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Ottawa, February 10, 1995
1995-011

Notes for an address by the Honourable Douglas Peters, Secretary of State (International Financial Institutions), to the Downtown Rotary Club of Toronto

Toronto, Ontario
February 10, 1995

Delivered text is official version

I am very pleased to have the opportunity to speak to such a distinguished audience about the changes that the government has proposed to the regulatory and supervisory system for the financial sector.

Canada has a world-class financial system and I believe that the proposals will help it stay that way. The proposals follow extensive review and consultations -- by the Department of Finance, the Senate Banking Committee, and others. The proposals also strike a critical balance between protecting Canadian investors and facilitating economic activity.

This balance is essential, but not well enough understood. Canadians are generally sensitive to the need to protect the funds the public entrusts to financial institutions. What is sometimes less well appreciated is that, in order to fulfil their critical role in the economy, institutions need the flexibility to respond to market conditions with market-based solutions.

Therefore, one of my major themes today is the importance of ensuring that public expectations of the regulatory and supervisory systems are realistic.

We have tabled this package now, not because the system is broken -- it isn't -- but because the system must evolve with market trends and respond to recent experiences. That's why there were changes in 1987 and 1992; that's why there will be changes in 1997; and that's why there are changes today.

I'm sure I don't need to remind anyone here that the financial sector's recent experiences include the failures of some trust companies and some life insurance companies -- the most recent examples being Confederation Life and Confederation Trust. These failures have focused attention on Canada's regulatory and supervisory system, and mechanisms for policyholder and depositor protection.

I want to emphasize that, overall, Canadian financial institutions have coped extremely well with the challenges of an increasingly competitive marketplace, and with added stresses such as the decline in commercial real estate values. Our financial system is safe and sound, and public confidence remains justifiably high.

Maintaining and enhancing the safety and soundness of the system -- and public confidence in it -- is one of the overarching principles governing the White Paper proposals.

But we must be realistic. In any financial system, no matter how sound, some institutions will fail. In a market system, this is a normal and natural process. Indeed, preventing failures at any cost would run counter to another underlying principle of the White Paper -- the need for Canada's financial institutions to remain competitive and efficient.

The White Paper proposals are governed by a further fundamental principle: that owning a financial institution is a privilege, not a right. The role of financial institutions is simply too important for matters to be otherwise.

Within the framework of these broad principles, the White Paper proposals are directed towards a number of more specific goals.

One goal is to reduce the cost of failures. The regulatory and supervisory systems are not designed to guarantee that failures will never occur. But they must provide incentives for institutions to act to resolve their problems. And they must ensure that any failures that do occur involve a minimum of cost and disruption.

A second goal is to put the protection plan for life insurance policyholders on a stronger legislative footing. CompCorp has done an excellent job to date.

Nevertheless, it has been suggested that some changes could help the compensation system operate even better.

A third goal is better control of systemic risks in clearing and settlement systems. Canada has one of the most efficient paper-based payments systems in the world. And there have been developments such as the new book-based system for clearing and settling government bonds, implemented by the Canadian Depository for Securities.

However, there are ways to achieve further gains in efficiency and reductions in risk. For example, we are currently the only G10 country without a system that provides finality of payment on the same day for large value payments.

I would now like to outline briefly the proposals themselves.

The White Paper focuses on six key aspects of the regulatory and supervisory system:

One, enhanced disclosure of financial information.

Two, an early intervention framework.

Three, deposit insurance changes, but no coinsurance.

Four, enhancement of the framework for protecting policyholders of life and health insurance companies.

Five, a stronger prudential framework for federal financial institutions; and

Six, controlling systemic risk in clearance and settlement systems.

Our proposals in each of these areas are fiscally responsible -- they do not involve any new cost for government.

We are also respecting the role of provinces in regulation. The proposals are aimed at federally regulated institutions, but a number of them can be extended to provincial financial institutions if the responsible provinces wish.

With respect to the first of the key areas, we are proposing that financial institutions, and OSFI, release more -- and more consistent -- information about the financial condition of institutions. This is something that industry analysts and other professionals serving customers and creditors of financial institutions have asked for.

