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.
Three Reasons
The Canadian dollar pared some of its intraday losses after the report. The currency was down 0.2 per cent to C$1.2798 per U.S. dollar at 10:48 a.m. in Toronto trading.
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.”
Uninsured Mortgages
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 per cent, which is being fuelled 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.
Uncertain
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.”
Bloomberg.com