A Report on the Work of the Office of the Superintendent of Financial Institutions

Catherine S. Swift, President and CEO, Canadian Federation of Independent Business, and Second Vice-President, The Empire Club of Canada; Nordo Gooden, Grade 12 Student, Westview Centennial Secondary School; Rev. Eleanor Clitheroe-Bell, Executive Director, Prison Fellowship Canada and Assistant Curate, St. Cuthbert's Anglican Church, Oakville; Bill Knight, Commissioner, Financial Consumer Agency of Canada; Guy L. Saint-Pierre, President and CEO, Canada Deposit Insurance Corporation; Stan Griffin, President and CEO, Insurance Bureau of Canada; Bart J. Mindszenthy, APR, Fellow CPRS, Partner, Mindszenthy & Roberts Corp., and Immediate Past President, The Empire Club of Canada; Raymond Protti, President and CEO, Canadian Bankers Association; and George L. Cooke, President and CEO, The Dominion of Canada General Insurance Company, and Past President, The Empire Club of Canada.

Introduction by William Whittaker

A lawyer and an accountant were discussing with St. Peter at the Pearly Gates why their admission to heaven was being held up. All of a sudden, there was a great flourish of trumpets, the Pearly Gates opened wide and a person in a magnificent robe on a great white horse charged through into heaven. The lawyer and the accountant looked at each other in wonderment and asked St. Peter if that was God. "No," said St. Peter, "he was a bank regulator who thinks he is God."

Under our Constitution, banking and insurance are matters of federal jurisdiction. Transnational policies resulting from unified federal regulation in Canada have allowed our banking and insurance industries to develop significant entities in relation to our small and scattered population. Contrast the Canadian experience with that of the United States, whose banking and insurance industries started with non-uniform state regulation and development. Indeed, the early regulation of the American banking and insurance industries parallels that of our securities industry today which is regulated by 13 different jurisdictions and faces increasing demands for one national regulator.

In 1990, Robert MacIntosh, a former president of the Canadian Bankers Association and senior executive with the Bank of Nova Scotia for many years, authored a book entitled "Different Drummers" which is rich in history and anecdotes respecting the Canadian banking system. In his book and in a speech to our club in September 1991, he outlined the impact of the changing regulatory climate on Canadian banks both from an international and national perspective beginning with Sir Henry Pellet of Casa Loma fame and the Home Bank collapse of the 1920s to the international collapse of the Bank of Credit and Commerce International in 1991. When BCCI was closed down by the British authorities in July 1991, one million investors were affected. Subsequent investigations revealed BCCI had been organized to avoid centralized regulatory review and to commit fraud on a massive scale. In Canada, the story was a happier one as the Superintendent of Financial Institutions at the time, Michael MacKenzie, did not rely on the supposed international supervision of the parent but quietly put the clamps on BCCI Canada by placing it on a monthly licence, monitoring its asset quality and requiring it to increase its capital with the result that it did not fail.

Mr. MacIntosh's remarks can be summarized by the statement that the only constant in the history of our Canadian banking and insurance industry is change and that significant challenges have been met by our regulators. The bottom line is that although Canadian banks and insurance companies have failed with losses to their shareholders, depositors and policy holders have been protected.

The Office of the Superintendent of Financial Institutions, or to use its acronym OSFI, was created in 1987 by joining together the former Department of Insurance and the Office of the Inspector General of Banks. OSFI regulates and supervises all federal financial institutions which at last count consisted of 148 deposit-taking institutions, 305 insurance companies and 31 foreign bank representative offices. It also oversees a multitude of private pension plans of companies and Indian bands, which fall under the jurisdiction of the federal Pension Benefits Standards Act.

This is Mr. Le Pan's second address to our club as Superintendent of Financial Institutions and, as before, he is not riding a white horse. Our sellout audience indicates a high degree of interest in his speech to us today.

