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7 Endnotes

1 Introduction Back to top

The banking industry in Canada is one of the safest and most efficient banking systems in the world. For five years in a row, the World Economic Forum has recognised Canadas banking system as the soundest in the world. Canadas banking industry is composed of domestically owned banks, foreign bank subsidiaries, full-service foreign bank branches, foreign bank lending branches (which cannot take deposits and can only fund themselves on the interbank market) and foreign bank representative offices. As of March 2013, the banking industry in Canada comprised 25 domestic banks, 24 foreign bank subsidiaries, 23 full-service foreign bank branches, 4 foreign bank lending branches and 21 foreign bank representative offices. 1

Canadian banks are regulated by the Office of the Superintendent of Financial Institutions (OSFI), which is generally regarded as one of the most conservative banking regulators in the world. OSFI is a strong proponent of meeting international best practice and has publicly announced its intention to fully implement Basel III well in advance of 2019. This conservative approach has served the Canadian banking sector well, enabling Canadian banks to weather the financial crisis much better than most of their international competitors (the Canadian government did not have to bail out any financial institutions in Canada).

2 Regulatory architecture: overview of banking regulators and key regulations Back to top

General overview

The Bank Act. a federal statute enacted by the Parliament of Canada, is the primary statute governing the banking industry in Canada. The Canadian Constitution gives the federal government exclusive jurisdiction to incorporate banks, establish their business and investment powers, and impose capital and other requirements regulating the business and affairs of banks. While Canadian provincial governments may incorporate and regulate certain deposit-taking institutions, such as credit unions, only institutions incorporated under the Bank Act may refer to themselves as banks.

The Bank Act has been supplemented by numerous regulations, guidelines, advisories and regulatory rulings that elaborate upon the principles and rules established therein.

Canada believes that there should be a separation between the financial services sector and the commercial sector of the economy. Therefore, government policy is to restrict the ability of banks to engage in or own interests in entities that carry on non-financial services business.

Office of the Superintendent of Financial Institutions

The Office of the Superintendent of Financial Institutions Act was enacted by the federal government in order to establish one consolidated regulator for the banking and insurance sectors in Canada. OSFI is the principal agency responsible for overseeing banks and administering the Bank Act on behalf of the Minister of Finance. It was created to contribute to the public confidence in the Canadian financial system. As part of its role, OSFI publishes guidelines and advisories in respect of the sector and provides interpretive rulings on a case-by-case basis. Among the key guidelines established by OSFI are those that set out the adequate levels of capital and liquidity to be maintained by banks. The Capital Adequacy Requirements Guideline, which was revised in January 2013 to incorporate new requirements contained in Basel III, is the key guideline in this regard.

Financial Consumer Agency of Canada

The Financial Consumer Agency of Canada (FCAC) was established in 2001 to administer the consumer provisions of the Bank Act. including disclosure requirements regarding borrowing costs and deposit account terms. The FCAC does not have any authority to grant redress to consumers, but can impose penalties on banks for failing to comply with the requirements of the Bank Act and the regulations.

Canadian Deposit Insurance Corporation

The Canadian Deposit Insurance Corporation (CDIC) was established to ensure the safety of small deposits and to assist in maintaining public confidence and stability in the financial system by providing deposit insurance for bank depositors. Although the CDIC relies upon the examination reports of the Superintendent as its vehicle for monitoring the performance of a particular insured bank, it has the authority to request that it be appointed as receiver of a troubled bank in certain circumstances if it perceives that a bank is in danger of becoming insolvent and the CDIC is likely to be called upon to make insurance payments to the depositors of the bank.

3 Recent regulatory themes and key regulatory developments Back to top

In general, Canadian banks weathered the financial crisis much better than most of their international competitors. However, Canada recognises that remaining stagnant is not an option, and is therefore a strong proponent of continuing to meet international best practice, including with respect to capital and corporate governance.

Capital

Canada announced its intention to fully implement Basel III capital requirements on all Canadian banks well in advance of 2019 (with the majority of the requirements already being imposed by January 2013). In particular, OSFI mandated (i) that all non-common capital instruments issued after January 1, 2013 contain features that require them to automatically convert into common shares of the bank if the bank ever becomes non-viable, and (ii) that all existing non-common capital instruments without such features be amortised over a 10-year period on a straight line basis.

