Hidden Risks in Stimulus Measures

Among various stimulus measures implemented by central banks around the world (with bond buying being the prominent topic of decision), a lesser discussed, but potentially equally important stimulus measure is the loosening of capital requirements via tier 1 capital ratio adjustments.

Canada’s banking regulator, the Office of the Superintendent of Financial Institutions (OSFI), has lowered the liquidity buffer ratio for Canada’s banks from 2.5% to 1% following the March volatility we saw.

In layman's terms, what this buffer amounts to is a slush fund of cash that banks need to keep aside for a rainy day. When times are good, regulators tend to increase these capital buffers; likewise, in major crises, the funds are typically released by regulators to be pumped back into the system via loans to individuals and corporations in need of liquidity.

OFSI recently announced it is maintaining this portion of the tier 1 capital ratio at 1%, and the total minimum ratio (inclusive of other capital reserve requirements) at 9% percent overall. All Canadian banks are above this ratio, signalling strength in the Canadian banking system for now.

That said, investors ought to keep an eye on how leaders continue to manage their liquidity reserves and loans losses, particularly in the coming months as government aid programs taper off.

Should we experience another leg down in financial markets, reduction in the capital reserve ratio for large Canadian lenders could be a hidden risk, in that we have little experience dealing with large financial shocks in the context of such minimal buffers.

Invest wisely, my friends.