In 2017 and 2019, the Basel Committee on Banking Standards (BCBS) published final revisions to the Basel III framework. The committee aimed to reduce variability in the calculation of global banks' risk-weighted assets (RWA) to improve comparability across jurisdictions and reduce the significance of internally generated models. BCBS left the implementation of the finalized Basel III standards to the relevant regulator in each jurisdiction.

On Jan. 31, 2022, in its letter to industry, the Office of the Superintendent of Financial Institutions (OSFI) outlined its implementation of the revised standards in Canada; the plan closely followed the reforms outlined by BCBS. OSFI also decided that it would apply Basel III reform in the country sooner than most other major jurisdictions.

Below, we provide key takeaways from OSFI's early implementation of Basel III reforms in Canada, and address potential impact this might have on Canadian banks' capital management strategies.

Frequently Asked Questions

What are the main capital changes related to Basel III reform that have been implemented in Canada?

Introduction of a 72.5% output floor.   The output floor is a key change that reflects BCBS' view that RWA comparability needs to be improved among banks globally. The output floor sets a lower limit to regulatory capital requirements, which includes capital requirements calculated by internal models, to 72.5% of the capital requirements as calculated by the Basel III standardized approach. In this way, the floor sets a limit on the use of internal models. OSFI opted to implement the output floor sooner than most regulators globally, but will do so gradually. It set the output floor at 65% in second-quarter 2023, and subsequently increased the floor another 2.5% in first-quarter 2024. OSFI initially expected to increase the floor 2.5% over the next two years, before capping it at 72.5% in 2026, but in July 2024, it opted to delay implementation an additional year. As it currently stands, the next output floor increase will be in fiscal 2026, to 70%, followed by another increase in 2027 to 72.5% (where it will stay thereafter). The reason provided for the delay is to give OSFI time to consider the implementation timeline of Basel III reforms in other jurisdictions.

New rules in the calculation and application of operational risk.   OSFI introduced a new standardized approach for operational risk in second-quarter 2023, consisting of two methodologies: the Standardized Approach (SA), which must be used by domestic systemically important banks (D-SIBs) and small and medium-size banks (SMSBs) with adjusted gross income above C$1.5 billion, and the Simplified Standardized Approach (SSA). Of note, advanced models for operational risk are no longer allowed. At a high level, the SA is made up of two components: the business indicator component, which is based off the past three years of income data; and the internal loss multiplier component, which is based off historical losses over the past 10 years. Conversely, under SSA, capital requirements are equal to 15% of three-year average adjusted gross income and, unlike SA, there is no historical loss component. All SMSBs with less than C$1.5 billion in adjusted gross income that are not approved to use SA must use SSA.

Foundation Internal Ratings-Based (F-IRB) approach replaced the Advanced Internal Ratings-Based (A-IRB) approach for certain asset classes.   Beginning second-quarter 2023, banks are no longer permitted to use the A-IRB approach for exposures to general corporate entities with total consolidated revenues of more than C$750 million and with exposures to bank assets and other securities firms and financial institutions. Instead, they should use either the standardized approach or the F-IRB approach. When using F-IRB, banks rely on supervisory estimates of loss given default and exposure at default, but still compute the probability of defaults using internal models. Under the standardized approach, banks are permitted to use external credit ratings as a base to the risk-weight calculation, but must additionally perform due diligence, as outlined by OSFI, in order to determine the appropriateness of the rating. The due diligence process can lead to a higher risk-weight, but the risk-weight cannot be lower than what is implied by the external rating.

Elimination of 1.06 IRB scaling factor.   This scaling factor was deemed no longer necessary, given the introduction of the output floor. The scaling factor was a 6% add-on to credit risk RWA amounts calculated under the IRB method and has been in place since the implementation of Basel II.

