, even if the impact on countries like Indonesia was and continues to be quite terrible. The important point is that, if it were not for some good management and a dose of good luck, the damage to developed economies could have been quite serious.
So, at this advanced stage of an unprecedented economic cycle, having just dodged one bullet and with some danger signs ahead, would it not be reasonable for policymakers to be putting up more prudential barriers?
Yet despite what OSFI has been doing over the last five years, the actual tendency is now just the opposite. What happens is that, at this point in the economic cycle, we all tend to see the world through rose-coloured glasses. Consumer spending is up. Business investment is up. Governments are spending again and even cutting taxes or promising to do so. And the focus of regulatory policy tends to shift toward reducing regulatory burdens-giving market participants more flexibility to innovate, grow and compete.
But of course there is more to the pressure to reduce regulatory barriers than typical late-cycle thinking; in addition to the frothy economy, there appears to be a sea change occurring in the international financial sector. Geographic barriers are dropping. Global institutions are emerging. And technology is fundamentally transforming products, delivery systems and customer relationships. There is a clear need to respond to these changes, even if we are doing so at what may be a late and therefore riskier point in the economic cycle.
The financial sector bill that Mr. Martin will introduce next week will form the government's primary response to these changes in the financial landscape. While some may fear that the bill will not go far enough, it is nevertheless a significant response. As you know from the government's policy paper issued a year ago, the bill is expected to bring:
• changes in ownership rules;
• more structural flexibility for Canadian financial institutions;
• reduced barriers to entry for new banks and other financial institutions; and
• enhanced consumer protection.
Despite our strenuous efforts to strengthen regulation and supervision over the last five years, and despite our still-vivid memories of past crises, OSFI is also playing a role to ensure that Canada's financial institutions are able to adapt quickly to the big changes now underway around the planet.
We have played a significant supporting role in the development of the new legislative package, particularly those sections directed at giving financial institutions more structural and operating flexibility. These include the new holding company provisions and expanded downstream investment rules. Contrary to recent media reports, many downstream investments made by financial institutions will not require ministerial approval but can be approved by the Superintendent, increasing flexibility and faster turnaround.
To add further flexibility, OSFI is also developing a streamlined approval process in which many approvals will be obtainable through a simple notice procedure.
At the same time, OSFI has been overhauling our supervisory practices-moving away from a standardised approach to a more flexible supervisory framework adaptable to the risk profile of each institution and placing heavy reliance on an institution's own internal controls and risk management systems.
What adds impetus to our efforts here in Canada is that similar initiatives are occurring in other countries. And some of the efforts are multilateral. One of the most important is the revision now underway to the Basel Capital Accord-the formula used to set regulatory capital of deposit-taking institutions in most developed countries. An effort is underway to tailor regulatory capital more closely to an institution's own risk profile and allow it to use its own risk-rating systems to determine the capital it holds. This should allow some well-managed institutions to release capital (though I confess I hope that it will not be too much). OSFI is playing a major role in this international undertaking.
But we are trying not to throw caution to the winds in the name of flexibility and competitiveness. The new legislative package should contain some additional regulatory powers that OSFI has been asking for, including the power to remove officers and directors under certain circumstances, the power to levy administrative money penalties, and some enhancement of self-dealing rules to help us oversee the more complex corporate structures likely to emerge from the legislative package.
Because so much of the pressure to relax our own rules is motivated to permit our institutions to compete with foreign players who may be subject to weaker rules, OSFI has been in the vanguard of the movement to set international standards of best practice for financial regulators and supervisors, including promoting a system of peer review to assess national supervisors' compliance with these standards.
OSFI itself was subject to a peer review against international standards last fall, carried out by the IMF as part of its new Financial Sector Stability Assessment Process. I am happy to tell you that OSFI and indeed the Canadian financial system generally passed with flying colours, although we did receive a number of helpful suggestions.
OSFI will continue its efforts to enhance its capacity to regulate and supervise. As soon as we gain more experience with our new supervisory framework, we will be introducing a new rating system for financial institutions. Like all other prudential supervisors, we won't make these ratings public because of systemic stability concerns, but we will be disclosing them to our institutions and using them as levers to encourage improvement. We will continue to strengthen our human resources with the help of a more competitive compensation system, ongoing recruiting from the private sector and a continuing emphasis on specialisation.
And most important, perhaps, we intend to become increasingly accountable, as we develop and test an array of performance measures and standards, and publish our successes and failures. To help us to strengthen accountability, we are forming an external Advisory Board, made up of former financial community executives. These advisors will review our performance against the objectives the government has set for us, and will also help us find the right balance in our supervisory policies between safety and soundness on the one hand and competitiveness and flexibility on the other.
While we are proceeding in a balanced and careful way, it is important for you to understand that, as a result of all the changes that are taking place, more prudential risk is being introduced into the financial system at a late stage in the economic cycle.
But despite the end-of-cycle rose-coloured glasses that we are all wearing to some extent, I think this is being done intelligently, with a reasonable understanding of the costs and benefits that are in play. I also believe that Canadians have matured to the point where a strategic shift of our system a few notches up the risk curve to obtain some important benefits is something many can understand and support.
The financial sector is key to our current and future economic success. We need a financial sector that offers a competitive array of products and services to Canadians and we need to ensure there is room for competitive, successful Canadian-based financial institutions as well as foreign institutions in our open economy. To achieve this, we can't ignore changes that are occurring beyond our borders, even if those changes are also influenced by the same end-of-cycle thinking that is driving our changes. While we need to maintain prudential walls around our institutions, those walls can't be higher than those which we see in our major trading partners. We have to seek a level playing field for our institutions. So OSFTs mandate continues to be the protection of your deposits and insurance policies in federal institutions, but we're trying to do this in a balanced way that recognises international developments and facilitates a competitive financial system.
The appreciation of the meeting was expressed by George Anderson, President and CEO, Insurance Council of Canada and Director, The Empire Club of Canada.