Proceedings of the Standing Senate Committee on
Banking, Trade and Commerce
Issue 17 - Evidence - November 5, 2014
OTTAWA, Wednesday, November 5, 2014
The Standing Senate Committee on Banking, Trade and Commerce met this day at 4:15 p.m. to examine the present state of the domestic and international financial system.
Senator Irving Gerstein (Chair) in the chair.
[English]
The Chair: Today we are pleased to welcome Mr. Jeremy Rudin, the Superintendent of Financial Institutions, for his first appearance before our committee. Mr. Rudin was appointed to the position of superintendent for a seven-year term in June of this year.
Before joining OSFI, Mr. Rudin has worked in the federal government for 20 years. For the last six years he served as Assistant Deputy Minister of the Financial Sector Policy Branch at the Department of Finance, where he led development of policy measures to support access to credit during the global financial crisis and contributed to many other financial sector policy issues.
In addition, he represented Canada on standing committees of the Financial Stability Board. Prior to his time in the federal government, Mr. Rudin taught economics at the University of British Columbia and Queen's University. He holds degrees from the University of Toronto, Harvard, and a PhD in economics from Stanford University — a most distinguished resumé, I might add, Mr. Rudin.
I would like to remind the committee and our viewers that the role of OSFI, of which Mr. Rudin is the superintendent, is to regulate and supervise all federal financial institutions and private pension plans and, in so doing, minimize undue losses to depositors and policyholders, thereby contributing to public confidence in the Canadian financial system.
OSFI is an independent, self-financing agency that reports to Parliament through the Minister of Finance.
Mr. Rudin, it is with great pleasure that we welcome you here today. The floor is yours, sir.
Jeremy Rudin, Superintendent, Office of the Superintendent of Financial Institutions Canada: Thank you very much for that kind introduction, Mr. Chair.
[Translation]
I am pleased to be here with you and the members of the Standing Senate Committee on Banking, Trade and Commerce. I look forward to talking with you about the Office of the Superintendent of Financial Institutions and my new role as superintendent.
[English]
I will begin with some background as OSFI's work as the prudential regulator and supervisor of federal financial institutions.
The key feature of financial regulation in Canada is the separation of prudential regulation from market conduct regulation. This is often called the twin peaks model and it has been adopted in a number of other countries, notably the United Kingdom and Australia.
OSFI is Canada's prudential regulator, promoting financial stability by keeping a close eye on the solvency, the liquidity, the safety, the soundness of federally regulated financial institutions. Our work covers about 400 financial institutions, mainly banks, insurance and trust companies, and over 1,200 pension plans, mainly in the private sector.
In regulating and supervising the financial institutions, we constantly ask ourselves these three questions: Are the institutions measuring, monitoring and managing their risks prudently? Do they have enough capital, that is to say, do they have enough capacity to absorb severe but plausible losses and still serve their clients? Do they have enough liquidity? That is to say, do they have enough cash or assets easily converted into cash to pay their liabilities as they come due, even if the institution comes under stress?
The regime governing the relationship between the financial institutions and their customers is known as market conduct, and it differs from prudential oversight in many respects. In Canada, it's a different agency, the Financial Consumer Agency of Canada, often known by its initials, FCAC, that oversees the market conduct of banks. For example, it's the FCAC that watches over the rules governing disclosure to customers before they enter into mortgages and the rules governing how credit limits are set for credit card holders.
[Translation]
OSFI works in close collaboration with the other members of the federal Financial Institutions Supervisory Committee, or FISC, which I have the privilege to chair. The committee has five member organizations:
[English]
So in the financial institutions supervisory committee there is OSFI, where I work, which I mentioned focuses on prudential regulation of the federal financial institutions. Also represented is the Department of Finance, and the department, as you know, develops federal legislation for the approval of recommendations to Parliament, budgets and a number of other aspects of financial policy and management.
Also represented on the committee is the Bank of Canada. The bank's main focus is monetary policy but it certainly has some financial sector-related responsibilities, particularly for the payment system and also for supporting the liquidity of the financial system as a whole. Also represented is the Canada Deposit Insurance Corporation, which ensures deposits at federal financial institutions, and the Financial Consumer Agency of Canada which, as I mentioned, administers the market conduct regulation for banks. The FCAC also leads the government of Canada's efforts to promote financial literacy.
The mandates of the various FISC members all have aspects related to financial sector policy and they complement each other. There is little or no overlap in those responsibilities by design. Together, those responsibilities compose an interlocking federal oversight framework for promoting public confidence in a strong, stable and competitive financial system.
This committee, often known as the FISC, meets regularly to share information to coordinate actions and to advise the federal government on financial system issues.
