Increased Canadian Capital Requirements Support Bank Credit Profiles

Fitch Ratings-New York-09 December 2022: The Canadian bank regulator’s 50 basis points (bps) upward adjustment to its Domestic Stability Buffer (DSB) requirement to 3.0% supports bank credit profiles and appropriately addresses rising risks, according to Fitch Ratings. The higher DSB, which applies to domestic systemically important banks, and is effective February 2023, will raise the common equity Tier 1 (CET1) ratio requirement to 11.0% from 10.5%. In addition, the Office of the Superintendent of Financial Institutions has increased the range of the DSB to a maximum of 4%, from 2.5%, signalling that capital requirements could rise further on future semi-annual (June and December) DSB calibrations.

Fitch views the higher capital requirement as appropriate, as it coincides with building risks related to the rapid rise in interest rates this year, including an ongoing housing market correction, declining household savings, and an anticipated economic slowdown. Fitch forecasts a decline in Canadian GDP to 0.6% in 2023 (from approximately 3.5% in 2022) and a rise in the unemployment rate to 6.1% (from 5.1% as of November 2022), according to its December Global Economic Outlook. The effective date of the revised DSB also coincides with the phasing in of final Basel III rules, which Fitch estimates could reduce risk weighted assets by approximately 3% across the six largest banks in 2023. All else being equal, we expect that the impact of the fully loaded Basel III rules over the three-year implementation period will be modest.

The regulatory capital changes are particularly salient for Bank of Montreal (BMO) and Toronto-Dominion Bank (TD) as they prepare to close significant all-bank acquisitions. Prior to the announcement of the DSB increase, BMO communicated that it’s CET1 ratio could fall below 11.0% on completion of its acquisition of Bank of the West (anticipated before March 31, 2023) with a build-up above 11.0% by the end of the fiscal quarter ending April 2023. In Fitch’s view, BMO, which reported a CET1 ratio of 16.7% at October 2022, could resort to continued use of loan sales, syndications and synthetic transfers to shore up capital above the new requirement, if necessary.

TD, which anticipates completing its acquisitions of First Horizon Corporation and Cowen Inc. by April 2023, reported its expectation of a CET1 ratio “comfortably above 11% post-closing”, similarly indicating the possibility of limited headroom above the revised minimum requirement. Similar to BMO, TD has options available to shore up capital if necessary. During the prior quarter, TD sold a portion of its investment in Charles Schwab Corporation, reducing its holdings to approximately 12.1% from 13.4% of outstanding shares, in order to provide an additional 49bps of capital in advance of the acquisitions. TD reported a CET1 ratio of 16.2% at October 2022.

Royal Bank of Canada, which expects to close its recently announced acquisition of HSBC Canada by late 2023, has sufficient time to adjust its capital planning to the revised requirement, in Fitch’s view. It reported a CET1 ratio of 12.6% as of October 2022, and it estimated a pro forma CET1 ratio in excess of 11.5% post-acquisition completion.

Source: FitchRatings