The Financial Stability Board released its October 2011 paper entitled Key Attributes of Effective Resolution Regimes for Financial Institutions, which recommends that all resolution authorities should have the ability to bail-in senior debt of a failing bank before taxpayers are exposed to losses. Pursuant to the Canadian federal governments 2013 Budget Plan, the federal government has proposed implementing a bail-in regime for systemically important banks, although there has been no public commentary as to how those bail-in debt requirements will be adopted in Canada.

In its 2013 Budget Plan, the Canadian federal government also introduced plans to impose a higher capital requirement on systemically important banks (as determined by OSFI). OSFI released an advisory in March 2013 describing considerations used to designate domestic systemically important banks and establishing a risk-weighted capital ratio requirement equalling a 1 per cent common equity surcharge for banks so designated. The Canadian banks designated as systemically important are Bank of Montreal, The Bank of Nova Scotia, Canadian Imperial Bank of Commerce, National Bank of Canada, Royal Bank of Canada and The Toronto-Dominion Bank. These banks are expected to meet the additional risk capital ratio requirement of 1 per cent by January 1, 2016.

Corporate governance

Another key development in Canada since the financial crisis in 2008 is the renewed focus on corporate governance. In 2010, OSFI created a dedicated corporate governance unit to conduct a cross-sector review of governance at larger financial institutions. This information was later used to update OSFIs guideline on corporate governance, which will be discussed in greater detail below, under the heading Bank Governance and Internal Controls. As a result of its review, OSFI has developed a greater focus on risk governance and risk appetite at banks. In particular, banks should have an enterprise-wide, board-approved risk-appetite framework that guides the risk-taking activities of a bank, and that is well-understood throughout the organisation. The risk-appetite framework should set basic goals, limits and benchmarks pertaining to the amount of risk a bank is willing to accept.

4 Bank governance and internal controls Back to top

The Bank Act sets out the required composition of banks boards of directors and mandates the establishment of certain board committees, including an audit committee and a conduct review committee. Under the Bank Act. Canadian banks must consist of, at a minimum, seven directors (at least half of whom must be Canadian residents). In addition, the CEO of a Canadian bank must be a resident of Canada and a director of the bank. Each director and officer of a bank in Canada must discharge his or her duties honestly and in good faith with a view to the best interests of the bank, and is required to exercise the care, diligence and skill set that a reasonably prudent person would exercise in comparable circumstances. While there is currently no law or regulation in Canada on bonus payments to management and employees of banks, OSFI requires Canadian banks to implement the Basel Committees compensation principles on an annual basis, in addition to other international best practices.

In addition to the Bank Act provisions regulating the governance of banks, in January 2013 OSFI issued a best practice guideline (the Guideline), which was updated from a previous guideline that was published in 2003, setting out its expectations regarding corporate governance of banks (as well as of other federally regulated financial institutions, such as trust and loan companies and insurance companies). The Guideline aims to promote industry best practices in corporate governance and address international standards as articulated by organisations such as the Financial Stability Board, the Organisation for Economic Co-operation and Development, the Basel Committee for Banking Supervision and the International Association of Insurance Supervisors. OSFI also articulates its expectations with respect to corporate governance through its Supervisory Framework and Assessment Criteria. which are available on OSFIs website.

Banks are expected to conduct self-assessments of compliance with the Guideline, which are to be made available to OSFI upon request. In addition to complying with the Guideline, boards and senior management of banks are expected to be proactive and aware of corporate governance best practices that are applicable to their institution and, where appropriate, to adopt these best practices. It is important to note that the Guideline is not intended to apply uniformly to all organisations, but is to be applied flexibly depending on the nature, scope and size of the bank.

OSFI has noted that it will take a number of approaches to assess the effectiveness of a banks corporate governance processes, including discussions with boards, board committees, senior management and oversight functions, and it will seek evidence that processes exist and are operating effectively.

Board and board responsibilities

The Guideline creates a critical distinction between the responsibilities of a banks board of directors and the responsibilities of its senior management. While the board is responsible for setting the direction and general oversight of the management and operations of an entire bank, senior management is accountable for implementing the boards decisions and is responsible for directing and overseeing the operations of the bank.