With that as background, I would like to take you inside OSFI and describe how we work. It's important to understand from the outset that OSFI's job is not to stamp out risk-taking by financial institutions. Risk-taking is an inherent part of providing financial services and the efficient and uninterrupted provision of financial services is essential for keeping the economy growing. However, we all saw in the recent financial crisis that excessive risk-taking by financial institutions, risk-taking unimpeded by sound risk management, that's lacking sufficient capital and liquidity — that's a recipe for disaster.
The ongoing balancing act for all regulators is to restrain excessive risk-taking, while allowing financial institutions to take reasonable risks and to compete effectively at home and abroad.
There are two principal facets to our work. First, we issue guidance to financial institutions. This provides them with a clear indication of what we expect of them in terms of capital, liquidity and risk management more generally. Second, we monitor closely how individual financial institutions are adhering to our guidance. That's our supervisory work.
To the extent possible we stay away from detailed prescriptive rules. We prefer to rely on high-level, broadly stated principles. This allows the financial institutions the flexibility we think they need to act on their responsibility to take reasonable risks and to manage those risks. Indeed, much of our guidance requires institutions to undertake risk management activities and then to report back to us on them.
We make this a bit more concrete by giving you some examples to illustrate.
We've issued a guideline on corporate governance and, among other things, it asks institutions to ensure that their boards include members with the requisite financial services industry expertise and members who can promote sound corporate governance, particularly in overseeing risk management.
We've also issued guidance on the capital base necessary to accommodate any major losses that an institution might incur. As I said, the capital base serves as a cushion, making it possible for the institution to absorb major losses but still serve its customers.
Since the financial crisis, OSFI has significantly increased the capital requirements for banks in line with the new international standards that were established in the wake of the crisis. Moreover, the capital requirement for banks that we judge to be particularly important to the Canadian financial system as a whole is higher than that for other banks. Or, in more simple language, this means that in Canada there is extra padding in the capital cushion needed to absorb big losses if the bank gets in trouble.
Now I'd like to expand a bit on global financial reform. Canada has been and will continue to be a strong supporter of international standards in financial sector regulation. This standard setting is now being led by the Financial Stability Board, also referred to as the FSB.
International agreements on minimum norms are the best way for us to be able to impose prudent standards on our globally active financial institutions without impeding their ability to compete with foreign institutions.
That alone is a strong argument in favour of adhering to these agreements, and being seen to do so.
[Translation]
As you know, the Financial Stability Board is a G20 body coordinating post-crisis financial reforms globally. Its role is to identify key weaknesses underlying financial turmoil, potential crises, and to recommend actions to improve market and institutional resilience.
[English]
At the heart of this global reform, as I was saying, is the development of international minimum prudential standards.
Thanks to our reputation for financial stability, Canada has had considerable influence in the development of these standards and they govern a wide range of items, including capital, leverage ratios, operational risk and a number of other important matters.
That said, we always carefully calibrate our implementation of global requirements to reflect the Canadian situation.
At OSFI we remain focused on the priority areas that are detailed in our annual report, which was tabled in Parliament in early October. The priorities for 2013-14 were these: responding to risks emanating from the economy; responding to risks emanating from regulatory reform; a high-performing and effective workforce, and an enhanced corporate infrastructure.
We will continue to deliver on these priorities while exercising the expenditure restraint expected of all branches of the federal government.
For reasons of brevity and to highlight our work in risk management, I will focus on the first two of these priorities in these remarks.
If we turn to addressing risks emanating from the economy, we have responded to concerns about low interest rates and high household indebtedness through enhanced monitoring, conducting reviews of retail lending practices and stress testing of the institutions we regulate.
[Translation]
We have conducted significant reviews in other areas as well, including: cyber security and operational risk, corporate governance, and catastrophic risk such as earthquakes and flooding.
[English]
We've also issued guidance on many aspects of risk management, including residential mortgage underwriting, insurance companies' own risk and solvency assessments, liquidity adequacy requirements and, of course, regulatory capital requirements, as I have noted earlier.
[Translation]
OSFI also participated in the International Monetary Fund's financial sector assessment program. The IMF report was very favourable about the effectiveness of the Financial Institutions Supervisory Committee partners' oversight of Canada's financial system.
[English]
I'd like to also quickly list some of the work we've undertaken to address our second priority, which is to address risks emanating from regulatory reform itself. We work quite closely with banks and insurance companies to gather data and assess the impact on these companies of the new capital requirements that have followed the financial crisis. We work similarly with banks on the new liquidity requirements, and we've closely monitored and we've made some pretty active representations about the evolution of international accounting standards and how they will affect the capital frameworks for our banks and insurance companies.
