Bank of Canada Sees Financial System Vulnerabilities EasingBy
Central bank warns risks remain elevated, measures take time
Growth of uninsured mortgages continues to be key worry
The Bank of Canada is optimistic higher interest rates and regulatory efforts to rein in risky borrowing will make the country’s financial system more resilient, though the process could take time to unfold and the outcome remains uncertain.
In its semi-annual financial stability report, Canada’s central bank painted a picture of a housing market where key steps have been taken to improve the quality of lending, particularly in the most expensive cities such as Toronto. At the same time, it warned risks remain elevated, particularly high household debt levels, and measures to rein in loans to the most highly indebted households will take time to work.
“Our financial system continues to be resilient, and is being bolstered by stronger growth and job creation, but we need to continue to watch financial vulnerabilities closely,” Governor Stephen Poloz said in a statement.
The language in the report parallels the main message in the central bank’s last Financial System Review in June -- that of strengthening resiliency of the financial system on the back of an improving economy -- that provided the backdrop for two rate increases in July and September.
“The Bank sees things as moving in the right direction -- towards reduced financial sector risk -- a scenario consistent with continued gradual tightening of monetary policy in 2018,” Brian DePratto, a senior economist at TD Economics said in a note to investors.
Investors are pricing in one more rate hike by May, and another rate increase by the end of next year.
The central bank cited three main reasons why it expects risks to mitigate over time: income growth, new mortgage finance policy measures and higher mortgage rates.
New regulations -- the federal government’s in 2016 and the banking regulator last month -- limit the creation of new highly indebted households, and should reduce demand in cities like Toronto where speculative demand has been a factor, the central bank said.
“The effects of tighter mortgage rules implemented last year have already improved the quality of new insured lending,” the Bank of Canada said. “Income growth, new mortgage finance policy measures and higher mortgage rates are expected to mitigate this vulnerability over time.”
Unlike in 2015 when Canadian output sputtered and the central bank was forced to reduce interest rates, the stronger economy now is moving in the same direction as tighter mortgage rules by reducing vulnerabilities, Poloz said.
“There is no fundamental inconsistency,” Poloz told reporters at a press conference after the report, adding the central bank’s “primary mission” is to target inflation, not reduce financial system imbalances.
“A nice by-product” of this year’s two rate increases is that “those things help reduce vulnerabilities at the same time,” he said.
One area that remains a major concern for the central bank is the growing share of uninsured mortgages, those with loan to value ratios at or below 80 percent, which is being fueled by higher Toronto and Vancouver home prices and tighter qualification rules for insured mortgages. The issue was a focus for a second consecutive report, with the central bank saying a portion of these loans are displaying riskier characteristics.
The proportion of low ratio loans to highly indebted households is trending up, and the share of these mortgages amortized longer than 25 years is also increasing, it said. The issue has been particularly prominent in regions with the highest price growth, such as Toronto.
The Bank of Canada analyzed the impact of October regulatory changes by the Office of the Superintendent of Financial Institutions, which make it more difficult to qualify for insured mortgages. It concluded they are “expected to decrease the proportion of highly indebted households among new borrowers” particularly in high price growth regions.
But the end result is still uncertain, the central bank cautioned.
“As borrowers and lenders adapt to the new OSFI guidelines, it will take some time to assess the extent to which this vulnerability is being alleviated,” it said.
Based on the impact of the federal government’s 2016 measures to curb riskier insured mortgages, “a material impact” on new lending could take as long as six months, it said. And because of the largest stock of debt, it could take “several years” to have a significant impact on overall vulnerability.
The central bank had a similar message for how higher borrowing costs and the new regulatory measures will impact housing markets like Toronto. It should reduce demand, “but the impact of these policy measures on the market is uncertain,” it said.
“There is uncertainty about how borrowers and lenders will react to the new OSFI measures,” it said. “There is also uncertainty around the sensitivity of the housing market to higher interest rates.”
(An earlier version of this story was corrected to show that low-ratio mortgages are those with loan to value at or below 80 percent.)
— With assistance by Erik Hertzberg