Canadian Lenders Should Set Aside More Capital As Mortgage Risks Mount: Regulator

Canada’s main banking regulator has directed lenders to hold more capital against mortgages that have seen their repayment terms extend beyond the original terms due to the record pace of interest rate hikes, to contain risks building in the system.

Canada’s nearly $2 trillion mortgage market has been shaken up by the central bank’s interest rate hikes, with many home owners only able to make interest payments, resulting in their mortgage repayment terms getting longer. This rare phenomenon, called the negative amortization, has had the regulator worried about the financial health of the banks.

The Office of the Superintendent of Financial Institutions (OSFI) announced revised capital guidelines, which kicks in next year, “will require institutions to hold more capital for mortgages where payments don’t cover the interest portion of the loan (i.e., negatively amortizing mortgages),” the regulator said in a statement on Friday.

“We believe these incremental changes add additional resilience to Canada’s financial system,” Superintendent Peter Routledge said.

To deal with the rising risks in mortgage loans, Canada’s top six banks have jointly set aside about C$3.5 billion towards bad debt provisions in their latest quarterly earnings, denting their profits.

During the first nine months of the fiscal year, the banks have set aside C$9.45 billion, more than four-times the amount set aside in the prior year.

Among the top six banks, Bank of Montreal BMO.TO, Canadian Imperial Bank of Commerce CM.TO, Royal Bank of Canada RY.TO and Toronto Dominion TD.TO offer fixed-payment variable rate mortgage options. Bank of Nova Scotia BNS.TO and National Bank of Canada’s NA.TO variable-rate offerings have payments that adjust upward with rates.

The Bank of Canada’s has raised interest rate to a 22-year high of five per cent which has pushed up variable-rate mortgages. In cases where the repayments are fixed, they largely go towards the interest portion of the loan and sometimes do not ever cover the interest owed.

The rise in global bond yields have made it more uncertain for homeowners as they brace for a shock interest rate jump in their mortgages when it is time for renewal.

OSFI has made changes to including its Capital Adequacy Requirements, Life Insurance Capital Adequacy Test, Minimum Capital Test, and Mortgage Insurer Capital Adequacy Test.

Fitch in a recent note said that the change can be “comfortably absorbed,” impacting common equity tier 1 ratios by less than two per cent of the average third quarter average of 13.5 per cent for the four banks with exposure.

The changes will not lead to an increase in monthly payments for consumers who currently have a mortgage, OSFI said.

For banks with a fiscal year end of Oct. 31, the revised CAR guideline is effective November 1, 2023.

Shares of the big six banks have lost between roughly three per cent and 12 per cent of their value so far this year.