Other changes to the calculation of certain credit risk capital charges.   Some of these changes are:

• Lower credit risk capital charges for qualifying revolving retail exposures
• Updated treatment of privately insured mortgages
• Deduction from Common Equity Tier 1 (CET1) capital when a reverse mortgage has a loan-to-value (LTV) ratio of 80% or higher. The exposure amount that is above 80% is deducted from CET1 capital

Implementation of a new market risk framework and CVA framework.  The implementation of the market risk framework is consistent with BCBS' fundamental review of the trading book (FRTB). The new standards move away from value at risk (VaR), which BCBS deems does not sufficiently capture tail risk, to expected shortfall. The credit valuation adjustment (CVA) framework removes the use of the internally modelled approach.

Updated treatment of mortgages that do not meet OSFI's expectations in its published B-20 guideline.   While they are not specific to Basel III reform, OSFI addressed concerns related to negatively amortizing mortgages under this guideline, and beginning first-quarter 2024, a negative amortization mortgage with an LTV ratio above 65% is not considered to have met OSFI's expectations and higher risk-weights are applied. OSFI's Guideline B-20 outlines underwriting standards of Canadian residential mortgages and is applicable to all federally regulated financial institutions.

When were the new Basel III reform changes implemented?

OSFI decided to implement Basel III in two phases. It implemented the first set of new capital requirements in second-quarter 2023 (beginning Feb. 1, 2023, for banks with a year-end of Oct. 31 and April 1 for banks with a year-end of Dec. 31). The requirements included enhancements to the calculation of credit risk, new standardized rules for operational risk, and the implementation of a 65% Basel III output floor (under prior regulatory requirements, most Canadian D-SIBs were operating with a nonbinding 70% floor).

OSFI introduced the second phase in first-quarter 2024 (beginning Nov. 1, 2023, for banks with a year-end of Oct. 31, and Jan. 1, 2024, for banks with a year-end of Dec. 31); the second phase included the adoption of FRTB and a new CVA framework. In addition, OSFI introduced new capital requirements related to negatively amortizing mortgages in first-quarter 2024, although this was unrelated to Basel III reform.

Which banks are affected by the Basel III capital changes?

All D-SIBs, as identified by OSFI, are affected by Basel III reform. OSFI identifies Bank of Montreal, Bank of Nova Scotia, Canadian Imperial Bank of Commerce, National Bank of Canada, Royal Bank of Canada, and Toronto-Dominion Bank as systemically important.

The reform also applies to SMSBs, as defined by OSFI, but to varying degrees. For example, the new market risk requirements apply only to D-SIBs or internationally active institutions; however, OSFI holds the right to apply the framework on a case-by-case basis to certain SMSBs.

How has Basel III reform affected regulatory RWA and the CET1 ratio as of Q2 2024?

The net impact to the CET1 ratio, after the two phases were applied, was modest. While some D-SIBs saw a net negative impact to CET1, others saw a net positive impact. The overall change was small relative to the size of internally generated capital that the banks produce quarterly.

The first set of Basel III revisions had a modestly positive impact on the D-SIBs' CET1 ratios (table 1). In general, the improvement to credit RWA was driven by the removal of the 6% IRB scalar, while the F-IRB approach for certain asset classes also benefitted certain banks. Most D-SIBs saw a positive benefit from the introduction of new standardized operational risk requirements. Of the D-SIBs, only Bank of Nova Scotia was affected by the 65% output floor in second-quarter 2023.

Table 1

Generally, the implementation of new market risk and CVA requirements had a negative effect on D-SIBs' CET1 ratios; however, the exact impact ranged depending on the bank (table 2). Disclosures varied and in addition to FRTB/CVA changes, a number of banks also included the impact of negative amortization mortgages, the impact of the output floor, and the adoption of IFRS 17. With the exception of Bank of Nova Scotia, the 67.5% output floor was not binding in first-quarter 2024.

Table 2

As of second-quarter 2024, the average CET1 ratio for the largest six banks was 13.1%, well above the regulatory minimum. The bank that is closest to its regulatory minimum is Royal Bank of Canada, and still it is 120 bps above its minimum ratio. We expect CET1 ratios will remain stable for the remainder of 2024 as pressure on operating performance continues, offset by low RWA growth that is consistent with low loan growth. Furthermore, we do not anticipate significant changes to bank capital levels as a direct result of further Basel III implementation.