At a minimum, the main focus of the boards attention and activities should be to approve the banks (i) short-term and long-term enterprise-wide business objectives, strategy and plans; (ii) significant strategic initiatives or transactions; (iii) internal control framework; (iv) appointment, performance review and compensation of the CEO and, where appropriate, other members of senior management; (v) succession plans with respect to the board, CEO and, where appropriate, other members of senior management; (vi) mandate, resources and budgets for the oversight functions; and (vii) external audit plan, including audit fees and scope of engagement.

Senior management, on the other hand, should be responsible for reviewing and discussing the banks (i) significant operational and business policies; (ii) business and financial performance in terms of the board-approved strategy; (iii) compensation policy for all human resources; (iv) implementation of internal controls; (v) organisational structure; and (vi) compliance with applicable laws, regulations and guidelines. However, the Guideline also notes that the board has a critical role in providing high-level guidance to senior management through review and discussion of the matters listed above. The board should also seek assurances from senior management that decisions are consistent with the board-approved strategy and risk appetite.

The Guideline identifies a number of attributes of an effective board, including: sound judgment when making decisions (taking into consideration the business objective and risk appetite of the bank); initiative (exercising responsibilities in a proactive manner with a readiness to probe and challenge); responsiveness to issues or deficiencies identified by senior management, regulators or the board itself; and operational excellence (permitting open debate and discussion and advance consideration of important matters). It also suggests that the board of a bank regularly conducts a self-assessment of the effectiveness of the board and board committee practices, occasionally with the assistance of independent external advisers (although the board has discretion in establishing the scope and frequency of such external input).

An effective board should provide objective and thoughtful guidance to, and oversight of, senior management and should collectively bring a balance of expertise, skills, experience, perspectives and competencies. The Guideline suggests that boards and board committees have reasonable representation of individuals with financial industry and risk-management expertise and that boards implement a skills and competency evaluation process that is reviewed annually and updated as appropriate. However, the Guideline does not specifically identify an optimal number of board members.

The Guideline requires that boards be independent from senior management. However, beyond the separation of the chair and CEO, OSFI does not view any single board structure as guaranteeing independence. Further, the board should document and approve an independent-director policy, taking into account the specific ownership structure of the institution and, where appropriate, direct tenure. In keeping with the idea that board independence should be maintained, the Guideline also suggests that the role of the chair be separate from the role of CEO. The chair is expected to have frequent dialogue with, and a high level of influence among, other board members and senior management, in addition to direct and ongoing dialogue with regulators.

For the board to fulfill its duties and role of oversight of the banks operations, OSFI expects banks to establish oversight functions that are independent from operational management through an appropriate committee, such as an Audit Committee or Risk Committee. The heads of the oversight functions should have unfettered access and a direct reporting line to the board and its relevant committees. Boards should approve the mandate, resources and budgets of the oversight functions and, where appropriate, approve the appointment, performance review and compensation of the heads of these functions. More specifically, boards should review and discuss findings and reports produced by the oversight functions and follow up with concerns or findings that are raised by the oversight functions.

Given the different size and complexity of various banks, the scope and sophistication of such oversight functions may vary among institutions. For example, instead of establishing specific oversight functions, boards and senior management of smaller, less complex banks will ensure that other internal or external functions or processes provide the required level of controls and independent enterprise-wide oversight. In addition, the board should regularly assess the effectiveness of the banks oversight functions and should occasionally, with the assistance of independent external advisers, conduct a benchmarking analysis of those functions or their processes. The board has discretion to establish the scope and frequency of such external input.

Risk governance

Risk governance is another key area that has been identified by OSFI. As mentioned above, the Guideline states that banks should have an enterprise-wide, board-approved Risk Appetite Framework (RAF) that guides the risk-taking activities of the bank and that is tailored to its domestic and international business activities. The RAF should be well-understood throughout the organisation, and all operational, financial and corporate policies, practices and procedures of the bank should support the RAF. The RAF should set basic benchmarks, goals and limits of the amount of risk the bank is willing to accept. The RAF is intended to be forward-looking and should consider the material risks to the bank, in addition to the banks reputation.