Much of the reform to date, globally and within Canada, has focused on the really big players in financial services. These are the financial institutions whose failure could threaten economic stability. In Canada, my predecessor designated six institutions as domestic systemically important banks, which we refer to as D-SIBs. OSFI has placed higher capital and reporting requirements on the D-SIBs and they are also subject to more intense supervision.
At the same time, we recognize that in some instances we may need to establish different expectations for Canada's smaller financial institutions, whose failure would not threaten financial stability and whose resources are not as plentiful as those of the D-SIBs. It is certainly important for these institutions to manage their risks appropriately, but we recognize that a one-size-fits-all approach could inhibit their ability to compete and grow. As a consequence, we are considering how best to apply our regulatory and supervisory approach to the smaller institutions so that our expectations are not an unnecessary burden on their ability to thrive, while respecting prudent standards in risk management and capital.
It has been over six years since Lehman Brothers filed for bankruptcy and that failure ushered in the global financial crisis, and significant changes and improvements in prudential regulation and supervision. It is important to recognize that even before those improvements, our financial system and economy got through the crisis in relatively good health and this is because of the sound management of our financial institutions, along with diligent regulation and supervision. Since the crisis, as I mentioned, we have increased the requirements for both the quantity and quality of capital and liquidity, and we have raised our expectations about risk management and risk measurement in many areas. At the same time, the Canadian financial services industry has continued to enjoy strong results.
Looking ahead, we will continue to focus on the priorities set out in our annual report and to strengthen the Canadian approach to prudential supervision and regulation.
[Translation]
So, thank you for having allowed me to provide you with a quick overview of the work of my office and our current focus. I look forward to responding to your questions.
[English]
The Chair: Thank you, Mr. Rudin. I'd like to go back to one of your opening comments and, if I may, quote directly from your presentation:
OSFI is Canada's prudential regulator, promoting financial stability by keeping a close eye on the solvency, the liquidity, the safety, the soundness of federally regulated financial institutions.
Now, if I look back 25 or 30 years, I suspect somewhere around the time that OSFI was founded sometime in the 1980s — I think it was 1987 — my recollection is we had several bank failures. I think one was the Canadian Commercial Bank. Am I right with that name?
Mr. Rudin: It was indeed.
The Chair: There was a Northland Bank and we had many, many trust companies in serious difficulty. This is only to say that I suspect our financial structure in Canada was not one that would have received global attention.
Fast forward 25 or 30 years, all of a sudden we're the paragon of what you should have as a regulatory oversight, the strength of our banks, et cetera. Tell me what happened. What happened in the 25 years? It didn't happen just because somebody wrote some new regulations. What do you think happened? What made the change?
Mr. Rudin: There have been a number of contributing factors. One is that there was certainly an important increase in the requirements of capital for financial institutions, deposit-taking institutions more generally. Capital loss absorbing capacity is one of the most important aspects of bank regulation and supervision because it's the ability to absorb losses — severe but still plausible losses — and still serve clients. That provides for continuity. For understandable reasons, institutions sometimes resist having as much capital as the public would like them to have.
It's important for this to be compulsory. It creates a level playing field across the institutions and makes for a much more stable system. We were able to do that in Canada. Another thing that happened, which was helpful although not as helpful as it might have been, was the creation of international standards for capital requirements. As I mentioned, that first agreement hammered out in the Swiss city of Basel, known as Basel I, was helpful in making it possible for regulators to impose prudent standards, capital requirements without unnecessarily impeding the competitiveness of their banks with others. That said, my predecessors very wisely looked at the requirements in Basel I and II and said that's not enough for Canadian purposes, and deliberately established higher capital requirements for our banks than had been agreed to internationally. That paid off very much at the onset of the financial crisis because that capital was in place and was known to be in place.
For other reasons that we'll have a bit of time to discuss, Canadian banks by and large didn't experience the dramatic losses that happened in other countries, but the knowledge that the capital was there as the crisis played out was instrumental in preserving confidence in the system and would have been very useful had the loss experienced been worse than it actually was.
Those are important contributing factors. The other is that we do not only regulate in Canada, we supervise. Close supervision of financial institutions, close examination of their risk management practices, and adopting — in the wake of the failure of CCB and Northland — a much more proactive approach for dealing with troubled institutions, which is embedded in the legislation that governs us, has also been very important in keeping the financial sector stable.
That said, we have to give credit to the management of the institutions themselves at the same time.
The Chair: Could I assume from your comments that Canadians could take comfort in the fact that the relationship between the Canada Deposit Insurance Corporation, OSFI, the Department of Finance and the Bank of Canada worked collaboratively to effect the substantial safety net that we have in Canada today?
