Law in Quebec

Canadian banks, long chastised for its conservativeness, are in solid shape, with the World Economic Forum going so far as to deem it to be the world’s soundest banking system, closely followed by Sweden, Luxembourg and Australia. While not immune to the impact of worldwide events, Canadian banks fared better than most, with combined annual profits for the Big Six banks dropping in fiscal 2008 by $7.5-billion to just over $12-billion from a record $19.5-billion in 2007. Tellingly, the relative ranking of Canadian banks within the global and North American industry has dramatically improved, with four Canadian banks making the list of North America’s ten largest by market capitalization.

In stark contrast U.S. banks face write downs of $2.7-trillion between 2007 and 2010, and the combined equity of U.S. and Europeans estimated to be close to zero if the institutions recorded all remaining losses today, according to the International Monetary Fund.

“Our (regulatory) framework assumes that institutions, unfettered, will take risks that may produce outcomes that are very costly for society,” OSFI Superintendent Julie Dickson told the ABA audience.  “Thus, Canada’s legislative and prudential rules prevent excessive risk taking while allowing institutions to go out along the risk curve to varying degrees.”

Not everyone shares that assessment. Some, like Graham, express reservations over the role that the legislative framework played in buffering Canadian banks from the almost unprecedented volatility and market failure. The Bank Act (Act), federal legislation that governs the banking sector, is overhauled every five years to allow for change and evolution in a disciplined and measured manner. The Act, which uses a principles-based rather than a rules-based approach, has two fundamental but “simplistic” provisions, says a respected adviser to banks, insurers and other financial institutions. Under s.485 of the Act, banks shall, in relation to its operations, maintain adequate capital and liquidity. And the Governor in Council may make regulations, and the Superintendent may make guidelines to ensure that the banks maintain adequate capital and liquidity.

“I don’t think that the legislative framework itself assumes that institutions will take risks that will produce outcomes that are very costly to society – that is more of a regulatory philosophy,” said Graham, who provides regulatory and transactional advice to Canadian and international commercial and financial services entities.

Unlike in the United States, where regulatory jurisdiction is fragmented, Canada has a strong financial sector regulatory policy approach, anchored by an independent, and hands-on financial regulator – the OSFI — that has the legal authority to take tough measures to keep more than 450 banks and insurers healthy and robust. Established in 1987 under the Office of the Superintendent of Financial Institutions Act (OSFI Act), OSFI’s mandate entails supervising all federally regulated financial institutions, monitoring federally regulated pension plans, and providing actuarial advice to the Government of Canada. OSFI derives its powers from, and is responsible for, administering the Bank Act, Trust and Loan Companies Act, Cooperative Credit Associations Act, Insurance Companies Act, Pension Benefits Standards Act, 1985, and all related regulations. The various Acts address the unique aspects of the sectors each governs, but are designed to be consistent with each other. All told, it oversees financial bodies that managed $4.75-trillion in assets as of the end of March 2008.

“The OSFI Act is a separate statute which defines in broad terms their authority to regulate while the individual statutes contain specific powers that too are very general, and they facilitate the activities of regulators to intervene on as needed basis,” explained Graham. “They give OSFI a variety of tools that allows them to require different practices institutions might not otherwise be prepared to follow.”

John Jason, a former technical adviser to the Department of Finance who continues to provide advice on issues relating to the Bank Act, contends that Canadian banks have so far been able to weather the financial storm because, while the Act itself may be principles-based, its application is in fact rules-based, hinging on a voluminous series of advisories and guidance published by the OSFI to facilitate compliance with their statutory obligations.

“The Bank Act simply states a principle, and does not provide hard-lined rules that banks have to follow in order to maintain adequate amounts of capital and liquidity,” explained Jason, a partner in the business law department with Osler in Toronto. “But derived from that principle, we have some 300-odd pages of factual rules on how banks need to calculate and determine their required capital level. So although the statute has a principle-based approach, we do a lot of back-filling with guidance.”

The legal weight that advisories and guidance issued by the OSFI is uncertain, with some business lawyers flatly stating they are “completely unenforceable” while others are not nearly as certain. All agree, though, that it is in the best interests of financial institutions to heed OSFI advisories and guidance because if they do not the Superintendent can invoke s.4 of the OSFI Act. In the event that an institution is not in sound financial condition or is not complying with its governing statute law, s4. allows the Superintendent to take or require the board or management to take necessary corrective measures in order to expeditiously deal with the situation.

That’s a situation that occurs rarely. OSFI works closely, but independently, with the banking community. “A mandate is important so a regulator knows what it is accountable for, but equally important is how a regulator relates to the industry it regulates,” said Dickson, who began her career at the Department of Finance in the 1980s. “We have an open door policy at OSFI and we encourage discussion with financial institutions on prudential issues so that we have all the information at hand and understand the impact of our decisions.”

But nor does the OSFI hesitate to take firm stances. One of the most closely watched measures of a financial institution’s ability to cushion against losses is the so-called Tier 1 capital, which compares the book value of common and most preferred stock against the size and risk of its loans and investments. Basel II  — recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision, an institution created by the central bank Governors of the Group of Ten nations – requires a minimum 4% tier 1 capital. A large proportion of the world’s banks faced the crisis with ratios of 5% or 6%. OSFI has compelled banks to hover above the 7% mark, which did not make matters easy for banks but the regulator stood firm.

“The international banking community has in the past been somewhat critical of the Canadian requirements for higher capital requirements but in this environment these very requirements helped protect the Canadian banks,” noted Robert Elliott, the national co-chair of Fasken Martineau’s financial institutions and services group. “Capital, of course, provides a cushion against losses in loan books, and we are now finding that international standards are probably moving more in line with what the Canadian standards have historically been.”

That wasn’t always the case. A series of “painful experiences,” beginning with the collapse of two small Western banks – Canadian Commercial Bank and Northland Bank – in 1985, followed by a number of trust company failures in the late 1980s led to the creation of OSFI  in 1987. The 1994 demise of Confederation Life Insurance Company, which was ranked as the fourth largest insurance company in Canada and among the top 30 in North America, with $19 billion in assets, ended up forging and shaping OSFI’s mandate into what it is today.  All of which laid the foundation behind the policies, internal controls, regulatory compliance and “a culture of prudence” now in place, says Marc Duquette, a senior partner with Ogilvy Renault in Montreal.

“We learned from those lessons,” remarked Duquette, practices corporate and securities law, with particular emphasis on the regulation of financial institutions. “We learned to adopt a culture of prudence, and that is something shared by the institutions themselves. In other places you try and find loopholes that the regulator won’t find. Here the culture is to comply and be transparent with the regulator.”

More changes now appear to be set in the cards. A deal reached early this April by leaders of the Group of 20, pledging to reform the global banking system and tighten regulatory controls to ensure monitoring of financial risks, appears to have triggered a redesign of Canada’s financial regulatory regime, though it is far too early to foresee what kinds of changes and when it will take place.