Depending on the size and nature of a bank, the board should establish a dedicated Risk Committee to oversee risk management on an enterprise-wide basis. The Risk Committee should consist of members who are non-executives of the bank, and members of the committee should have sufficient knowledge in risk management of financial institutions. Through assurances from the Chief Risk Officer, the Risk Committee should ensure that risk-management activities are independent from operational management, are adequately resourced and have appropriate visibility throughout the organisation. The Risk Committee should receive reports on significant risks of the bank and exposures relative to the banks risk appetite (including approved risk limits) and should provide input on the approval of material changes to a banks strategy and corresponding risk appetite. Banks should also have a senior officer who is responsible for identifying, measuring, monitoring and reporting on the risks of the bank on an enterprise-wide level, and who has unfettered access and a direct reporting line to the board or Risk Committee. This officer should provide regular reports to the board, the Risk Committee and senior management, including reporting on whether the bank is operating within the RAF. In addition, the board and Risk Committee should periodically seek assurances from the Chief Risk Officer that any risk information or analysis provided by business lines is objective. The Guideline also specifies that the Chief Risk Officer and risk-management function should not be directly involved in revenue-generation or in the management and financial performance of any business line or product of the bank, and that the Chief Risk Officers compensation should not be linked to the performance of specific business lines of the bank.

Audit Committee

Under the Bank Act. banks are required to establish an Audit Committee comprising non-employee directors, a majority of whom are non-affiliated with the institution. Duties of the Audit Committee include reviewing annual statements and evaluating and approving internal control procedures.

The Guideline stipulates that the Audit Committee, not senior management, should be responsible for recommending to shareholders the appointment, reappointment, removal and remuneration of the external auditor; the Audit Committee should agree to the scope and terms of the audit engagement and approve the engagement letter. The Audit Committee should also establish criteria for the types of non-audit services that the external auditor can and cannot provide to the bank and should be satisfied with the content of the auditors engagement letter before it is signed. The Audit Committee should also assess whether any change to the external auditors materiality level and/or proposed scope continues to ensure a quality audit. Annually, the Audit Committee should report to the board on the effectiveness of the external auditor.

OSFI also expects an Audit Committee to discuss the overall results of an audit and any related concerns raised by the external auditor with both senior management and the external auditor, including key areas of risk for material misstatement of financial statements, areas of significant auditor judgment (including accounting policies and estimates), significant unusual transactions, difficult or contentious matters noted during the audit, changes in the audit scope or strategy, internal control deficiencies identified during the course of the audit, and areas of financial statement disclosures that could be improved.

5 Bank capital requirements Back to top

Regulatory capital of a bank in Canada consists of Tier 1 capital (which comprises Common Equity Tier 1 capital and Additional Tier 1 capital) and Tier 2 capital. 2 The Bank Act requires that banks maintain adequate capital and liquidity, and authorises the Superintendent to establish guidelines on these issues. The Superintendent has issued guidelines for both capital and liquidity.

The current capital adequacy guideline was revised in January 2013 to reflect the changes to capital requirements contained in Basel III. Canada is a strong supporter of the work of the Basel Committee and firmly believes that Canadian banks should meet international best practices for capital. The intention is, therefore, for all Canadian banks to fully implement the Basel III requirements well in advance of 2019. In that regard, OSFI released a draft advisory in February 2013 to provide clarification on the implementation of the Basel Committee on Banking Supervision Disclosure Rules (the BCBS Disclosure Rules). In particular, the advisory clarifies that the new composition of capital public disclosure requirements apply to all financial institutions regardless of the size of the institution or whether it is publicly listed. The full disclosure requirements are to be implemented by all Canadian banks beginning in Q3 2013 (i.e. July 31, 2013 for institutions with October 31 year-ends, and September 30, 2013 for institutions with December 31 year-ends) with certain modifications to reflect Canadian-specific adjustments. In the interim period (Q1 and Q2 2013), Canadian banks are required to disclose detailed components of the transitional capital ratios as well as the All-in Capital ratios. However, starting in Q3 2013, institutions will be required to disclose the full components of the All-in Capital ratios and limited components of the transitional capital ratios. 3

Canada requires that the ratio of a banks assets to its capital not exceed an assigned leverage ratio. The leverage ratio is assigned by the Superintendent on the basis of a number of factors, including the overall size of the bank, its perceived level of risk and the length of time that it has been in existence. Currently, the maximum leverage ratio that may be assigned is 23 times total capital, but most institutions would have a much lower multiple. However, Canada is committed to implementing the Basel III leverage ratio once it is finalised.