Mr. Rudin: I agree. The strong working relationships we have, which are partly grounded in statute and partly grounded in custom, expectation and the culture we have, is an important part of our system. It has been cited by the IMF and other observers as one of the strengths of our system. When you look at some of the difficulties that happened in other countries, poor communications between various arms of the government is often cited as one of the weaknesses.
Senator Tannas: Welcome to the committee, sir. Thank you for your opening comments. I have two questions. I will put a light in the window for my second question in the next round if that's all right. First, I'm from the insurance industry, and still involved. There has been a lot of talk in our industry around the tremendous risk and worry about earthquakes, particularly in the Lower Mainland of B.C. and in Quebec, and what that could potentially do to overwhelm the Canadian insurance industry and possibly spill over into the banking industry by virtue of defaults on loans of damaged houses that are not insured or insured by an insurance company that can't pay.
I know this is a subject that's moving along and I think the members of the committee would be interested to know where OSFI has put its efforts and its influence to date, and where you think you might be in the future.
Mr. Rudin: Broadly speaking, OSFI in recent years has taken two important steps in this regard. One is to revise our guidance about the capital that insurance companies should hold against earthquake risk and has raised that capital requirement.
We do this by requiring the insurance companies to estimate, within the plausible range, the most severe earthquake that they might experience. Usually in the earthquake business, as in flooding, it's done as one in X number of years; and we've substantially increased that horizon and the capital requirement that goes along with it. This provides an additional measure of protection for policyholders against the failure of an insurance company in the wake of a quake.
You put your finger on something important. As do other financial institutions, including the banks, we have to examine exposure to earthquake and look at an earthquake scenario and stress test their portfolio to see how exposed they would be. These are both positive steps. They have not led, as you alluded to, the high levels of earthquake coverage that would be desirable on the face.
The Chair: Senator Tannas, at this committee we allocate by time, not by number of questions, so please continue.
Senator Tannas: Great. You were given the position and came in from outside OSFI. Your predecessor was a home-grown person promoted from within. You're 100-plus days in. What observations do you have? Without surprising anybody, could you share any observations of renewal that you can see within the organization?
Senator Massicotte: What was your first mistake?
Mr. Rudin: I'll take your previous question first and hope that you forget the second question. Just by way of background, the financial institution supervisory committee provides a window into the operations of OSFI for all of the members. I've been attending that since I became ADM Financial Sector Policy over six years ago. To that extent, I had a window in, which I think was very helpful.
I've been very impressed — not surprised — by the quality of the staff that works at OSFI — the people, not only their background and skills, although it's an impressive array. Many, particularly in supervision, come in from the financial sector and have a commitment to what we do with a level of engagement and derive an amount of satisfaction from their work. As I said, I wasn't surprised by that, but it's gratifying.
I've done a pretty common thing for an incoming CEO — try to meet with as many people as I can, so I've been doing one-on-one meetings with my top 50 people. I always get very thoughtful comments. There are a number of touch stones that we do at OSFI: our supervisory framework, our focused mandate and the quality of colleagues that really matter to people. That's very impressive and reassuring to me.
In terms of moving forward, the priorities for this year are very similar to the priorities for the previous year. We need to continue to move ahead internally with renewing our infrastructure. We're going to put an additional emphasis — this is mentioned briefly in the annual report — on enhancing our supervisory processes. We hired a lot of new supervisors in the wake of the crisis. That was definitely a good move of my predecessor. It's a job to bring people in and make them supervisors. We need to pay attention to how we enhance our supervisory culture and to look at our processes so we can be more efficient and get more out of the resources that we have.
Finally, we've been through a period of very rapid and justifiable growth; but circumstances permitting, we're coming to the end of that period. We need to spend more time thinking about managing within an existing envelope rather than continually adding to it.
[Translation]
Senator Massicotte: Congratulations on your appointment, Mr. Rudin.
Mr. Rudin: Thank you very much.
Senator Massicotte: In 2008-09, we went through a financial crisis and we are still living with the consequences. That financial crisis revealed that Canada is very well positioned as far as its financial institutions are concerned. Nevertheless, a global financial crisis affects all the world's players, especially a country like Canada, which imports and exports a great deal.
Every country, especially those in the G8, showed a willingness to institute reforms designed to reduce the risk of seeing such a crisis happening again. In 2008-09, many countries, including the emerging markets, made the commitment to achieve that. Does that willingness still exist? Will we see the desired results? Do you think we are headed in the right direction?
Mr. Rudin: In my opinion, that willingness still exists. Canada has made a lot of progress on the world stage, especially with the new Basel Accord, which establishes new standards for bank capital. What that means is a significant increase in the amount and the quality of the capital.
