The Bank of Canada released the latest edition of its biannual Financial System Review this morning, laying out an updated view of the main risks facing Canada’s financial system. Household indebtedness and housing market imbalances once again took center stage. However, robust economic growth and tightened mortgage rules are seen as factors that should mitigate these vulnerabilities over time. The vulnerability of the Canadian financial system to cyber-attacks was also highlighted as a risk.
On the topic of household indebtedness, the Bank noted that credit growth continues to outpace income growth, largely due to mortgage and HELOC activity. Encouragingly, the share of mortgage originations going to highly-indebted, high-ratio borrowers has declined notably, likely due to mortgage stress test rules implemented last year. However, there are signs that risks may have shifted towards low-ratio borrowers. They account for about 9 in 10 new mortgages in Toronto and Vancouver, with the share of both borrowers that are highly indebted and those with amortizations of more than 25 years trending up, pointing to heightened risk.
The newest mortgage underwriting guidelines from OSFI are meant to address this risk, but the Bank of Canada sees uncertainty around the effectiveness, noting that around 17% of outstanding uninsured mortgages are held by credit unions that are not regulated by OSFI and therefore not subject to the new guidelines. As such, there remains the possibility that high risk borrower activity shifts away from the more heavily regulated areas of the financial system. However, the extent of migration may be limited by the relatively smaller lending capacity available. On balance, the new guidelines are seen as broadly supportive of overall credit quality, although the large stock of outstanding debt means it will take some time for the overall vulnerability to be reduced.
On a related note, the Bank highlighted the vulnerability stemming from imbalances in Canadian housing markets. The report notes that as Toronto has undergone an adjustment over the summer months, home price growth elsewhere has remained steady, with healthy growth in Vancouver and nascent signs of a recovery in Alberta. This has served to reduce the differences in regional home price growth. Policy measures, including changes to underwriting standards are expected to continue to reduce demand and thus price growth, particularly in the high growth markets of Toronto and Vancouver. The Bank also noted that some localized measures, such as foreign buyer taxes in specific regions may have only a limited impact, and may be pushing demand to other cities.
Cyber threats have always been a risk to the financial system, but the growing interconnectedness of the system means that the impacts can be more significant, with a successful attack against one institution potentially spreading more widely. The Bank is working with financial institutions to increase resiliency and put recovery plans in place.
Other vulnerabilities discussed include brokered deposits at monoline lenders, with the experience at Home Capital Group earlier this year demonstrating the risk of rapid funding withdrawal. Risk taking, in a general sense, is being incentivized by low interest rates and low market volatility, leading to the use of higher leverage and rising risk profiles among investors. Finally, high corporate indebtedness was noted – corporate debt relative to GDP is at historic highs, although firms appear to have adequate cash buffers at present.
Key Implications
Canada’s financial system may be facing a number of key vulnerabilities, but the Bank of Canada sees things moving in the right direction. For both high household indebtedness and housing market imbalances, changes to underwriting standards and rising interest rates are having, or are expected to have, the desired effect. The report noted that past changes to standards for borrowers with low down payments had something of a balloon-squeezing impact, pushing some risk into high down payment lending, but this should be at least partially mitigated by expanded mortgage stress-testing requirements in the new year.
More fundamentally, rising borrowing costs, which impact all sectors of the market, should work to slow activity. The Bank noted that five-year fixed mortgage rates are up 70 basis points since June, bringing them in line with levels seen five years ago. At the same time an improved economic backdrop, including robust employment growth, is seen as also working to reduce vulnerabilities through time.
In light of the sizeable stock of debt outstanding, it will be some time before these factors work their way through the market, with these vulnerabilities not going away any time soon. However, 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.