Consumers, too, have told us that they need more information in order to make sound investment decisions. And greater disclosure is consistent with international developments in the financial sector.

Under the proposed rules, information about regulatory capital would be made available. Also, there will be more public information on the valuation results of insurance company actuaries, and information on executive compensation similar to that disclosed by publicly traded companies.

This kind of information is important for evaluating an institution. But once we know that an institution is in trouble, how should we proceed? The Senate Banking Committee heard a great deal of testimony on the subject of early intervention and resolution. I think it's fair to say that almost everyone supports the principle of resolving a financial institution's problems earlier rather than later. Very simply, early intervention makes a lot of sense -- because the earlier the intervention, the greater is the scope for avoiding large losses down the road.

The proposed framework for earlier resolution has three main elements. Taken together, these elements help bring about an early resolution system that is effective without being too mechanistic. We have been careful to leave room for judgement and discretion in the light of particular circumstances.

The first element is a legislated mandate for OSFI. This will establish the basis for OSFI's accountability and acknowledge the importance of prompt action to deal with problem institutions.

Second, we have enhanced the transparency of the system, outlining the steps that the authorities -- OSFI or CDIC -- can be expected to take if the financial condition of an institution deteriorates. This way, managers and directors of institutions can know what to expect in given circumstances, and respond accordingly to find solutions to the company's problems.

Third, we are proposing changes to financial institutions legislation and the Winding-up Act to make it easier for the Superintendent to move to close an institution in trouble while it still has some positive capital. This will help to limit the losses of depositors, policyholders and compensation funds.

This brings me to the subject of depositor and policyholder protection. It is a complex area, but once again the fundamental trade-off is between consumer protection and market discipline.

With respect to deposit insurance, perhaps the biggest news is what we did not do. The current $60,000 limit for deposit insurance will be maintained. And, after listening carefully to arguments for and against coinsurance, we decided not to propose such a measure. We recognize that coinsurance could introduce a useful element of market discipline to the deposit-taking sector. But we are also mindful of the practical limits on the capacity of consumers to evaluate financial institutions, and of the possible perception that bigger necessarily means safer.

The government is, however, proposing two changes to the deposit insurance framework.

The first of these changes is some reduction of so-called stacking of insured deposit accounts within a group of affiliated institutions. "Stacking" in this case refers to the practice of having multiple insured deposit accounts in related deposit-taking institutions. Deposit insurance is intended to protect the average depositor. There is little point in having a $60,000 limit if you can easily multiply it many times over within one institution and its subsidiaries.

I can appreciate that this change may engender some confusion among consumers as to what is and what is not covered. For this reason, there will be reasonable transitional measures, so that the new rule will apply as existing term deposits mature or new funds are invested. There will also be measures to promote consumer awareness of the new rules. But let me emphasize that the vast majority of Canadians will not be affected by this change.

We are also proposing the introduction of risk-based deposit insurance premiums. While the precise form of such premiums will be determined following consultations, the basic thrust of the proposals is that CDIC could vary premiums on member institutions on the basis of such considerations as their capitalization and their supervisory rating.

This measure will send a signal -- with financial consequences -- to directors and managers of financial institutions about the risk rating of their institutions. It is a key measure to enhance the incentives for institutions to act to solve their own problems before they become too serious.

Closely related to the subject of depositor protection is that of policyholder protection. Here, the government is proposing to create a new entity -- the Canadian Life and Health Insurance Policyholder Protection Board, or PPB -- to protect policyholders and annuity holders of life and health insurance companies. The structure of the PPB is similar to policyholder protection mechanisms at work in the U.S. and U.K. It is also consistent with the recommendations of the Senate Banking Committee.

The PPB strengthens the legislative basis for policyholder protection in a number of ways. For example, assessments on member companies, established by statute, will facilitate borrowings by the PPB in public markets. In addition, the PPB's corporate governance structure will facilitate the sharing of information on the financial condition of companies between OSFI and the PPB. As a result of these changes, the PPB will also be able to support going concern solutions, and not just facilitate liquidations.

