Canada’s lenders need to assume responsibility for managing risks in lending to households and shouldn’t rely on regulators to avoid hazards, the head of regulation at the country’s banking watchdog said.
Lenders must “make sure they have the financial resources to manage those risks and the institutional capacity to manage those risks,” Mark Zelmer, assistant superintendent in charge of regulation, said in an interview. “Anybody that was just simply running the business and managing to OSFI expectations is putting a lot of faith in the regulatory framework.”
The Office of the Superintendent of Financial Institutions released draft guidelines for mortgage underwriting in March urging lenders to establish internal standards on the ability of borrowers to service their debt and take “reasonable steps” to verify income. The rules would also limit home equity lines of credit to 65 percent of the value of the property.
Zelmer’s comments underscore tension between policy makers and mortgage lenders as a booming housing market helps drive profits at banks even as it increases their exposure to a drop in home prices. Analysts at CreditSights Inc. assigned an “underperform” rating for the Canadian banking industry in a May 15 report, citing concern that current spreads on their debt don’t “adequately compensate” for potential risks in the housing market.
“Ultimately, it’s the institutions that are first and foremost responsible,” Zelmer, 51, said. “The regulatory framework and supervision is the safety net that stands behind that.”
Low Borrowing Costs
While Canada escaped the last housing crisis by steering clear of subprime mortgages, low borrowing costs set by the Bank of Canada and commercial lenders have fueled a debt surge in Canada that now threatens the country’s recovery. Canadian household debt levels relative to income have surpassed those in the U.S. and the U.K.
Household debt is the biggest risk to Canada’s financial system and necessitates prudent lending practices to help avoid the type of crises experienced elsewhere, according to Zelmer.
“Certainly, what’s happening with rising household indebtedness is probably the most important domestic vulnerability facing the Canadian financial system,” Zelmer said in the interview. “Hopefully, ours would be a benign path as opposed to some of the history we’ve seen elsewhere.”
In an April 5 speech, OSFI Superintendent Julie Dickson said the regulator had found cases where lenders weren’t following mortgage-lending practices approved by the company’s board of directors. The agency’s proposed rules would require boards to approve companywide mortgage policies, and senior executives to declare annually the plans are being followed.
The rules may “have a negative impact on borrowers and could cause mortgage costs to rise,” the Canadian Association of Accredited Mortgage Professionals said in a written response to OSFI. The association, which represents mortgage lenders, insurers and brokers, has urged the regulator to be flexible in imposing some of the rules.
The period for commenting on the proposals rules closed May 1. OSFI is trying to have a final version of the guidelines by the end of June that will have “benefited from the feedback that we’ve received,” Zelmer said.
Canadian banks, including Royal Bank of Canada and Bank of Montreal, have said they’re comfortable with their exposure to the housing market.
‘Very Well Managed’
Royal Bank Chief Executive Officer Gordon Nixon said during the May 8 Bloomberg Canada Economic Summit that lending policies in Canada are “very well managed.” Bank of Montreal has said it could absorb losses under an “extreme stress scenario” with high unemployment, a “significant decline” in housing prices, a rapid increase in interest rates and a drop in economic output.
Canada’s banks have been ranked the soundest by the World Economic Forum for four straight years. Four Canadian banks were among the world’s six strongest in Bloomberg’s second annual rankings released May 3. Canadian Imperial Bank of Commerce was No. 3, followed by Toronto-Dominion Bank, National Bank of Canada and Royal Bank.
Bank exposure to a housing correction is “very manageable” given their relatively strong financial position, according to a May 16 report by Scotiabank analyst Kevin Choquette, who tested a scenario where house prices decline by as much as 35 percent. Direct bank earnings would drop as much as 16 percent under that scenario, the report found.
In the interview, Zelmer said Canadian lending standards are “not in a situation” like the U.S. before the financial crisis and the regulator’s objective is to be “pro-active” with new guidelines. He said Canadian regulators may seek to draw lessons from JPMorgan Chase & Co. $2 billion trading loss announced last week.
“If there are lessons to be drawn we’ll be paying close attention to see what are the facts as opposed to all the hype around the situation and see what that tells us in terms of the oversight of our own institutions,” Zelmer said.
“Given past experience elsewhere, given what’s happening in Canada, it’s incumbent on us to be very clear about what our expectations are at this stage of the cycle,” he said.
There is evidence some OSFI officials are concerned that banks may be vulnerable. A memo by OSFI’s manager of policy development, Vlasios Melessanakis, obtained by Bloomberg News under freedom-of-information law, warned that Canada’s banks aren’t immune to collapses triggered by falling housing prices. A spokesman for the regulator said Melessanakis’s remarks don’t reflect the regulator’s official position and were not sent to Dickson.
“We’re paying close attention to it because it is an important potential vulnerability for the system,” Zelmer said.
In April, Canadian Finance Minister Jim Flaherty introduced legislation that prevents lenders from using government-insured mortgages as collateral for bonds. Canada’s biggest covered bond issuers have piggy-backed off government guarantees to cement top AAA ratings for their bonds, which cut their funding costs compared with European and Australian banks.
Flaherty has also refused to raise the C$600 billion legal limit on mortgage insurance of the Canada Mortgage Housing Corp., and the federal housing agency has begun rationing bulk insurance for financial institutions.