The other important factor is that we have agreed to establish a peer-review process to check whether countries are complying with the new standards and to what extent. In my opinion, that will encourage countries to comply.
That said, some parts of it are simple and other parts are harder. One of the more difficult aspects is achieving consistency between regulatory systems so that financial institutions that are active globally can participate without a huge burden to manage, without the difficulty caused by a lack of consistency between one country's regulations and another's.
That remains a work in progress. It is one thing for a country to decide to change the regulations or to tighten the parameters of a program. It is more difficult to achieve something that works consistently from one country to another. It is important, because lots of people have a counterpart in one country and another counterpart in another country. So, when programs differ, it impedes the effective delivery of financial services.
[English]
Senator Black: Mr. Rudin, as my colleagues have said, congratulations to you in your appointment and thank you very much for the service that you continually provide to Canadians.
Like in so many things, hindsight is always 20/20. Using foresight, I wonder if you could share with us the top two or three things that you worry about in your new role.
Mr. Rudin: Sure. Let me start with the top one. It sort of encompasses them all.
If you read the history of a financial crisis in another country or a major institution failure, I would assert that all of them have the following narrative: There were a bunch of warning signs; it was obvious; it was an accident waiting to happen; people should have seen it; they didn't recognize the signs; or they willfully ignored the signs. That's the thing that bothers me most. Is there something staring us in the face right now but we don't see it? That's a question I ask myself constantly.
In cooperation with our partners around the FISC table, we take a very active attempt to look over the horizon to identify weaknesses. The Bank of Canada, as you may know, does this for the system as a whole, and they publish their results in their financial system review. It is such a common part of the narrative of any major financial institution failure that I always assume there's something; and I'm always driving my colleagues crazy. What about this? What about that? What are we missing? That's the first thing.
The second thing that I always assume is that I'm not going to find it, which is a bit depressing, but I can't afford to assume that I'll be able to, or my colleagues, as smart and devoted and motivated as they are, will be able to spot it. This is why capital and liquidity are so important, because they're generic protections. They're not scenario-dependent. If you've got a lot of capital, you can absorb losses and whatever loss there is.
One of the things that's very important internationally, something we've also done in Canada, is to improve what we call the quality of capital. That's kind of an odd expression: What's the quality of capital? High-quality capital will be able to absorb losses regardless of the scenario. We have in the past recognized as capital things that might be loss-absorbing in certain circumstances but not so loss-absorbing in other circumstances. You've got more capital, higher quality capital and greater liquidity requirements. They're generic and the best protection against the scenario that I may fail to see.
Senator Black: Switching gears, if I may, as the primary regulator and supervisor of federally regulated pension plans, are you able to comment on the quality of risk management, governance and solvency of those plans that you oversee?
Mr. Rudin: I'd be glad to. The bulk of the regulations about pension plans are set by the government and we administer them. They focus particularly on two areas. One is for all types of pension plans, basic but important things, such as whether the money that's being deducted from people's paycheques is actually being handed over to the pension plan, those sorts of things. We have a mandate to protect the interests of the members and pensioners in particular, so that's important.
For defined benefit pension plans, where many of the contributions are invested against a promise of specific benefits going forward, the investment strategy and risk management are very important to protecting the security of the benefits going forward. In that regard, we look at whether the investment plan is prudent.
The regulations allow, and I think appropriately, a fair bit of flexibility to the managers because it's the managers of the pension plan that are responsible at the end of the day, just as the managers and boards of banks and insurance companies are responsible for their results at the end of the day. But they certainly have to meet a prudent person test, and we look at various indicators to see if we can get ahead of them.
With that said, going into the financial crisis, many of our pension plans had an investment strategy that was certainly affected by the dramatic changes. You've got a typical pension plan, and this was the conventional wisdom in the investment and actuarial business; you need to have equities and long bonds. As interest rates fell, the present value of the liabilities went way up. The bond portfolio also went up in value but not as much as the value of the liabilities.
What was in equities, you'll recall, fell dramatically and we had very dramatic reductions in measured solvency ratios. There has been quite a rebound in that with the improvement in equity values and some, until recently, back up in long rates towards something a bit more normal, but we do watch that quite carefully. The solvency situation remains exposed to volatility in asset markets, there's no question about that.
Senator Black: I would take from that that for those folks watching us who are pensioners regulated and supervised by the work you do, can I take it that you are confident in the existing risk management governance and solvency provisions of the federal pension plans that you oversee?
