The Office of the Superintendent of Financial Institutions (OSFI), the federal financial institutions prudential regulator, recently addressed the issue of a cap on issuance of covered bonds which presently stands at 4% of a bank’s total assets.
OSFI is now taking a hard look at this limit and is doing so in the context of its expectations on a bank’s overall management of asset encumbrance. The Superintendent of Financial Institutions has stated that any revision must encourage banks to maintain enough unencumbered, high quality assets when times are good to be able to meet both higher collateral requirements and broader funding needs, if times turn sour.
Covered bonds are debt securities issued by a financial institution which are collateralized against a pool of assets that are meant to cover claims should an issuer fail. This subject has attracted prudential oversight in Canada, particularly given its benefits.
One such is that covered bonds continue as obligations of the issuer, unlike asset-backed securities that are created in a securitization and are taken off of the issuer’s books. The covered bond investor benefits from recourse against both the issuer and the pool of cover asset, often known as ‘dual recourse’.
The investor also enjoys statutory protection as the bonds are issued under covered bond programs registered pursuant to the National Housing Act (NHA) and listed on the Canadian Covered Bonds Registry.
In Canada, the eligible collateral for covered bonds is restricted to residential mortgage loans that are not insured against default. These are mortgages for homes on which the borrower has paid a minimum 20% deposit.
The historical volatility of the housing market has inspired OSFI to strengthen its mortgage underwriting guideline and intensify supervisory scrutiny.
In particular, OSFI is looking for clear evidence that lenders have undertaken the following:
- validated that borrowers can meet their debt obligations through a range of economic conditions, including higher interest rates;
- ensured that borrowers have a cushion to absorb changes to their cash flow;
- relied less on collateral values in the underwriting process and more on borrower income in markets where housing prices have risen rapidly or where prices are high relative to incomes; and
- held more capital for mortgages to borrowers who have higher risk characteristics.