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Office of the Superintendent of Financial Institutions head Peter Routledge says 'it’s likely that banks across the world are going to suffer some losses associated with commercial real estate and they’re likely to be meaningful.'Dave Chan/The Globe and Mail

Canada’s banking regulator is warning that global banks will be hit by losses in commercial real estate as valuations sink under the weight of higher borrowing costs and waning demand.

Peter Routledge, who heads the Office of the Superintendent of Financial Institutions (OSFI), told a Toronto-Dominion Bank conference Friday that risk in office space and multiunit housing is looming over lenders, especially those with significant loan books in the United States.

“It’s likely that banks across the world are going to suffer some losses associated with commercial real estate and they’re likely to be meaningful,” Mr. Routledge said.

For Canadian banks, those impacts are likely to show up in financial results, with lenders setting aside higher-than-expected provisions for credit losses – the funds that banks allocate for loans that could default.

Mr. Routledge described the higher risk level for office space in the U.S. as dark red, and in Canada as dark orange. While the chance of loan defaults in the major banks’ domestic market is lower, OSFI expects the financial institutions to prepare for the riskier U.S. market.

“You could say that conditions are less bad in the Canadian office-space market, but we’re regulating to a more ominous scenario as a just in case,” Mr. Routledge told reporters at a media roundtable. “The Canadian institutions will be quick to point out to us that we’re too careful. We try and listen empathetically, but our job is to think of the worst and hope for the best.”

When OSFI looks at individual banks, each has a distinct level of exposure to different real estate segments in each region. Some portions of their commercial real estate portfolios could experience higher losses in Canada than in the U.S.

“In Canada, and in the U.S. to a greater extent, offices are the weakest subcomponent,” Mr. Routledge said. “However, with new multiunit housing construction, we do have worries because higher interest rates are lessening demand for buyers of newly constructed units and that is complicating matters and that could lead to losses.”

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Office buildings account for a small portion of lending portfolios at the major banks. The segment makes up about 10 per cent of their commercial real estate books and 1 per cent of their total loans. But many of Canada’s largest lenders have cited increasing credit risk in commercial real estate in quarterly financial earnings results over the past year.

In the case where loan losses start eating into the capital levels that banks are required to hold as a cushion against an economic downturn, OSFI could consider lowering the domestic stability buffer (DSB) to free up money for the banks to absorb those losses.

In December, OSFI held the DSB level steady, bucking analyst and investor expectations after it hiked the buffer twice in the previous year. Since late 2022, the regulator had raised the buffer to 3.5 per cent of a bank’s risk-weighted assets from 2.5 per cent, citing rising risks in areas including variable-rate mortgages and commercial real estate. The moves also forced the banks to hold onto billions in excess cash.

An adjustment to the DSB also prompts a change to the minimum capital levels that a bank is expected to hold. The common equity tier 1 (CET1) ratio – a measure of a lender’s ability to absorb losses – sits at 11.5 per cent, but all six major banks hold ratios of more than 12 per cent.

OSFI’s abstention from a third consecutive increase signalled that the regulator believes the country’s largest banks have enough cash to withstand an economic downturn.

“We didn’t do it because we thought the vulnerabilities had stabilized,” Mr. Routledge said during the conference. “We also thought that the six banks – their boards in particular – took their capital ratios up above 12, which is a nice 50-basis-point buffer for the unexpected, and it gives those parties the ability to react in a timely frame.” (One hundred basis points equal one percentage point.)

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