Nicholas Le Pan was appointed Superintendent of Financial Institutions effective September 1, 2001 for a seven-year term. Prior to joining OSFI in 1995, Mr. Le Pan led a Department of Finance task force which produced the government white paper on the supervisory, deposit insurance and policyholder protection regimes we have today and the subsequent legislation implementing them.

In July 2003, Mr. Le Pan was appointed Vice-Chair of the Basel Committee on Banking Supervision of the Bank for International Settlements. Mr. Le Pan is also a member of the Auditing and Assurance Standards Oversight Committee and the Governing Council of the Canadian Public Accountability Board.

Please join me in welcoming Nicholas Le Pan, Superintendent of Financial Institutions to our podium today.

Nicholas Le Pan

Welcome.

The Office of the Superintendent of Financial Institutions (OSFI) is the prudential regulator for over 450 banks and insurers and over 1,200 federally registered pension plans. Prudential means we focus on safety and soundness. It also means we care about the success of the institutions and plans we regulate.

There are two topics I would like to share with you today: first, the state of the financial institutions and pension plans regulated by OSFI and my view of important factors for success in regulation going forward.

OSFI's Mandate

OSFI has a mandate from Parliament for early intervention to deal with potential safety and soundness problems and to promote policies and procedures designed to control and manage risk.

OSFI's legislation requires us to have due regard for banks and insurers to be able to compete effectively and take reasonable risks.

It also recognizes that management, boards of directors and pension plan administrators are ultimately responsible and that financial institutions and pension plans can fail. I know the word "fail" doesn't make most of us feel warm and fuzzy. Having said that, the Canadian financial-services industry (like the industry worldwide) has been enormously successful over the past decade at weathering disruptions that would have produced a lot more serious consequences historically. It's easy to forget how to deal with problems.

Recognition of the Importance of the Financial-Services Sector

I want to emphasize that policy-makers, regulators, decision makers, and those in charge of financial institutions need to recognize the incredible importance of the financial-services sector to the Canadian economy. A properly functioning, efficient financial-services sector is behind so many parts of our economy and our day-to-day lives. Financial services represent 6 per cent of Canada's Gross Domestic Product, employ over 600,000 Canadians and pay $13 billion in taxes. They are one of the few, large, internationally successful groups of Canadian companies. Toronto is headquarters for five major banks and two major insurers. That concentration in a single North American city may be unique outside New York. The sector is also very important in other Canadian cities. So finding and keeping a regulatory regime that protects depositors and policyholders, but also supports industry success, matters.

State of the Industry

Financial Institutions

The credit quality of banks has been excellent and they are well capitalized. Core earnings remain near record highs.

We may have passed the peak in credit quality and there is that old truism that bad loans are made in good times. The market and credit risk in complex, potentially illiquid products deserves ongoing and active management.

Capital ratios for the life insurance industry remain well above minimum regulatory requirements. Overall, we see a stable outlook, with improvements in profitability, asset quality and capital levels.

I think inherent operational risk for banks and insurers is still increasing, though so is the capability to manage it. Reputation risk issues, including anti-money laundering and counter-terrorist financing, deserve ongoing heightened attention. Our message is also that expense control should not undercut high-quality compliance and risk management.

Many smaller banks or life companies are less diversified, pursuing niche-oriented strategies to remain competitive. The challenge is to ensure that, in an effort to achieve growth and sales objectives, these institutions do not make compromises that ultimately add risk beyond their capability to manage.

Returns on equity in the property and casualty insurance sector are approaching 20 per cent, though there are some that are nowhere close to that. I have been pleasantly surprised by the sustainability of these results.

The improvement in operating results since 2002 has led to a material decline in the number of property and casualty insurance companies subject to OSFI's heightened supervision.

I am impressed by the property and casualty insurance industry's commitment to strong discipline in pricing and underwriting. That reduces the risk of a repeat of the bad times of a few years ago.

Internationally, the loss experience of the past two years from catastrophes was the most severe in history. But the strong financial condition of the sector meant the global industry was able to sustain the impacts of these events. The spill-over effect on Canadian insurance markets has not been serious.

