TORONTO Canada’s banking regulator is requiring certain financial institutions to stress-test a 50 per cent decline in house prices in Greater Vancouver, and a 40 per cent dive in Greater Toronto, the two hottest markets in the country.
A 30 per cent decline in house prices must be tested across the rest of Canada, the Office of the Superintendent of Financial Institutions said in a notice Tuesday to the country’s “standardized” banks.
These do not include the country’s six largest banks, or HSBC Canada, according to an OSFI spokesperson. The country’s next largest bank, Laurentian, and other smaller deposit taking institutions will be subject to the new stress tests, the results of which are to be reported to OSFI by yearend, analysts said.
Significantly, the assumptions for declines in the Vancouver and Toronto housing markets are to be raised from an earlier assumed downturn of 30 per in all markets across the country, according to OSFI.
Annik Faucher, a spokesperson for OSFI, said the regulator does not disclose details of specific scenarios used to stress test Canada’s largest banks — those categorized as domestic systemically important financial institutions. Those banks also conduct their own internal tests to assess the impact of “severe but plausible” scenarios, which are shared with OSFI, she said.
Still, market watchers said the more pessimistic stress tests that must be conducted by Canada’s smaller deposit-taking institutions shed some light on what the regulator is thinking.
One noteworthy element of the new tests for the smaller banks is that they will measure the impact on more than just the closely watched CET1 capital level and total ratios. They will also contemplate scenarios in which a bank’s “authorized leverage ratio may be breached.”
Insured mortgages are not used to calculate capital requirements, but they are included in the leverage ratio, so their impact would be captured by the new stress test requirements, said Jason Mercer, an analyst at Moody’s Investors Service.
“In theory, a bank could beat the stress [test on capital] by assuming it starts insuring the remainder of its mortgage portfolio,” he said. “The leverage ratio would then pick this up” and could fall below the required threshold even if capital did not.
The regulator’s stepped-up stress tests are “not surprising given the recent concerns on housing and household debt,” said Mercer, who recently wrote a report that estimated a U.S.-style housing crisis would cost the country’s biggest banks and mortgage insurers more than US$17 billion.
Unlike regulators in the United States, OSFI does not make the results of bank stress tests public. However, the bank watchdog has been making tweaks over the past year, in tandem with federal and provincial governments, aimed at cooling red-hot real estate markets and tamping down financial risk.
OSFI’s directive to smaller banks Tuesday came on the heels of the British Columbia government’s move this week to introduce a 15 per cent tax on foreign homebuyers. The land transfer tax, widely viewed as a tool to cool the hottest pocket of the province’s real estate market by reducing foreign speculation, is to come into effect on Aug. 2 and would apply to residential real estate in Vancouver.
Earlier this year, OSFI proposed changes to the amount of capital the country’s biggest financials institutions must hold against some residential mortgages to keep pace with the rapid rise of house prices and highly leveraged buyers in some markets.
The new requirements are to come into effect in November.
In addition, OSFI Superintendent Jeremy Rudin sent a letter to Canada’s banks this month in which he laid out enhanced expectations for mortgage lending practices including income verification.
“The risks are getting larger,” Rudin said in a statement on July 7, the date the letter was sent. “OSFI wants to see sound mortgage underwriting procedures in place that adapt to the ever-changing circumstances in this area.”
He told the Financial Post the regulator wants banks to understand that they should not treat OSFI’s guidance for mortgage lending simply as a “compliance exercise,” or use threshold examples set by the regulator as “safe harbours.”