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Raising the limit for covered bonds could spur smaller Canadian banks to establish such programs as the uninsured-mortgage market grows.

Covered bonds, which are a popular source of funding for uninsured residential mortgages in Canada, have grown dramatically since their inception in 2013, according to a report published by ratings agency DBRS Ltd. on Monday.

They now constitute 14 per cent of the combined $1.5-trillion of outstanding mortgage loans issued by Canada’s six biggest banks – Royal Bank of Canada, Toronto-Dominion Bank, Bank of Montreal, Bank of Nova Scotia, Canadian Imperial Bank of Commerce and National Bank – and Desjardins Group. In total, there are $160-billion of outstanding covered bonds in Canada, according to the report.

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But the growth of covered bonds – which provide a cheaper source of funding for the banks than deposit notes – is now being constrained by a regulatory requirement that they not exceed 4 per cent of a bank’s total assets.

That limit also prevents smaller Canadian banks from issuing covered bonds. According to the DBRS report, the costs of instituting such a program – such as legal fees, registration fees and getting a team in place – are too large relative to how much debt a smaller bank would be able to issue.

The cap was implemented to protect the stability of the financial system in the event of a significant economic downturn. But the Office of the Superintendent of Financial Institutions is now revisiting that limit, Superintendent Jeremy Rudin said in a speech last April.

Some industry insiders have speculated that the cap could climb to as high as 8 per cent of assets, according to DBRS.

That could motivate smaller banks such as Laurentian Bank of Canada, Canadian Western Bank, Equitable Bank and Home Trust Company to start issuing their own covered bonds.

“It’s an important source of funding for the larger banks, and giving the smaller guys access to this source of wholesale funding would be beneficial for them,” Maria-Gabriella Khoury, senior vice-president of the global financial institutions group at DBRS and one of the report’s authors, said in an interview.

HSBC Bank Canada, which launched a covered-bond program and completed its first issuance last month, says it is participating in ongoing discussions with OSFI regarding the cap on covered bonds.

“Canada has taken the most conservative approach to the cap vis-à-vis other jurisdictions,” HSBC spokeswoman Caroline Creighton said in an e-mail. “There does seem to be a robust argument that Canada could increase the current cap without putting the financial system at undue risk.”

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