Canada's financial regulator has told the country's six largest banks they are crucial to the country's economy – and that they must hold more capital on their books to protect against a liquidity crisis.
Even though the major banks have been granted more than two years to build this new cushion, analysts say the pressure will be on the sector to hit those targets almost immediately.
The federal banking regulator announced Tuesday that the country's Big Six lenders will face a 1-per-cent surcharge to their risk-weighted capital, meaning they will have to hold an extra buffer of capital on their books by 2016, when the new regulations take hold.
The move is designed to avert a liquidity crisis in the sector, and comes on top of the 7 per cent of capital that the Office of the Superintendent of Financial Institutions (OSFI) requires them to hold, which can be easily liquidated by the banks during a time of financial pressure to stabilize operations.
The six financial institutions named by OSFI to the list of "domestic systemically important banks" are Royal Bank of Canada, Toronto-Dominion Bank, Bank of Nova Scotia, Bank of Montreal, Canadian Imperial Bank of Commerce and National Bank of Canada.
The list signals which financial institutions could potentially pose a problem to the Canadian economy if they were to encounter liquidity problems and ultimately fail, and requires them to hold more capital as a worst-case-scenario defence against such problems – and avoid a government bailout. Bond-rating agency Moody's Investors Service said regulators looked at several factors to draw up the list of systemically important banks in Canada, "such as asset size, degree of interconnectedness … and the degree to which each participates in Canada's payment system and financial markets."
The move had been widely telegraphed by the banking regulator for the past year, and was signalled in last week's federal budget.
However, even though banks are being given a lead-up time to comply with the regulations, analysts noted that the unwritten expectation in Canada is that they will adhere as soon as possible to the new threshold – and will most likely exceed the new level even further – to appease regulators.
"While the incremental buffer formally takes effect in 2016, the precedent here in Canada suggests that phase-in periods are for the weak and are to be disregarded," CIBC Capital Markets analyst Rob Sedran said in a research note to clients. "We expect the banks to formally target 8.5 per cent and operate closer to 9 per cent."
Based on recent company data, National Bank of Canada is the only member of the Big Six not currently above the new minimum threshold. However, National's ratio of 7.9 per cent is only marginally below the 8 per cent of so called Tier-1 capital that is required.
Canadian Imperial Bank of Commerce has the most room to breathe, at 9.6 per cent, followed by Bank of Montreal (9.4 per cent), Royal Bank of Canada (9.3 per cent), Toronto-Dominion Bank (8.8 per cent) and Bank of Nova Scotia (8.2 per cent).
While National may look to boost its capital levels in the coming months, analysts don't expect the bank will have any trouble reaching the necessary level by the next year or two.
"The 8 per cent minimum ratio was widely anticipated by the market and is easily achievable given the current pace of capital generation," Mr. Sedran wrote. "In fact, our estimates imply that without capital deployment, all of the banks would be far in excess of that level by the 2016 formal implementation date."
Though National Bank is considerably smaller than Canada's Big Five banks, its inclusion on the list is largely a nod to how intertwined the banking sector is, since problems at one bank could cause issues at another. With $145-billion in assets, National Bank is less than half the size of fifth-biggest bank CIBC.
Moody's said National Bank's inclusion on the list has more to do with the fact that it is so much bigger than other smaller banks such as Laurentian Bank and Canadian Western Bank. "OSFI attributes the inclusion of [National Bank] to the fact that it is significantly larger than the remaining banks on the list," Moody's said, adding that at a time of stress it would be difficult to determine which of the Big Six were systemically important, so it was safer to include National. "The list is not intended to be static, but will be reviewed and updated as necessary," Moody's noted.
John Aiken, an analyst with Barclays Capital, said he didn't think it would have an effect on bank share prices, which were largely unaffected yesterday. "Given the capital positions of the banks … and the fact that the transition will have three years to be implemented, we do not believe that this will be an onerous burden," Mr. Aiken said in a research note to clients.
Editor's note: A reference to Bank of Nova Scotia has been corrected to Bank of Montreal in relation to Tier-1 capital standings in the online version of this story.