Lastly, parts of the banking and insurance industries have experienced material compliance lapses. But these have not been systemic in Canada in my judgment. The response by industry in tightening oversight and governance from OSFI's perspective has been impressive.

Major banks and insurers are following much more divergent strategies than they used to. They are operating in a more complex environment--more complex products, different geographies, tougher competition, and less room for error. Overall, however, in part pushed by regulators like OSFI, management, governance and oversight of risks is markedly improved from five or 10 years ago. Canadians need to understand better what a success story this has been.

Pension Plans

In contrast, the defined benefit pension plans that OSFI regulates continue to show significant challenges to their long-term health and viability. Our estimates show that some three-quarters of defined benefit pension plans have a solvency ratio of less than one and the number of plans on our watch list is rising and we expect it to rise further. Partly this is due to lower market interest rates and to the fact that people are living longer. It is fair to say the situation for defined benefit pension plans continues to be challenging, but I believe it is manageable.

OSFI has seen an increase in the use of defined-contribution-plan versus defined-benefit-plan arrangements.

Does this matter? I think so. Defined benefit and defined contribution arrangements are, of course, markedly different in how they share risk. I don't advocate one over the other, but I think that employers and employees ought to have a fair choice and know what the real risks are. Right now, I think the choices are stacked against defined benefit plans. Partly this is because of tax rules, partly because of ongoing fights regarding ways to resolve surplus disputes, and partly it results from costs of multiple rules and rigidity in funding.

Some Important Success Factors Going Forward

So, as a country, what does it take to maintain and sustain success going forward?

The Right Mindset in Approaching Regulatory, Legislative and Policy Issues

Financial institutions are not public utilities. Success is important, particularly from OSFI's perspective, as it is the number-one line of defence against safety and soundness problems.

What do I mean? The economic and financial environment has been exceptionally good, and I have no sense of short-term deterioration. But we know that from time to time stresses inevitably arise. We want the financial-services sector to be accepting risk and measuring and managing risk well. When you are dynamic and accept risk, there are going to be losses. And we want the financial sector to be a good absorber of economic and financial shocks, not a magnifier of shocks, as it has been in some countries. When industry players have major losses, it is one thing if those losses eat up only a quarter or two's earnings, it is quite another if they cut materially into capital and thus risk cutting into public confidence.

Of course the financial-services sector is regulated, and there are important tradeoffs between various policy goals. But when I tell people what I do for a living they don't enthuse about the safety and soundness and success of our financial-services industry.

And in terms of mindset we have to understand that those who want to continually bash major industry players are not committing a victimless crime. Of course these organizations make mistakes from time to time. They need to be fully held to account for those. That's what OSFI does in the safety and soundness sphere. But making decisions about rules and policies based on a "bashing" mindset is wrong.

I do not advocate failing to address legitimate public-policy issues and concerns (whether it be who ought to market or distribute insurance or how par policyholders ought to be treated). But it does mean addressing these issues based on as much dispassionate analysis and judgment as possible, and with a full range of options under consideration, not just on interest group politics or the "sky will fall" kind of analysis.

And it means facing the real financial and economic costs of suggestions before deciding whether they are a good thing--not, for example, promoting new guarantees for pensioners as inexpensive or neglecting to mention that a guarantee fund could make the regulatory job harder by reducing incentives for plan stakeholders to face and solve their problems themselves.

When public-policy decisions affect major strategic direction of financial institutions, or of defined benefit plans, it is also key that whatever decision is taken by governments be clear and timely; otherwise we introduce unnecessary risk and inefficiency into the system.

Efficiency and Rules

This is also where efficiency in the legislative and regulatory structure comes in. If we don't give due regard to efficiency, we sap success.

I believe that the prudential regulatory system stacks up pretty well in this regard. OSFI runs a reliance-based, risk-focused regulatory and supervisory system that is not very costly. Our average cost recovery from a large financial institution is $4-5 million. We are increasingly working with foreign regulators such as the U.S. and the U.K. to avoid unproductive duplication and overlap in our supervision program. In Canada, harmonization of key prudential rules between the federal government and provinces is in place. Basic prudential rules are becoming less one-size-fits-all and more related to real risks.

