Once lagging behind banks in other countries, Canadian banks are now a case study in ERM best practices — thanks to factors such as strong regulations, substantial loss events that galvanized ERM efforts, and ERM best practices capabilities of people, processes, systems and data in the individual banks.
Canadian banks are now strong, stable and profitable. They have become sterling examples of successful Enterprise Risk Management (ERM). Yet, it wasn’t very long ago that Canadian banks were in a worse position than many banks in other countries. Traditionally, Canadian banks had a greater exposure to high-risk assets and loans. Their exposure to less-developed countries (LDC) loans was nearly 11 times the exposure of U.S. banks, for example. Their exposure to commercial real estate was 2.5 times larger than the exposure of U.S. banks. Between 1980 and 1994, Canadian banks received three hits that resulted in significant loan losses: 1) 1982 losses in less developed countries (LDC); 2) mid-1980s losses in the energy sector (notably Dome Petroleum); and 3) from 1990- 1994, losses in the commercial real estate sector.
How did the Canadian banking sector overcome these setbacks to become ERM leaders in their industries?
According to Lois Tullo of York University’s Schulich School of Business, three factors played a major role in the turnaround.
The first factor was Canada’s strong regulatory environment and stable economic environment. The effort began in 1987 with the creation of the Office of the Superintendent of Financial Institutions (OSFI) to promote sound business and risk management practices. Among these practices are Internal Capital Adequacy Assessment Process (ICAAP) submission requirements that ensure that Canadian banks are not under-capitalized. All Canadian banks are currently on target to meet their next ICAAP deadline of December 2016, according to Tullo’s recent conversations with their CROs.
The Canadian mortgage market is also more stable than in other countries. For example, adjustable rate mortgages are not allowed, preventing borrowers from being enticed by low rates that then climb. And because mortgage interest is not tax deductible, people have more motivation to pay off their mortgages.
Canadian banks have also been world leaders in applying international banking standards. Canadian banks became the first in the world to appoint chief risk officers (CROs). Canadian banks were also the first required to incorporate the provisions of all of the Basel banking accords, far ahead of U.S. and European banks. That Canadian banks lead all peers in compliance to the 2013 Basel Committee on Banking Supervision (BCBS) risk data aggregation and reporting guidelines is not a surprise: they have been working on such governance and reporting principles before the guidelines were published.
The second factor that contributed to best practice ERM were burning platform (catastrophic) loan losses for the individual banks. As the term implies, burning platforms require urgent action, which led to the third best practice ERM factor: a complete re-evaluation of a bank’s risk management strategies and processes.
The Bank of Nova Scotia’s burning platforms, for example, included employee fraud in its Mexican division that led to the 2001 death of a branch manager and the conviction of 16 employees for embezzlement of funds. And the problems of BNS were not finished. That same year, Argentina defaulted on its foreign debt, leading to a $540 million write-off.
In response to its foreign setbacks, BNS has developed best-in-class country risk assessment teams who become deeply involved in every international joint venture. Enterprise risk management is built into the joint venture process. Every deal undergoes a thorough risk assessment that covers: the country, the target firm, the management of that firm, its processes, its systems, and its assets and liabilities. In addition, a country Chief Risk Officer (CRO), reporting to the Canadian CRO, is assigned to any country in which BNS has activities.
Not all of the lessons from the Canadian banks can be applied globally. The economic stability of the country is perhaps exceptional. The importance of a strong regulatory environment, however, should be taken under advisement.
More specifically, individual banks should make every effort to anticipate disasters before they occur. The five Canadian banks featured by Tullo in her Journal of Financial Transformation article endured burning platform disasters that spurred best practices. The case of the Canadian Imperial Bank of Commerce is typical. It endured a series of burning platforms: premature investment in electronic banking in the U.S.; a strange scandal involving errant faxes sent for years to a West Virginia junkyard; entanglement in the Enron scandal; and involvement in the mortgage- backed securities crisis. Finally, in 2008, CIBC’s board of directors made risk management its highest priority, including (among a number of initiatives) strengthening its funding profile, exiting non-core business that did not fit its new risk strategy, enhancing talent and experience within its top leadership, and reducing its U.S. residential mortgage market exposure.
The bottom line for all banks is to realign their risk appetites to face the reality of a complex and increasingly volatile environment... before the platform starts to burn.
Enterprise Risk Management — Canadian Best Practices: How Did They Get There? Lois Tullo. Journal of Financial Transformation (October 2015).
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