Introduction

The high-paced growth of residential house prices, particularly in the Vancouver and Toronto markets, is continuing to generate concern from both the Bank of Canada and the Office of the Superintendent of Financial Institutions (OSFI). In its semi-annual Financial System Review, released on June 6 2016, 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 7 2016 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 addressed 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 its comments serve as a good reminder for institutions when addressing any principles-based requirement.

Income-appropriate loans

As was seen in the 2008 financial crisis, 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 expects lenders to 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 it has been undertaking with 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 standardised approach. Changes to these rules would affect 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 amortisation 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 affected if banks adopt the more conservative practices suggested in the letter. Only time will tell whether the letter will be sufficient to address the escalating risks noted by OSFI and the Bank of Canada.

For further information on this topic please contact John Jason at Norton Rose Fulbright Canada by telephone (+1 416 216 4000) or email (john.jason@nortonrosefulbright.com). The Norton Rose Fulbright Canada website can be accessed at www.nortonrosefulbright.com/ca/en/.

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