On the market conduct side of financial institutions regulation, in contrast, we have a bewildering array of factors, both federally and provincially, risk-based approaches to regulation are just starting to be talked about, a range of products that are economically similar are treated differently, and my sense is that compliance costs are rising rapidly.

One key question is always whether we need more rules, and the balance between principles versus rules. This is not only a matter for those of us at OSFI, but also for other financial regulators and other standard setters who have a big impact on financial institutions, such as in the area of accounting and auditing.

Today, I think we've reached "new rule overload"--new accounting rules, Sarbanes-Oxley 404, new international rules in banking and insurance, and new market conduct rules.

Over the past few years, OSFI has tried very hard to resist the temptation to put in place detailed new rules. The Basel Committee on Banking Supervision, whose membership is composed of the G-10 countries and of which I am proud to be serving as Vice-Chair, has decided on a rule pause.

More and more rules and more detailed rules risk becoming a checklist, at which point their benefit is greatly reduced; the rules themselves become a risk. At worst, a financial institution or a regulator administering a plethora of rules may take their eye off the things that really matter.

In the pensions world, efficient regulation means dealing with the issues raised (in the recent Department of Finance discussion paper) to create a more level playing field in the choice between defined benefit and defined contribution plans. I support those initiatives. Longer term, it also means recognizing the costs to plans of dealing with rules from multiple jurisdictions.

Whatever happens with these bigger picture pension initiatives, they are unlikely to be much help with the immediate funding challenges faced by defined benefit plans. Nevertheless, they should still be pursued.

For efficiency in regulation, I strongly support key rules based on international norms. But then, we must be very disciplined to allow for local variants or add-ons, only where it is absolutely essential.

Focus on Contingency Preparedness

Even in good times OSFI and the institutions we regulate have to be prepared to deal with problems. Increasingly, we don't just focus on risks but also on the resiliency of our institutions and the financial system to deal with the unexpected. Currently, for example, OSFI is reviewing the contingency plans of major banks and insurers to deal with a flu pandemic. While there can be no guarantees of success, I am satisfied with financial institutions progress to date in this regard.

Pensions--The Short Term

Dealing with problems like those in the pension sphere means facing them, communicating frankly with those who need to be involved, and acting. Despite the continued decline in solvency ratios and the fact some plans are in difficulty, the majority of federal plans continue to fund their deficits. However, because of current challenges, plan administrators may need to review their plans' benefit structures and determine whether the plans, in their current structure, continue to be affordable. Don't wait for interest rates or markets to turn around. In the present environment, high-quality disclosure to members regarding the health of their plan is key.

OSFI has seen a marked increase in the number of plans seeking to reduce benefits. In some cases, this option may be better for plan members than the alternative of plan termination. But I want to be clear: this is not an easy road to pursue.

Recently, the Globe and Mail called OSFI the most active pension regulator in Canada. I like to think that is true. To that point, OSFI is prepared to continue working with plan sponsors and members to find reasonable solutions. This could involve plan restructurings to make them more affordable, and we are approving benefit reductions where this is better for plan members than the alternative of plan termination. We have been impressed by the number of plan administrators/sponsors, who have given us a heads-up on looming problems. It is very important to engage OSFI early in the process so that we can consider viable options together.

Pension Funding Rules

OSFI would support flexibility in the regulations, perhaps temporarily, for plans to deal with increased deficits. However, we also want it more likely that plan members will not be any worse off under any new arrangements and that they are made aware of the risks. This decision is not OSFI's to make, and we will continue to work with the Department of Finance on these issues.

Conclusion

Despite the issues I have mentioned here today, Canadians can have a high degree of confidence in the fundamental soundness of our financial institutions and private pension system. The prudential regulatory system is sound. Thank you.

The appreciation of the meeting was expressed by George L. Cooke, President and CEO, The Dominion of Canada General Insurance Company, and Past President, The Empire Club of Canada.