Large Canadian banks’ earnings show above-expected results for some and higher dividends for most. But all of them carry liquidity cushions far exceeding regulatory requirements. Could it actually make the system less safe?
Scotiabank has a liquidity coverage ratio of 128 per cent, RBC is at 127 per cent, National Bank at 173 per cent, CIBC at 132 per cent, and TD at 138 per cent. These ratios reflect banks’ ability to survive a 30-day financial crisis with high-quality liquid assets. A reassuring picture overall.
Could liquidity regulation make system less safe ?
Yet, a Bank of Canada staff analytical note highlights the “unintended consequences of liquidity regulation”, suggesting to reduce the reliance on liquidity requirements while tightening capital requirements to improve financial stability.
Tight liquidity regulation pushes banks to hold more of the safe assets, in turn increasing their funding needs. Banks must then pay higher rates on wholesale deposits, eroding their profitability and making them less attractive to equity markets.
“When bank regulators do not account for this externality, liquidity regulation is excessive and hurts the profitability of banks to an extent that is socially harmful,” the paper said. Banks struggle to raise capital and maintain the capital buffers needed to provide protection against insolvency.
The paper’s conclusion should give regulators pause: “When liquidity regulations that make a given bank safer are imposed on all banks, the banking system as a whole can potentially become less safe.”
It suggests that reducing bank holdings of safe assets by one third while increasing capital ratios by just 50 basis points could reduce the frequency of financial crises. “The policy implication is that liquidity regulation tools, such as the LCR, should be calibrated.”
Canada and other countries have been hurrying to build resilience in different corners of the economy through various tools, regulation being one of them. Going by the paper’s logic, better capitalized banks despite lower liquidity metrics could absorb losses and continue lending through downturns, which would help build resilience.
The paper is published against the backdrop of increasing filings of consumer insolvencies amid lower perceived job security among Canadian employees despite a decline in the unemployment rate to 6.5 per cent in November from 6.9 per cent in October.
Rising consumer insolvencies filings
Morningstar DBRS said in a December report on Canadian credit card performance that “Although the Bank of Canada has cut the policy interest rate nine times since June 2024 to 2.25 per cent to boost economic growth, the economic impact from the U.S. trade war is weakening the labour market and has led to an increase in unemployment, contributing to an increase in the number of filings for consumer insolvencies.” The Canadian Association of Insolvency and Restructuring Professionals reported in November that consumer insolvencies in Canada were up 4.8 per cent in the third quarter from a year earlier.
Meanwhile, mortgages are also being or have been refinanced at higher rates than a few years ago, continuing to add strains to Canadians’ finances amid ongoing affordability concerns.
In fact, collectively, the large Canadian banks have been increasing provisions for loans that could go bad, earnings reports show.
Market participants see household debt among top risks to financial system stability
Household debt ranks third among investment dealers and portfolio managers surveyed by the Canadian Securities Administrators (CSA) about risks to the stability of the financial system. The 2025 CSA Systemic Risk Survey summary released Thursday shows that 62 per cent of respondents see household debt posing a high or very high risk, although this is down from 68 per cent last year. Concerns have also edged down for housing market and interest rate-related risks from their peak in 2023.
Unsurprisingly, trade, in relation to geopolitics, remains the top threat to the stability of the financial system, followed by cyber vulnerabilities, with artificial intelligence contributing to cyber security concerns.
It is worth noting that government debt ranks sixth out of 19 listed risks, higher than corporate debt (13th). Concerns are the lowest for stock liquidity.
