Canada’s top banking regulator says that the cost of higher capital requirements is worth it, but publicly identifying systemically-important financial firms and publishing stress tests is not.

In a speech to a conference in Geneva Wednesday, Superintendent Julie Dickson, Office of the Superintendent of Financial Institutions, discussed what she sees as some of the costs and benefits of various regulatory reforms that are being pursued in response to the global financial crisis. She argued that, “banking regulation and supervision are critical and should not be watered down to achieve other objectives.”

“While healthy debate about regulation is good, including debate about whether the pendulum has swung too far, we need to be careful about opting for milder reforms in the hope that it will help solve another problem,” she said.

That said, while Dickson noted that new capital and liquidity requirements, known as Basel III, are a good step, she cautioned that they should not be considered the last word in banking regulation. “Unintended consequences may emerge over time,” she allowed. “So we need to be on high alert and be prepared to reassess Basel III, depending on what we see.”

She also tackled the question of systemtically-important financial institutions, and how regulators should be dealing with them. Dickson said that Canada is opposed to publishing a list of SIFIs. “We are more supportive of measures such as contingent capital, bail-in debt and living wills, as these can be applied across a wide range of institutions. With these in place you do not need to define a category of institution called a SIFI or a [global] SIFI,” she said.

Indeed, Dickson said that the debate over how to deal with SIFIs, while unresolved, has had some positive effects. For one, it has raised awareness of the issue, she noted, “Prior to the crisis I am not sure that CEOs would have spent much time thinking about the possibility of imposing social costs on society. Rather, they would focus on the benefits for shareholders and customers like boosting share prices, facilitating trade, and one stop shopping.”

Also, she said the focus on living wills is a significant step forward. “Prior to the crisis we decided it was too dangerous to test of what would happen if a major institution failed – this was considered too delicate an operation, especially if anyone got wind of it. Now it is becoming standard procedure,” she said.

However, she suggested that she’s also skeptical of publicly-reported stress tests. “The benefit might be that more information may be presented to the market, but there are downsides as well. For one, we want markets to do their own credit assessments.”

“We will not solve the problem if we move from a system where investors think their investment in a systemically important bank is backed by a government guarantee, to a system based on a seal of approval from regulators,” she said. “This would only arm investors with a new argument to be paid out when things go wrong.”

Instead, financial institutions should focus more on disclosure, she argued. “Otherwise, an important element of the governance framework over the financial system – market discipline – will not work.”

“We need incentives for market participants to demand disclosure and to act on such disclosure. Unless investors believe that they have something to lose and that they will not be bailed out, they will have no reason to demand disclosure or to pay close attention to the information provided by financial institutions,” she concluded.

IE