Mr. Rudin: Well, we have 1,200 pension plans. I think we have a good regime, but it's not a regime that is designed to guarantee the solvency of the pension plans. The regime is based on the idea that these are a private bargain. Someone's got to be looking out for the interests of the pensioners and members, and that is the office of the superintendent, but at the end of the day, the investment and benefit decisions are private decisions and management is responsible. It says quite explicitly in the legislation that this does not obviate the possibility that benefits might have to be reduced in some cases. That's our system.
Senator Ringuette: Thank you. I have two questions for Mr. Rudin.
Last spring, this committee was very concerned with cooperative insurance companies that were looking into becoming non-cooperative organizations. Would you be involved in the supervision of that transition?
Mr. Rudin: I believe, senator, you're speaking about the possibility of demutualizing a property and casualty company or a general insurance company. The government has in legislation established that a property and casualty company may demutualize, but only in accordance with the regulations established by the government, and those regulations have yet to be promulgated and brought into force.
I believe there is a consultation on what those regulations should be that was launched by my former colleagues at the Department of Finance, but the actual regulations have not been specified. So I do not yet know what role, if any, OSFI will have in the supervision of such a demutualization. It wouldn't be surprising if we had some role because we certainly had a role in the demutualization of life insurance companies, but this is yet to be determined.
Senator Ringuette: My other question is not only of concern to me. We're talking about a real estate bubble, where particularly with huge condo buildings in every major city in Canada, as far as I know, the rule of thumb used to be you could start building if 60 per cent of the properties were sold.
What are the guidelines you are providing to financial institutions with regard to these kinds of huge commercial undertakings? We've been hearing for almost two years that there's a real estate bubble in Canada. What are your implications? How are you looking into this issue?
Mr. Rudin: Let me start by talking about residential mortgage lending in general and then I'll focus on condominium construction lending, which I think was one of the issues that you raised.
We have a guideline that's a relatively new initiative on residential mortgage lending in particular. It's our guidance to institutions that are in the business. It is largely principles-based. It says that if you are in the residential mortgage lending business, you need to have an underwriting policy. The decision on what the policy is would be up to you, but you need to have one, and you need to monitor and measure yourself against that policy so that you don't inadvertently start moving down the credit curve, so to speak, without even knowing it.
There are a few bright lines in the mortgage underwriting guideline that aren't entirely principles-based. One is that mortgages have to amortize. You can't make mortgages, at least mortgages with elevated loan-to-value ratios, that don't amortize, that don't pay down over time. There are home equity lines of credit that don't necessarily amortize, and we have a bright-line limit that the maximum loan-to-value ratio on a home equity line of credit is 65 per cent. This is to ensure that, on average, the book amortizes, and that definitely reduces risk over time.
The other bright-line test is you have to assess the borrower's ability to repay. One of the big issues in the United States during the sub-prime crisis was people were getting mortgages without any regard for their ability to repay, despite in some cases the lender being convinced they wouldn't be able to repay. The idea was the recovery would be made either by selling on the mortgage to someone less informed or by seizing the property at default and selling it. It definitely will require the lenders to assess and consider ability to repay and also to carefully assess the value of the property. You can't be heedless about any of those things.
The other thing that's important from a financial stability point of view is, of course, we look carefully at the amount of capital, the loss absorbing capacity that residential lenders have against their book.
I should mention we also supervise the private mortgage insurers. It's the default risk on high ratio mortgages, so mortgages above 80 per cent loan-to-value ratio. It doesn't stay with the lender, it by law has to go to a mortgage insurer, whether it's CMHC or the private insurers. We supervise the private insurers and we examine CMHC, which is similar but not exactly the same as supervising it.
Senator Ringuette: Which is recent.
Mr. Rudin: Which is also recent, and we have a draft guideline for the mortgage insurers, which we will shortly be finalizing.
In terms of construction lending, we don't have as detailed a guideline about construction or other forms of lending, whether it's credit cards or auto lending. The guideline on residential mortgages is a bit of an exception for us and we did it because of the very large exposures that we have across the system, the materiality of the residential mortgage book. And, of course, to some extent things that restrain risk taking or improve risk management for the residential mortgage lending also reduce risk in the condo market because there's a buyer at the end of those condos and many of those condo buyers have mortgages, not all by any stretch, but many of them do.
This was a decision that belongs to the minister rather than OSFI, but if a person wants to a buy a condo and rent it out, they can't get an insured mortgage for that condo so that means that the loan-to-value ratio can't be any higher than 80 per cent for that.
We do have a few, not a great many, institutions that do construction lending and we take a close look at commercial real estate in general and we, again, have principles-based requirements for them that they have underwriting policies that they measure and monitor their risks and we carefully watch the capital that they have against those risks.
