The Bank of Canada today made an important addition to its website: the Financial Stability Hub, "a dedicated space....for timely analysis and research on financial stability issues". The Bank and its political bosses at the Department of Finance were little short of smug at the domestic banking sector's stability during the financial crisis a decade ago. With the next financial conniption only a matter of time, the Bank evidently thinks it's important to get an early start on convincing investors and depositors that the system is well-prepared and resilient.
The new Hub is off to a flying start, with three new papers added on the first day. A couple of these are worthy of comment: a report on the vulnerability of the financial system to house price corrections, and an analysis of the impact of recent policy changes on the mortgage market.
The paper on house price corrections is rich in acronyms, introducing us to a "suite of models" known as FRIDA: Framework for Risk Identification and Assessment. FRIDA and her less pronounceable offspring (including CDM and MFRAF) allow the Bank to model the macroeconomic impact of a house price correction and increase in financial stress. The Bank has specifically modelled the impact of a nationwide 20 percent fall in house prices. It considers this an improbable scenario, but it is worth noting that in the key Toronto and Vancouver markets, this would represent less than a 50 percent retracement of the price increases recorded in the past five years.
The results from FRIDA are reassuring. Thanks to tightened regulations, Canada's banks have more, higher quality capital than in the past. As a result, the scenario under consideration would result in lower bank earnings over a five-year time horizon, but would not threaten capital positions. That said, the Bank recognizes that things could turn out worse if a house price correction were to coincide with some other shock to the system -- a national recession, for example, or a loss of international investor confidence. It appears FRIDA will be set to work examining some of these additional risks in future reports.
As for the impact of policy changes on the mortgage market, the Bank cannot quite avoid taking a self-congratulatory tone. Its policy changes are having "a clear impact" on the market, and in particular the "number of new highly-indebted borrowers has fallen". This is worth focusing on, because the Bank's definition of "highly indebted" is terrifying: it refers to borrowers taking on a mortgage loan equivalent to 450 percent or more of their annual income. The Bank provides various measures of how its tighter rules have affected this segment, but the broadest measure is that the overall percentage of new borrowers falling into the highly indebted category has fallen from 18 percent to 13 percent.
The report also looks at regional trends in mortgage lending. Overall growth in the mortgage market has slowed in response to tighter rules and a pullback in house prices. The biggest declines have been seen in the formerly overheated Toronto and Vancouver markets. The number of new highly indebted borrowers in those markets has also fallen, but it remains worryingly higher than in the rest of the country. This suggests that even if the financial system as a whole could weather a correction, the level of pain in some parts of the country could still be extremely high.
One further vulnerability in the market gets only a passing mention in the report, but will bear watching as things evolve. Tighter mortgage rules at the major banks have pushed more borrowers into the arms of private lenders, whose lending criteria are unregulated and undoubtedly less stringent. In Toronto, the only area for which the Bank appears to have data, these lenders have boosted their share of overall mortgage lending, though it still stands short of 10 percent. The systemic issue here is not whether these folks, both borrowers and lenders, will run into trouble if house prices tumble. They undoubtedly will. But if I were the Bank of Canada, what I'd be worrying about is, what is the source of the money that the private lenders are so enthusiastically shovelling out?
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