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Canada's banking regulator says mortgage lending risks have increased considerably since the onset of the pandemic, and as a result they are proposing tougher lending rules.Justin Tang/The Canadian Press

Canada’s bank regulator is proposing tougher lending rules that would make it even harder for borrowers to get a mortgage, after a spike in borrowing costs that has upended household budgets and ramped up risks to the banking system.

Three proposals unveiled Thursday by the Office of the Superintendent of Financial Institutions (OSFI) would tighten underwriting rules for federally regulated banks, which already have the strictest standards among lenders.

The regulator is considering limiting the share of highly leveraged borrowers a bank can have in its mortgage portfolio, toughening debt servicing metrics and bolstering the mortgage stress test for risky loans. If new rules are implemented, they would make it harder for borrowers to get a mortgage.

But the current climate is already tough for many lenders, and borrowing has dropped significantly, as many Canadians no longer qualify for a mortgage because interest rates on the loans have more than doubled in a year.

“This is really just incrementally impacting people’s ability to borrow,” said Mike Rizvanovic, financial services analyst with investment bank KBW. “It’s almost after the fact. This should have been addressed before the last run-up [in the market], which was all through COVID, practically.”

The real estate industry has been asking OSFI to relax the mortgage stress test, which requires borrowers to prove they can make their monthly payments at an interest rate at least two percentage points higher than their actual mortgage rate.

But aside from toying with offering more flexibility in the stress test, the plans OSFI floated on Thursday would further squeeze lending at a time when the sharp rise in interest rates has priced many prospective buyers out of the market and increased monthly expenses for mortgage holders.

OSFI’s proposals are open for comment until April 14. The regulator did not say how long it would take to review the comments or issue new rules.

In a statement with the proposals, OSFI praised the mortgage stress test for ensuring that borrowers could handle higher borrowing costs. But it also said that “mortgage lending risks, particularly related to debt serviceability, have increased considerably since the onset of the pandemic.”

OSFI proposes curbing banks’ loans to highly indebted borrowers, defined as those whose mortgage is 4.5 times greater than their annual income or more, also known as a loan-to-income threshold. OSFI wants to limit these borrowers to 25 per cent of a lender’s new loans every quarter. As part of this, OSFI is mulling a consistent definition of income, which is tricky given the bevy of situations households find themselves in, such as the loss of earnings during a parental leave.

The second proposal could toughen criteria that evaluate a borrower’s ability to pay their mortgage loan and all other expenses, also known as debt service metrics. Borrowers who must take out mortgage insurance currently have to meet specific requirements that show that their share of monthly household income can cover all housing costs, credit cards, lines of credit and other loans. (A borrower needs mortgage insurance when they make a down payment that is less than 20 per cent of the property’s purchase price.)

OSFI has floated using the same debt service rules for borrowers who do not require insurance – those who make a down payment that is at least one-fifth of the property’s purchase price. That would give lenders less discretion to deal with uninsured borrowers and toughen the rules on those borrowers.

The third proposal looks at changing the mortgage stress test so it corresponds more closely with a loan’s level of risk.

The mortgage stress test was introduced during the 2016-2017 real estate frenzy in Toronto and Vancouver. The real estate industry heavily criticized the stress test during the boom times because it reduced the maximum a client could borrow.

If some of OSFI’s proposals are adopted this year, it is not clear what they will accomplish when households that took out large loans when interest rates were near zero during the real estate boom early in the pandemic are now swimming in debt.

“What problem are they trying to address here? And even if they were to address the problem, it’s only new home buyers,” said Dan Eisner, chief executive with True North Mortgage, a non-bank prime lender and mortgage brokerage.

For each proposal, OSFI has asked a series of questions and is seeking comment on the potential joint impact of all three plans.

Mortgage experts said tighter bank rules would push more borrowers to subprime lenders, which are not regulated by OSFI. Borrowers who have not qualified for a large enough loan from a bank have already flocked to private lenders.

“What does this mean for borrowers? This will push them into the private lending space, where they will be hit with significantly higher borrowing costs,” said Laura Martin, chief operating officer of mortgage brokerage Matrix Mortgage Global.

Most of the major banks did not respond to a request for comment. Royal Bank of Canada said it will participate in the consultation process and said it has prudent underwriting policies and practices.