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OSFI says housing market tops risks to Canada’s financial system

Growth of non-bank lending also raises concern

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The housing market has topped an annual list of the biggest risks to Canada’s financial system released by the country’s top banking regulator, which also flagged the danger that trouble in the “non-bank financial” sector could pose for the broader system.

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Risks tied to liquidity and funding as well as to commercial real estate, that latter of which has been identified by market watchers as being particularly vulnerable to rising interest rates, were also singled out in the Office of the Superintendent of Financial Institutions’ annual risk outlook for 2023-24.

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“Given the rapidity at which interest rates globally have increased, the risk has grown that such an adjustment may not be completely smooth,” OSFI said.

The April 18 assessment noted that Canada’s financial system is resilient but highlighted “growth and uncertainty in unregulated non-bank financial” activity, which, it said, “may increase the likelihood of risk transmission to the broader financial system during periods of volatility and market decline.”

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Peter Routledge, OSFI’s superintendent, said the annual risk report, the second of its kind, is intended to highlight “significant risks facing Canada’s financial system” and inform the public about the regulatory response to these risks.

On a media conference call, Routledge said unregulated and “under-regulated” mortgage lenders remain a fairly small segment of the Canadian market and OSFI’s concerns about risk spilling over into the regulated banking sector — a new red flag added to the 2023 report — have more to do with hedge funds or other investment companies that may have large derivative contracts with the banks.

“We want to make sure that the bank is managing that counterparty risk appropriately, that there’s appropriate collateral and margining practices in place, (and) that those collateral and margin practices are well understood both by the bank and the counterparty,” he said.

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When it comes to risks in the housing market, Routledge said OSFI “is preparing for the possibility but not predicting that the housing market will experience sustained weakness throughout 2023.”

The regulator flagged variable-rate fixed-payment mortgages, in particular, because monthly payments on these mortgages in the rising rate environment can fail to cover even the interest in some cases.

The short-term solution is to extend the amortization period, but Routledge said this sets up borrowers for potential “payment shock” on renewal in the next two to three years when the mortgage will typically return to the original amortization period, causing a fairly significant increase in monthly payments.

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He said OSFI is urging banks to get ahead of this by developing strategies that include reaching out to clients early and “working through and planning … how to adapt to a higher payment.” This can include overpaying on monthly amounts and making early lump sum payments on the mortgage.

“It’s not so much (that the) banks can force them. They can work with them constructively to help them manage that risk out there,” Routledge said.

“In terms of capital, we’ll continue to look at our capital allocation and capital rules for mortgages and, generally speaking, if a mortgage has higher credit risk, institutions will have to put more capital aside.”

OSFI is also monitoring pressures on liquidity and funding conditions as markets absorb the impact of tightening monetary policy and geopolitical uncertainties. Early warning signs of problems would include material changes in deposit stability or funding access, and counterparty credit exposures, Routledge said.

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Meanwhile, inflation, the potential rise of borrower defaults, and ongoing supply chain issues are already putting pressure on construction and development which, along with office assets, are the sub-segments of commercial real estate facing the most uncertainty in the coming year.

“We are continuing targeted monitoring (to) identify signs of borrower and portfolio vulnerabilities,” Routledge said.

He noted that Canada continues to have low unemployment and salaries are rising, which should bolster credit quality and absorb some of the housing risk, and said he was surprised at how “benign” credit conditions were despite the substantial rise in interest rates from 0.25 cent to 4.25 per cent in a single year. The overnight rate was raised another notch to 4.5 per cent in January before the Bank of Canada paused increases.

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“We haven’t seen an acceleration of interest rates this dramatic since the 1980s,” said Routledge.

“What is surprising, but certainly interesting to us is relatively benign credit conditions despite all that.… I would have expected to see more credit losses.”

But he said OSFI is “not at all relaxed” and he is taking into consideration that there tends to be 12- to 18-month lag before the full effects of monetary policy are seen.

“One of the reasons we put out an annual risk outlook is to remind ourselves and everyone that we’re not through this yet — risks are still out there,” Routledge said.

OSFI’s 2022 assessment did not rank risks by importance and included significant cyberattack and digital innovation among them. Last year’s assessment also warned that rapidly rising interest rates would put pressure on retail, corporate and commercial borrowers in terms of their ability to service debt.

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