In accordance with guidance from OSFI, the CVA risk capital charge for Canadian banks has been phasing in since the first quarter of 2014. In 2016 and 2017, the CVA risk capital charge applicable to CET1 was 64% and 72% of the fully implemented charge, respectively, and it is expected to increase to 80% in 2018.
Capital Regulatory Developments
A number of regulatory capital changes, some finalized and some under development, will put upward pressure on the amount of capital BMO is required to hold over time. The nature of these changes is outlined below.
OSFI implemented the countercyclical capital buffer in the first quarter of fiscal 2017. It is calculated as the weighted average of buffers in effect in jurisdictions where the bank has private sector credit exposures. The impact of the countercyclical capital buffer has been immaterial.
In March 2017, the BCBS issued a Pillar 3 standard that aims to improve comparability and consistency of financial regulatory disclosures through more standardized formats. The standard includes new disclosure requirements in respect of the Total Loss-Absorbing Capacity (TLAC) regime.
In June 2017, OSFI released a draft guideline on TLAC for comment. OSFI’s draft guideline will apply to Canada’s D-SIBs as part of the federal government’s bail-in regime. The draft TLAC guideline is consistent with international standards developed by the Financial Stability Board (FSB), but is tailored to the Canadian context. Public disclosure of D-SIBs’ TLAC ratios is anticipated to begin in the first quarter of fiscal 2019, and D-SIBs are, based on current guidance, expected to fully meet the TLAC requirements by November 2021. OSFI is expected to release the final TLAC guideline later in 2017 or in early 2018.
In conjunction with OSFI’s release of the draft guideline on TLAC, the Department of Finance Canada introduced draft regulations setting out the details of the bail-in framework for Canada’s six D-SIBs. The bail-in regulations are expected to come into force 180 days after the regulations are finalized. Under the new regulations, upon a determination by OSFI that the bank has ceased, or is about to cease, to be viable, the Governor in Council may, upon a recommendation of the Minister of Finance, make an order directing the Canada Deposit Insurance Corporation to convert all or a portion of certain shares and liabilities (i.e. with an original term to maturity greater than 400 days) of the bank into common shares of the bank. The bail-in regulations and TLAC guideline are not expected to have a material impact on BMO’s funding strategy.
In July 2017, OSFI extended the Canadian implementation of the Minimum Capital Requirements for Market Risk (Fundamental Review of the Trading Book, or FRTB) rules by at least one year, with the first regulatory reporting under the FRTB rules to commence no earlier than the first quarter of fiscal 2021.
In October 2017, the BCBS signalled that it was close to finalizing the Basel III reforms, including an output floor, AIRB input restrictions, a new standardized credit risk weighting approach and a new operational risk weighting approach that replaces the AMA. Earlier in the year, OSFI stated that it is prepared to move forward ahead of the BCBS on related aspects of capital reform.
In October 2017, the BCBS issued final guidelines on step-in risk aiming to mitigate the risk of stress in shadow banking entities spilling over to banks. The guidelines entail no additional Pillar 1 capital or liquidity charge but focus on identifying entities that may have step-in risks. The BCBS expects the guidelines to apply no later than 2020.
In November 2017, OSFI released the final version of the CAR Guideline for implementation in the first quarter of fiscal 2018. Revisions mainly relate to the capital treatment of allowances as a result of the adoption of IFRS 9Financial Instruments. OSFI also reiterated its intention to implement in the first quarter of fiscal 2019 the Standardized Approach to Counterparty Credit Risk, the revisions to the capital requirements for bank exposures to central counterparties and the revised securitization framework that was released by the BCBS in July 2016.
IFRS 9 will impact our reported capital as a result of the adjustment recorded in retained earnings on adoption of the standard; however, this impact is not expected to be significant. Refer to the Adoption of IFRS 9Financial Instruments section on page 116 for further discussion.
We are also monitoring potential regulatory capital developments that may replace AMA with a new Standardized Measurement Approach for operational risk.
Capital ratios are impacted by deferred tax assets. Given our net U.S. deferred tax asset, under the proposals contained in theTax Cuts and Jobs Act, a reduction in the U.S. federal tax rate from 35% to 20% would result in a net decrease of approximately 15 basis points in the CET1 Ratio. This one-time impact is expected to be offset over time by higher net income resulting from the reduction in the U.S. federal tax rate. The ultimate impact will depend on final tax changes and the effective date of the lower tax rate. Refer to the Critical Accounting Estimates – Income Taxes and Deferred Tax Assets section on page 114 for further discussion on the expected impact of the proposals.
2017 Regulatory Capital Review
BMO is well capitalized, with capital ratios that exceed OSFI’s published requirements for large Canadian banks, including the 1% D-SIB Common Equity Surcharge implemented in 2016. Our CET1 Ratio was 11.4% at October 31, 2017, compared to 10.1% at October 31, 2016. The CET1 Ratio increased from the end of fiscal 2016 due to higher capital, largely from retained earnings growth and common shares issued through the Shareholder Dividend Reinvestment and Share Purchase Plan (DRIP) and the exercise of stock options, partially offset by share repurchases, with other items having largely offsetting impacts. The net impact of source currency RWA changes was relatively small, largely due to higher RWA from business growth being more than offset by the benefits of risk mitigation and capital management actions and methodology changes. The impact of foreign exchange movements was meaningful to RWA and CET1 capital, compared to October 31, 2016, but are managed by the enterprise such that the impacts largely offset. BMO’s investments in foreign operations are primarily denominated in U.S. dollars. The foreign exchange impact of U.S. dollar-denominated RWA and U.S. dollar-denominated capital deductions may result in variability in the bank’s capital ratios. BMO may offset the impact of foreign exchange movements on its capital ratios, and did so during 2017. Any such activities could also impact our book value and return on equity.
Our Tier 1 Capital and Total Capital Ratios were 13.0% and 15.1%, respectively, at October 31, 2017, compared to 11.6% and 13.6%, respectively, at October 31, 2016. The increase in the Tier 1 Capital Ratio was mainly due to the factors impacting the CET1 Ratio discussed above and issuances of preferred shares, partially offset by the redemptions of non-NVCC preferred shares. The increase in the Total Capital Ratio was mainly due to the factors impacting the Tier 1 Ratio.
BMO’s Leverage Ratio was 4.4% at October 31, 2017, up from 4.2% at October 31, 2016 and in excess of the 3% minimum requirement established by OSFI.
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