What impact will Basel III reform have on bank strategy?

We do not expect a material impact on bank strategies. However, in light of more costly capital charges, Canadian banks have had to review overall business mix, mostly at the margins, to determine where they can employ capital most efficiently. Capital charges on corporate and commercial loan exposures have been particularly affected by the reform, and we expect the D-SIBs will be more thoughtful in their respective commercial and corporate businesses in terms of loan extension. Maintaining client relationships remains an important consideration, and so, Canadian banks will need to weigh the benefit of the relationship against added capital costs. We expect that banks could focus more on fee-related business with a client in addition to the lending relationship.

Large Canadian banks with U.S. business will also have to consider how Basel III capital rules are implemented in the U.S. (see "How The U.S. Proposes To Implement Basel III Capital Rules And The Impact On U.S. Bank Capital Ratios," published Jan. 11, 2024). This could change the competitive landscape and alter Canadian banks' ability to compete, especially if U.S. regulators pull back on some proposed measures. U.S. banks rallied against the Basel III endgame implementations proposed by U.S. prudential regulators, arguing that the measures are too punitive and will lead to less lending within the banking system. This has yet to play out, and although OSFI did delay the implementation of the output floor an additional year, it's still unclear if it will implement further changes.

Are there ways banks can mitigate the capital impact of Basel III on their RWA?

The use of credit risk transfer (also known as synthetic or significant risk transfer [SRT]) as a tool to optimize capital has picked up globally (see "Banks Ramp Up Credit Risk Transfers To Optimize Regulatory Capital," Feb. 22, 2024). Most D-SIBs have increased the use of SRTs, primarily targeting corporate and commercial loan exposures, and we expect they will continue to use it under the new regulations. SRTs allow banks to offload credit risk in reference loan portfolios to third-party investors while attaining capital relief. SRTs can also help banks rebalance any single-name or sector concentrations in their loan portfolio. As the output floor increases through fiscal years 2026 and 2027, these tools may become more relevant. Although banks increased wholesale synthetic securitizations in the banking book early during the Basel III phase-in, this has slowed in recent quarters (see chart). With the exception of Bank of Montreal, usage of SRT remains relatively low, while National Bank of Canada has not engaged in any SRT activity.

What impact will Basel III reform have on S&P Global Ratings risk-adjusted capital calculation?

On April 30, 2024, S&P Global Ratings published its updated risk-adjusted capital framework (RACF) methodology criteria. The changes target a limited aspect of our RACF criteria, specifically addressing revised calculations for market risk on the trading book and CVA risk. At this time, the updated criteria apply only to banks using revised Basel III reporting (see "Additional Details On The Update To Our Risk-Adjusted Capital Framework Methodology," April 30, 2024). Our revised criteria translated into higher trading and CVA risk charges on average for Canadian banks (although some banks saw a reduction). Nevertheless, trading risk for Canadian banks makes up a relatively small portion of total RWAs, and thus, the impact to our RAC ratios was limited (table 3). Canadian D-SIBs operate on average with an RAC ratio at the high end of our adequate range.

Table 3

What impact will Basel III reform have on Canadian bank ratings?

We expect the rollout to be neutral for Canadian bank ratings. In the past few years, Canadian banks, and in particular the D-SIBs, have increased capital levels in anticipation of new Basel III capital requirements and in-line with OSFI's domestic stability buffer requirement. The D-SIBs continue to hold a buffer above these requirements, and we do not anticipate significant capital level changes will result from the adoption of Basel III reform.

Related Research

• Additional Details On The Update To Our Risk-Adjusted Capital Framework Methodology, April 30, 2024
• Your Three Minutes In Banking: BCBS Calls Time On G-SIB Window Dressing, March 13, 2024
• Banks Ramp Up Credit Risk Transfers To Optimize Regulatory Capital, Feb. 22, 2024
• How The U.S. Proposes To Implement Basel III Capital Rules And The Impact On U.S. Bank Capital Ratios, Jan. 11, 2024
• EU Banking Package: Inconsistencies Temper Framework Improvements, Jan. 9, 2024