Canada Banks Face New Climate Regulation, Capital Requirements

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Canada Banks Face New Climate Regulation, Capital Requirements
Canada Banks Face New Climate Regulation, Capital Requirements

Fitch Ratings expects Canada to establish climate-related bank regulation over the next 2-3 years that will include stress tests, mandatory risk disclosures, supervision of banks’ risk management and possibly the introduction of capital requirements.

Canada’s advancing focus on climate-related considerations and financial risks should improve the scope and transparency of data, corporate governance and enhance the stability of the banking system, all of which are supportive of credit profiles.

The government has been engaged in a multi-year process to understand the risks posed by climate change to the banking sector. Within the coming days or weeks, the Office of the Superintendent of Financial Institutions (OSFI) is expected to publish key findings from its recent three-month consultation with federally regulated financial institutions and pension plans to assess their measurement of and sensitivity to climate-related risks.

Canada Banks Face New Climate Regulation, Capital Requirements

In addition, by year-end, the Bank of Canada and OSFI are expected to publish findings from their pilot project to use climate-change scenarios developed with a small group of banks and insurers. The OSFI has stated that any incorporation of climate risk into its regulatory framework would adhere strictly to its mandate to protect depositors and bank creditors.

Fitch expects that the consultation paper and the pilot will form the basis of regular climate stress tests. Moreover, the newly appointed bank superintendent has stated publicly that climate-risk disclosure requirements will expand materially beyond banks’ current voluntary disclosures. Over the medium term, therefore, Fitch expects greater standardization of disclosures around climate risk, and comparability of performance under stress, supporting greater transparency and systemic stability.

The transition to a low-carbon economy may have particular relevance in Canada due to its economic reliance on oil and gas. Excluding securities investments and underwriting services, oil and gas loans averaged approximately 1.4% of gross loans and acceptances across the largest 6 banks as of July 2021, compared to 2.0% as of July 2020. Banks have moderately reduced their lending to the oil and gas sector, but further reduction is unlikely in the near term.

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The reduction may reflect the outsize volatility in oil prices during 2020 and the disproportionate build-up of reserves against energy loan losses. However, the economic importance of the energy sector makes it unlikely that banks would further materially reduce their exposure in the absence of a decline in the sector’s overall economic contribution. Although data is not uniformly available, oil and gas related loans outstanding plus undrawn lines and securities holdings would not likely represent more than 5% of banking system assets, relative to an industry representing roughly 10% of GDP.

Other areas of transmission of climate-related risk to the financial system include agricultural exposure (a material source of emissions), which represents approximately 2.3% of average loans as of July across the largest 6 banks. Industrial or manufacturing exposure is similarly sized. Utilities represent approximately 1.7% of average gross loans. The scale or scope of emissions from these sectors is not disclosed, but taken together, positions vulnerable to a green economy transition are likely sizeable.

Potential for unaccounted climate risk is also present in residential real estate, the largest share of banks’ loan books at nearly 47% on average as of July 2021. Although generally tightly underwritten, location specific vulnerabilities to natural disasters or un-insurability, as well as higher heating and retrofitting costs, could erode collateral values or household debt capacity. Higher regulatory requirements around disclosure and standards around risk management will likely clarify the materiality of these and other vulnerabilities.