Senator Ringuette: You monitor a portion.
Mr. Rudin: Yes.
Senator Ringuette: Okay. That doesn't relieve my concerns though but, anyway, I think there is an issue out there and we'll see. Thank you very much.
[Translation]
Senator Bellemare: I would like to go back to the problem that Senator Black raised about private federally regulated pension plans. This particularly interests me. Going back to your risk assessment framework, you explained earlier that the liquidity of some private plans may be on shaky ground. They are not all fully capitalized and solvent. You also raised the idea that some plans should perhaps consider reducing their benefits.
So here is my question: does the Office of the Superintendent of Financial Institutions have clear rules for private pension plans that have a major liquidity problem? For example, are there rules under which a company has to improve its liquidity, its capitalization in five years or 10 years? Are there rules of that kind? That is my first question.
Mr. Rudin: There are rules of that kind already. Retirement plans are subject to solvency assessments. When there is a shortfall, they need a plan to address it. The timeline is generally about five years. That said, if something else negative occurs, a reduction in the value of the assets, for example, that triggers another plan that will restore the liquidity.
Those rules are established by the government on the recommendation of the Department of Finance. It is our duty to oversee, manage and audit pension plans to make sure that they are in compliance with the regulations. In terms of protecting pension plans that are in a less favourable situation, those, for example, with a solvency ratio of less than 80 per cent, we impose restrictions in order to prevent the solvency from deteriorating further.
Senator Bellemare: Continuing along those lines, we know that, with interest rates and returns low, there are stock market booms, but, overall, revenues are not as great as they were. The current value of pension schemes is greater and contributions have to be raised. As superintendent, do you have an idea of the contribution rate, as a percentage of the payroll, for traditional defined benefit plans? What might the overall contribution rate be that will achieve an overall balance and allow promises to be kept?
Mr. Rudin: I do not have those figures at my fingertips. If I recall correctly, the average insolvency rate for federal retirement plans at the end of last year had improved by more than 90 per cent, actually 91 or 92 per cent. I can provide you with the precise figures, which are encouraging.
At the same time, the percentage masks significant variations between plans. If you take similar situations, with stock market indices at such and such a level and interest rates at such and such a level, there are major discrepancies in insolvency rates. That is a function of the demographics of the plans, the investment history and the current investments. It all makes a significant difference from one plan to another.
Senator Bellemare: I have one more question for you. Do you know the current average contribution rate for retirement plans? Is that information available for federal defined benefit plans? Looking at the amounts that the employees and the employer contribute, do we have an idea of current rates? An option to consider would be to increase contribution rates rather than to reduce benefits.
Mr. Rudin: I understand. I do not even know whether we have that figure, because we ask for reports on solvency. I am not saying that we do not ask for that information, but I do not know. Something else to point out it that there are plans that are closed, meaning that no one is currently contributing to them. The plans still exist because benefits are payable to those who participated previously. Very few people contribute to those plans because they are not offered to new employees. In some cases, the plans are completely closed and there is no option to increase contributions because there no longer are any.
Senator Bellemare: The plans turn into defined contribution plans.
Mr. Rudin: It is possible to continue paying benefits based first on the performance of the invested premiums and then on any potential contributions from the employer.
Senator Maltais: Congratulations, Mr. Rudin.
Mr. Rudin: Thank you very much.
Senator Maltais: We feel sure that you will perform this huge task with all the skill we know you have.
Mr. Rudin: Thank you very much.
Senator Maltais: I come from the world of insurance too, not as an owner, like my colleague Senator Tannas, but as a broker and an insurer. We are seeing a phenomenon today that we did not see perhaps 20 or so years ago. This is the repeated acquisition of insurance companies and insurance trusts. Are you at all concerned that we now find ourselves with 10 or 15 major sectors that we cannot avoid, and that they will be controlling the world of insurance in terms of general insurance?
Mr. Rudin: Our responsibility is to make sure that institutions are well managed and capitalized. We are also responsible for paying attention to competition and making sure that the sector is effective. A sector that is more open to new competitors will be more effective. We do not have a mandate to directly consider the effect of a merger on competition. That responsibility lies with the Competition Bureau. Potentially, it is something that the minister might consider. In terms of the life cycle of institutions, the creation of a new institution, a change of control and so on, even if I have to make recommendations to the minister, at the end of the day, the minister makes the decisions. He could consider the non-prudential factors at the appropriate time.
Senator Maltais: In Quebec, the Mouvement des caisses Desjardins has become the second largest financial cooperative in the world, which is no small achievement. It is also involved in a lot of acquisitions. Following a system of recapitalization, it has been selling parts each year. This year, it stopped doing so, probably for a number of reasons. I now find my tax deductions to be no more, but that is life.
