The high-paced growth of residential home prices, particularly in the Vancouver and Toronto markets, is continuing to generate concern both from the Bank of Canada and the Office of the Superintendent of Financial Institutions (OSFI). In its semi-annual Financial System Review, released on June 6th, the Bank noted that the vulnerability of the financial sector continues to rise due in part to strong mortgage credit growth and rapidly increasing home values in some regions.

On July 7th, OSFI took the somewhat unusual step of publishing a letter that was sent to all federally-regulated financial institutions reminding them of OSFI’s expectations for prudent mortgage lending practices as described in Guideline B-20.  In particular, the letter addresses OSFI’s expectations for income verification, non-conforming loans, debt servicing ratios, appraisals and risk appetite.

Not a compliance exercise

Guideline B-20, like most of OSFI’s more recent guidelines adopts a principles-based approach to regulation. In this case, the guideline sets out certain principles that OSFI expects lenders to consider in establishing their mortgage underwriting standards and practices.  OSFI took the opportunity to remind lenders that it expects them to carefully consider each principle in the context of their own institution.  Simply addressing a principle in a cursory manner so that it is “checked-off” reflects what OSFI calls a “compliance exercise” and not the type of careful review that is intended for principles-based requirements.  OSFI takes the same view across all of its principles-based guidance and OSFI’s comments serve as a good reminder for institutions when addressing any principles-based requirement.

Income appropriate loans

As was seen in the financial crisis of 2008, in times of rapidly escalating prices, lenders can place too much reliance on collateral coverage and not enough emphasis on debt servicing capability. OSFI took the opportunity in the letter to remind lenders to adopt robust and conservative practices for income verification and debt servicing.  For example, lenders were reminded that their debt servicing assessment should not assume that the current low interest rates will persist.

Conservative appraisals

The rapid escalation in house prices also led OSFI to comment on the processes used to appraise collateral values. In this regard, OSFI encouraged lenders to adopt conservative practices and not to assume that prices will remain stable or continue to rise.

Risk appetite and portfolio risk should align

Although there has not yet been a marked increase in mortgage defaults, both OSFI and the Bank of Canada warn that the risks associated with mortgage lending have changed. OSFI cautioned that lenders that do not adjust their underwriting standards and practices to address the evolving risks may find that the risk associated with their mortgage portfolios is greater than their stated risk appetite would permit.  OSFI noted that it is expecting that lenders will conduct regular reviews to ensure that there continues to be alignment between their standards and practices and their appetites.

Capital considerations

The OSFI letter made mention of the work that they have been undertaking with the large banks to ensure that their models for calculating their regulatory capital continue to be appropriate. However, OSFI also mentioned that work is underway at the Basel Committee for Bank Supervision to revise the capital requirements for residential mortgages under the standardized approach.  Changes to these rules would impact the smaller banks that compete in the residential mortgage market.

Impact on mortgage market

The OSFI letter is only one of several steps that have been taken to address the potential risks emanating from the mortgage market. Previously, the government moved to reduce amortization periods and raise down payments required for certain insured mortgages.  While the letter does not change the rules for mortgage lending, the supply of mortgage loans could be impacted if banks adopt the more conservative practices suggested in the letter.  Will the letter be sufficient to address the escalating risks noted by OSFI and the Bank of Canada?  Time will tell.