On May 22, 2024, the Office of the Superintendent of Financial Institutions (OSFI) released its Annual Risk Outlook – Fiscal Year 2024 - 2025 (the "ARO"), which summarizes the current risk environment and underscores the primary risks facing Canada's financial sector. The ARO outlines OSFI's measures to maintain public confidence in Canada's financial system, including protecting the rights and interests of depositors, policyholders, financial institution creditors, pension plan members, former members, and entitled beneficiaries.
Additionally, the ARO sets out OSFI's priorities and supervisory strategies for federally regulated financial institutions and federally regulated pension plans for the calendar periods from Q2 2024 to Q2 2025 fiscal year.
Current Risk Environment
The ARO identifies the following current risk factors to be:
- high interest rates and market uncertainty,
- rising household debt costs,
- wholesale credit stress and changing depositor behavior, and
- integrity and security amidst geopolitical uncertainty.
Top Risks for 2024-2025 and OSFI's Responses
OSFI intends to primarily focus on four risk areas in the following order of importance.
Real Estate Secured Lending and Mortgage Risks
A significant number of mortgages will renew by the end of 2026, potentially causing payment shock for homeowners, particularly those with a Variable Rate Mortgage with Fixed Payments (VRMFP) and those with mortgages from 2020 to 2022. Some VRMFPs have scheduled payments that no longer cover the full interest costs or the principal. Options to mitigate often include lump sum payments, refinancing or returning to the original contract term, but these may not eliminate the impact of the rate increases. VRMFPs constitute about 15% of outstanding residential mortgages in Canada and as such, if mortgage rates remain high, the financial commitment required by borrowers to return to their contractual amortization may put financial strain on many of those households.
Key OSFI initiatives include monitoring the risk profiles of institutions' residential mortgage lending activities and regularly conducting examinations to ensure they adhere to sound underwriting standards and use prudent lending, portfolio and account management practices. OSFI will also implement institution-specific loan-to-income limits at the portfolio level for uninsured mortgages to prevent a buildup of highly leveraged borrowers.
In December 2023, OSFI announced it was maintaining the minimum qualifying rate for uninsured mortgages at the greater of the mortgage contract rate plus 2% or 5.25%. This will ensure borrowers can still make payments even if they experience negative financial shocks, such as a reduction in income, an increase in household expenses, or an increase in mortgage interest rates. OSFI also seeks to enhance its supervisory practices to ensure sound proactive engagement with vulnerable borrowers.
Wholesale Credit Risks
Corporate credit and commercial real estate (CRE), especially construction and development, and office sectors continue to face adverse uncertainty. While funding sources remain available, economic instability is causing changes in investor and depositor behavior.
OSFI will increase monitoring for wholesale exposures and lending activities to properly assess borrower and portfolio vulnerabilities, account management and underwriting practices, and loan loss provisioning. OSFI will also introduce a new data collection program to improve its understanding of market developments and compare risks across institutions.
Funding and Liquidity Risks
Liquidity and funding risks are highly sensitive to uncertain financial market conditions, with global rates trends significantly impacting risk tolerance. Increased digitalization in banking could lead to sudden and intense deposit outflows, and liquidity shocks therefore remain a constant concern. While access to wholesale funding and the repo market remains open, unstable interest rate changes continue to affect the valuations of high quality liquid assets and have the potential to affect the capacity of markets to provide liquidity and to contribute to market stability in periods of stress.
Liquidity and funding risks are also closely linked to credit risks as deteriorating conditions can negatively impact securitization markets. This could seriously impact the liquidity risk for institutions that rely on securitization as a key source of funding, as well as access to wholesale funding for impacted institutions.
This year, OSFI intends to intensify its assessment of liquidity risk, focusing on intra-day liquidity risk management, and the effectiveness of liquidity and interest rate risk management in material foreign subsidiaries. OSFI will also assess operational aspects of contingency funding plans to better understand asset monetization decisions during stress events. This will include industry consultations on implementing OSFI's intraday liquidity guidance in Q2 of 2024. These consultations will address proposed updates to the Liquidity Adequacy Requirements Chapter 7 – Intraday Liquidity Monitoring that reflect payment system modernization changes and introduce formal intraday reporting requirements.
OSFI expects institutions to enhance their reporting and operational capabilities to maintain data integrity, and responsiveness to market disruptions.
Integrity, Security, and Foreign Interference
To address integrity, security and foreign interference risks, OSFI has established the National Security Sector, along with an Integrity and Security Risk Division, to lead integrity and security supervision and policy. This year, OSFI issued an Integrity and Security Guideline to help institutions align with security expectations and improve resilience against security threats. By building its capacity and partnerships, OSFI aims to safeguard the integrity of Canada's financial system and public confidence in it.
Other Key Risks
OSFI notes that it also monitors interdependent risks like cyber threats, climate impact and third–party dependencies, which could disrupt the stability of the financial system. OSFI states that it remains committed to proactive risk management and regulatory oversight and will selectively assess institutions against technology and cyber risk management guidelines.
In relation to OSFI's supervisory strategies for federally regulated financial institutions and federally regulated pension plans, the ARO also includes two annexes:
- Annex I outlines OSFI's guidance priorities and divides them into three streams: risk management guidance, capital and accounting guidance for institutions, and guidance for pension plans with calendar timing. Key initiatives include operational risk and resilience guidelines (Q3 2024), culture and behaviour risk guidelines (Q4 2024), and various public consultations and final guidelines on capital requirements and crypto assets. Starting Q3 2024, OSFI will pilot Quarterly Release Dates for streamlined guidance publication, with specific dates set for industry updates. This approach will be reviewed in Q1 2025, and any changes will be reflected in the 2025 Annual Risk Outlook. No new guidance for pension plans is expected to be released in the period from Q2 2024 to Q2 2025.
- Annex II outlines OSFI's supervisory industry strategies for fiscal year 2024/2025, focusing on a risk-based approach for pensions, insurance and banking. For pensions, priorities include enforcing funding requirements, migrating to a new supervisory system, and conducting thematic reviews on funding and investment risks. Insurance supervision will emphasize capital management, operational resilience, risk governance and compliance with the Insurance Companies Act, including thematic reviews on cyber resilience and third-party risks. Banking supervision will focus on capital and liquidity management, operational resilience and risk governance, with reviews on business strategies, financial resilience, and technology and cyber risks, particularly for systemically important and smaller banks.
Looking Forward
Goodmans will continue to monitor developments in this area and OSFI's responses to existing and emerging risks.
For more information concerning the ARO, please contact any member of our Financial Services Regulatory Group.
The content of this article does not constitute legal advice and should not be relied on in that way. Specific advice should be sought about your specific circumstances.