The Mouvement des caisses Desjardins is making a lot of acquisitions in an area under your control. It even acquired a bank. You remember the Laurentian Bank, which has a federal charter. Slowly but surely, it is slipping into federal government control. It comes under the jurisdiction of the provincial government because it is a cooperative. But, because of its activities and its actions, it is almost under federal jurisdiction.
Do you have an opinion on that? How does it see that indirect transfer?
Mr. Rudin: In my opinion, Desjardins remains largely regulated by the province. Where OSFI has a role is if Desjardins becomes the owner of a federal insurance company under federal prudential regulation. Other companies come under provincial prudential regulation. That is also the case if Desjardins acquires a bank, because all banks are federally regulated.
As for Laurentian, it was, but is no longer, a Desjardins affiliate. I believe it has become another small bank.
A large majority of Desjardins' operations and assets continue to be overseen.
Senator Maltais: In Quebec and in Canada, when we talk about reinsurance, the risks are often distributed between different companies, but we also get into international markets, especially in the United States.
Mr. Rudin: Yes.
Senator Maltais: One question has always occurred to me. As brokers, as reinsurers, we were supposed to get information about a company's solvency. So we went to the American federal government department in charge of finance and banking.
Today, do we have a better way of verifying whether the co-insurer that we are looking for in New Hampshire, for example, is solvent? Do we still have to rely on that kind of report, or do we have a more modern tool, a quicker one, to tell us whether it is solvent?
Mr. Rudin: In general, reinsurance is an important part of insurance companies' risk management, as you well know, probably better than I do. So it is essential to have a market that works really well. We recognize, however, that we cannot regulate and supervise all reinsurers.
Senator Maltais: That is true.
Mr. Rudin: What is actually important is to spread out the risk. In Canada, certainly, but not exclusively, for life insurance, we have affiliates of large European or American companies. Our insurance companies often have the option of doing business with an affiliate that is supervised, overseen, by the OSFI. We believe that it is always important to understand that those companies are free to look for their reinsurers elsewhere. Of course, we have less information about the solvency of insurers from elsewhere, about whether they go to the capital markets to make commitments in the event of a disaster, for example. Once again, we have less information on that. In a way, that is the compromise we have to make.
Senator Bellemare: My question is about something other than pension funds; it is about the international financial system.
I have been asking myself this question since 2007 and I have never been able to find an answer. It occurs to me that, in your position, with your trips to Basel, you might be able to answer my question.
You will recall all the financial difficulties we had in Canada in 2007. I was in Quebec at the time and, in the course of a parliamentary committee, we were questioning some of the people involved. One of the questions we asked in 2007 was about the ABCP, the asset-backed commercial paper and about the whole matter of the securitization of assets. At the time, the Bank of Canada did not understand commercial paper. I asked myself at the time how it could have flown under the radar.
Let me ask the question, because, earlier you said something very, very important. You said that you were checking to find out what cannot be seen.
Mr. Rudin: Yes.
Senator Bellemare: Today, could a financial innovation like that fly under the radar of national and international oversight?
Mr. Rudin: Let me say two things about that. First, I hope not. I think we learned our lesson in 2007-2008 and our oversight is now greater and more rigorous as we try to avoid similar gaps in our knowledge.
That said, it is one of the reasons why I told you that little story about the inability to see the warning signs or possibly perhaps to not understand them. In the Bank of Canada's Financial System Review, there were at least two, possibly three articles on the ABCP being issued by organizations that were not banks. The last of them was published, I remember it very well, in June 2007, before the freeze in the market, that is. The article very clearly explained the problem with, and the fragility of, the system.
I read the article in June 2007, but I did not realize the scale of the problem. The information was there, the signs were there, but, at the time, I did not see them. Perhaps it was because of my lack of experience, but it was also because there were some unusual aspects. That is why my answer to Senator Black was yes. Each day, I assume that there is something to be found and that could be overlooked. We must always be mindful of the hypothesis that we might miss something. We then have to rely on different approaches in order to forearm ourselves against a financial crisis where the superintendent, or anyone else, might not recognize the problem or the warning signs that would keep us ahead of it.
Senator Bellemare: I am going to read that article. Thank you very much.
[English]
The Chair: Mr. Rudin, you have been succinct, direct and transparent, and you have answered our questions very clearly. That's a characteristic that I know this committee enjoys very much. I know I speak on behalf of every member of the committee wishing you all good wishes for your new position as superintendent, and we are delighted with your appearance today. We look forward to your appearance sometime in the future again.
Mr. Rudin: My thanks to all of you.
(The committee continued in camera.)