One of the principal activities of bank supervisors is to monitor compliance with the capital requirements established under the capital adequacy guideline. Supervisors receive quarterly capital returns from banks, and, when trends begin to develop that suggest that a banks capital adequacy ratios are reducing, supervisors will require that bank to establish a plan to address these trends. The Superintendent has also published an advisory describing its supervisory intervention programme. Under the advisory, as capital deteriorates, a bank will be assigned escalating stages of intervention. Depending on the stage assigned, additional reporting will be required and other restrictions on the business of the bank may be imposed, including a requirement to cease all dividends paid to shareholders.

If the Superintendent believes that a bank is undercapitalised, it has the authority to direct a bank to increase its capital, and if the Superintendent believes the situation has deteriorated to the point where there is a material risk to depositors and other creditors, it may take control of the assets of the bank to protect them from erosion (or, if that is not sufficient, take control of the bank).

6 Rules governing banks relationships with their customers and other third parties Back to top

Investment powers

Under the Bank Act. banks are prohibited from engaging in or carrying on any business other than the business of banking, except as permitted thereunder. Banks can: provide, among other services, any financial services, investment counselling services and portfolio management services; act as a financial agent; and issue and operate payment, credit or charge card plans. Banks may also invest in securities, but are limited in making substantial investments or in controlling certain types of entities. A substantial investment will arise through direct or indirect beneficial ownership of voting shares carrying more than 10 per cent of the voting rights attached to all outstanding voting shares of a corporation, shares representing more than 25 per cent of the shareholders equity in a corporation, or interests representing more than 25 per cent of the ownership interests in any unincorporated entity.

Banks may, however, make controlling and, in certain circumstances, non-controlling substantial investments: in Canadian banks, trust or loan companies, insurance companies, cooperative credit societies and entities primarily engaged in dealing in securities; in foreign-regulated entities that are primarily engaged outside Canada in a business that, if carried on in Canada, would be the business of banking, the business of a cooperative credit society, the business of insurance, the business of providing fiduciary services or the business of dealing in securities; and in factoring, finance, financial leasing, specialised financing and financial holding entities. Certain substantial investments may be made only with the prior approval of the Minister of Finance or the Superintendent of Financial Institutions.

Confidentiality and privacy

All banks in Canada have a common law duty of confidentiality in their dealings with customers and in customer identification. In addition, Canadian banks must comply with Canadian privacy laws, including the federal Personal Information Protection and Electronics Documents Act (PIPEDA). PIPEDA applies to all organisations in respect of personal information used, collected or disclosed by an organisation in the context of commercial transactions, and requires that organisations obtain an individuals consent prior to using such personal information. A positive duty to safeguard personal information that has been collected is imposed on organisations, and certain limits on the retention of personal information are also set out in PIPEDA.

Consumer protection

The Bank Act contains a number of regulations that focus on consumer protection issues, including requirements for the disclosure of the cost of borrowing and disclosure of interest rates. As mentioned above, the FCAC was established to administer the consumer provisions of the Bank Act (in addition to strengthening oversight of consumer issues and expanding consumer education in the financial sector). In particular, the FCACs mandate, which derives from the Financial Consumer Agency of Canada Act. includes the following: (i) ensuring that the market conduct of banks complies with federal legislation and regulations; (ii) promoting the adoption of policies and procedures designed to implement legislation, regulation, voluntary codes of conduct and public commitments by banks; (iii) monitoring federally regulated banks compliance with voluntary codes of conduct and their own public commitments; (iv) informing consumers about their rights and responsibilities when dealing with banks; (v) providing timely and objective information and tools to help consumers understand, and shop for, a variety of financial products and services; and (vi) monitoring and evaluating trends and emerging issues that may have an impact on consumers of financial products and services.

In cases of contravention or non-compliance with legislation, the FCAC will notify a bank of such violation and may also seek a commitment from the bank to remedy the issues within a short time, impose a monetary penalty, impose criminal sanctions or take other actions as are necessary.

With respect to protection of customers deposits, the CDIC was established to ensure the safety of small deposits and to assist in maintaining stability and public confidence in the financial system by providing deposit insurance for the banks depositors. CDIC member institutions fund deposit insurance through premiums paid on the insured deposits that they hold. Deposit insurance is automatic for certain eligible Canadian dollar-denominated deposits (including savings accounts, chequing accounts and term deposits with an original term to maturity of five years or less) 4 up to $100,000 per depositor per institution.

7 Endnotes Back to top

www.osfi-bsif.gc.ca/osfi/index_e.aspx?DetailID=568 .