Under the structure we are proposing, policyholder protection will continue to be funded entirely by the insurance sector, without government guarantees or access to the Consolidated Revenue Fund.

The government examined the possibility of creating a full Crown corporation, and decided that, on balance, it was inappropriate. There are differences between deposit-taking institutions and insurance companies that justify different compensation schemes for the two sectors. Tough decisions had to be made at a time when the government is re-thinking its role -- and its financial commitments -- in a number of areas.

Let me move on to one of the other key areas of the White Paper -- the prudential framework for financial institutions. Again, I want to emphasize that the regulatory and supervisory framework is fundamentally sound. We do not believe that OSFI needs expansive new powers. We do think, however, that some additional supervisory tools and improvements to existing supervisory standards would be useful to strengthen the prudential framework.

The government has proposed options for developing a role for OSFI in the choice of directors for financial institutions. One option is to empower the Superintendent to veto appointments of directors and senior officers. Another option, as suggested by the Senate Banking Committee, is to allow the Superintendent to veto appointments and remove incumbent directors, but only of problem institutions.

I recognize that corporate governance is not something to be interfered with lightly, and that the impact of any changes has to be thought through carefully. That is why the government has not finalized its views in this area.

Some of the proposed changes to the prudential framework are quite technical, and I will not dwell upon them at length. But a couple warrant mentioning.

Under the proposals, the Superintendent of Financial Institutions would have the authority to obtain an independent actuarial review of a federal insurance company.

Other measures will enable the Superintendent to better ensure the independence of directors. For example, the Superintendent would have the authority to designate certain directors as "affiliated" for purposes of the existing requirement that one third of the board of federal institutions be unaffiliated with the institution. Unaffiliated directors of institutions would not be permitted to also serve on the board of the institution's unregulated parent.

The final policy area addressed by the White Paper that I will touch on today is that of clearance and settlement systems. Our objectives here are twofold. We want to ensure that the design and operation of these systems control risk effectively. And we want to ensure that clearing and settlement systems contribute to the international competitiveness of Canada's financial system.

A number of initiatives are already underway to improve efficiency and reduce risk in these systems. For example, financial institutions are working with the Canadian Payments Association to develop a Large Value Transfer System, or LVTS, that will offer same-day finality of payments for its users. Other recent or impending innovations include the introduction of new systems for clearing transactions of government debt securities and foreign exchange.

In the paper, the government is proposing changes necessary to implement the LVTS. We are also proposing to give the Bank of Canada a more explicit role in the oversight of clearing and settlement systems that may be sources of systemic risk.

In all the other major industrialized countries, this oversight role belongs to the central bank. Central banks have discussed the development of measures to deal with systemic risk concerns in a variety of fora, such as the Bank for International Settlements.

My discussion of the White Paper has not been exhaustive, but I have said a great deal about policy issues. I want to use the little time remaining to say a few words about process -- and specifically the process of consultations.

Most of the areas covered in the paper have already been the subject of extensive consultations. I am thinking not only of the work of Finance officials, but also of the Deposit Insurance Advisory Committee and the valuable contribution of the Senate Banking Committee.

I should point out that the vast majority of the Senate's recommendations have been picked up in the White Paper. Enhanced disclosure, early intervention and the Policyholder Protection Board are important themes in both the Senate Report and our proposals.

The government intends to proceed with legislation as expeditiously as possible. The Department of Finance is inviting written comments on the policy paper until the middle of April. In a number of areas, however, the details of the proposals have not yet been fully worked out. Consultations on these items will begin immediately.

Finally, I would like to mention briefly a further proposal that was also announced yesterday. We are proposing that CDIC meet its future borrowing requirements directly in the capital markets. This would reduce the federal government's borrowing requirements. With respect to any future borrowings, CDIC would compensate the government for the credit enhancement that the government's loan guarantee provides on CDIC's debt.

Ladies and gentlemen, I have covered a lot of ground. I hope you share my view that the proposed changes will help keep our supervisory and regulatory structure up to date -- so that the financial sector can continue to play its vital role in sustaining growth and building a stronger Canada.

Thank you.