The Office of the Superintendent of Financial Institutions (OSFI) released the 2023-2024 edition of its "Annual Risk Outlook" (ARO) on April 18.
This is the second time OSFI has published this document intended for the general public. If risks evolve during the year, an update may be published in the fall.
The ARO outlines the risks viewed as most significant facing Canada’s financial system over the next 12 months, as well as the actions OSFI will take to respond to these risks.
Superintendent Peter Routledge says the regulator promotes “sound risk management in the financial sector in a deliberate and proactive way to reinforce Canadians’ confidence in our financial system.”
OSFI is working with the Department of Finance to introduce legislative amendments to modernize the federal framework to address emerging risks to Canada’s financial sector and ensure the integrity and security of federally regulated financial institutions (FRFI), including against foreign interference. These changes were announced in the 2023-2024 budget tabled by Minister Chrystia Freeland in late March.
Nine key risks are identified, along with the supervisory and regulatory actions OSFI is taking to address them.
Housing market downturn
Regarding the housing market downturn risk, OSFI notes that “given the significant impact of real estate secured lending (RESL) activities in the Canadian financial system, a housing market downturn remains a key risk.”
The OSFI’s supervisory work includes ensuring that FRFIs’ lending standards “are aligned with Guideline B-20 (Residential Mortgage Underwriting Practices and Procedures) expectations. “
Liquidity and funding
The second threat listed is liquidity and funding risk. This risk did not appear in last year’s report.
“As financial systems digitalize, the speed and amplitude of investor and depositor reactions to both environmental and idiosyncratic stresses will intensify,” the outlook reads.
“This phenomenon will challenge institutions and policy makers to adapt their business and regulatory infrastructure with agility and urgency. These vulnerabilities may manifest as the slowdown in the general economy and weigh on households and industry.
To address this risk, OSFI will revise its capital and liquidity guidelines, which have been updated to reflect the Basel III reforms.
OSFI also plans to issue a discussion paper on liquidity risk for insurance companies in the first half of 2024.
Commercial real estate
Regarding the third risk, related to commercial real estate (CRE), the OSFI expects that “hybrid work arrangements and reduction in staffing levels are likely to affect demand and, over time, have a negative impact on office asset valuations. Macroeconomic developments, particularly consumer spending preferences, can also have a negative impact on retail assets’ post-covid recovery.”
Also in connection with Basel III, OSFI updated its capital requirements, notably to add more granular requirements for CRE financing.
The fourth threat is the risk of transmission from nonbank financial intermediaries (NBFI). This threat did not appear in last year’s report either.
This sector comprises broad categories of entities, including insurers, pension funds, financing companies, independent broker-dealers, and regulated and unregulated investment funds.
In times of high volatility, financial margin requirements throughout the system can surge, OSFI says. “If CPP capital requirements and default fund rules are not appropriately stressed, measured, or anticipated, member default risk could be transmitted broadly.”
OSFI will carefully monitor counterparty risk that could weaken the banking industry, especially during market downturns.
In terms of corporate and commercial credit risk, the OSFI thinks that commercial debt remains a significant exposure for FRFIs.
Rapidly rising interest rates are increasing borrowers’ financing costs. New loan origination volume is slowing, and refinancing is becoming more challenged, they point out.
The sixth threat monitored by OSFI in 2023-2024 is digital innovation risk. The delivery of financial services is being altered by the acceleration of digital innovation.
While the recent collapse of several cryptocurrency firms and projects implies diminishing risks for the mainstream financial sector, digital risks continue to grow, the Bureau notes.
Climate risks will be a major focus for OSFI in the coming year. Increases in the frequency and severity of physical risk events could affect exposed insurance liabilities, invested assets and loan portfolios, it says.
Given the carbon-intensive make-up of the Canadian economy, an aggressive transition to alternative energy sources also carries risks.
OSFI says that expectations for climate risk resilience in FRFIs will be integrated with its new Supervisory Framework, which is one of its transformational Blueprint initiatives. In a related action, it will soon launch its Climate Risk Forum.
Cyber risk is another concern. “A successful cyber-attack could result in impacts to the confidentiality, integrity, and availability of data and computer systems, which could result in loss of public trust, reputational damage, and financial loss" OSFI points out.
After being piloted in 2022-2023, the intelligence-led cyber resilience testing (I-CRT) will be integrated in an implementation guide, based on a more formal framework, in spring 2023.
The OSFI Guideline B-13 on technology and cyber risk management was issued in July 2022. It will take effect on January 1, 2024.
Third-party risk rounds out the list of nine major threats under scrutiny. “The financial services industry continues to expand its use of third-party arrangements. Increased dependency on external arrangements heightens the risk that FRFIs could be unable to deliver critical services or that their data could become compromised. Third-party providers may also have external arrangements of their own, which creates additional complexity for oversight,” the Bureau explains.
OSFI has issued a guideline (B-10) related to this risk in April 2023. The requirements for FRFIs have been strengthened in this final version.