A year after he was appointed Canada’s top banking watchdog, Jeremy Rudin shared his reflections on the challenges of the postcrisis era. Speaking to a Toronto business crowd back in June, 2015, Mr. Rudin said the failure of Lehman Brothers and its aftermath opened eyes around the world to lapses in banking regulation.
Lehman Brothers, once the fourth-largest investment bank in the United States, filed for bankruptcy 10 years ago this weekend, on Sept. 15, 2008. Its collapse fuelled a financial crisis that changed the way regulators around the world keep watch on financial institutions. Banks have had to rebuild. They’re now required to keep more capital on hand, undergo more rigorous stress tests to ensure they can survive another financial disruption and spend ever-increasing amounts on compliance.
But although regulators now have better oversight of financial institutions, they still have an imperfect view of risk. “Supervisors are used to looking where the light is shining: at organizational charts, at risk limits, at quantitative models and so on,” Mr. Rudin said during his speech.
“But to be effective, we also have to look at things that won’t be found under the lamppost, including how culture reinforces or impedes responsible risk management." In other words: The darker corners of the financial system matter, too.
The events of the past three years underscore the prescience of his remarks. In fact, you can draw a direct line between Lehman’s collapse and moves Mr. Rudin’s office has made in more recent times. The financial crisis led to a deep recession followed by a slow recovery. The slow recovery has resulted in a prolonged period of low interest rates. Low rates encouraged the taking of bigger risks by borrowers and lenders, especially in the real estate market. And to tamp down that lending activity, under Mr. Rudin’s leadership, the Office of the Superintendent of Financial Institutions has taken repeated action to curb credit risk at domestic banks.
Ten years after Lehman, we have an explosion in mortgage and consumer debt in Canada. Some of that is well understood. But what lurks in regulators’ blind spots still poses a threat to the financial system.
Tougher mortgage rules implemented by Ottawa have pushed most of the lower-quality loans out of the most heavily regulated part of the system – i.e., out of the banks – to the alternative lending space. While that has ring-fenced major banks, the changes have shunted more risk to dimly lit markets. The worry is that government is actually pushing home buyers to turn to alternative lenders with looser standards, from which they can borrow too much at a time when interest rates are finally on the rise.
Part of what’s happening is a problem of Canadian federalism. OSFI’s mandate is limited to federally regulated financial institutions. Some other kinds of mortgage lenders are regulated by the provinces. Further complicating matters is that federal and provincial watchdogs have been known to engage in turf wars with one another instead of sharing information.
OSFI’s new rules, which took effect on Jan. 1, target uninsured mortgages. To get one of those loans, borrowers with down payments of 20 per cent or more must pass a stress test to prove they can afford their payments if their mortgage rate rises. To be eligible, they must qualify at the greater of the five-year benchmark rate published by the Bank of Canada or the contractual rate, plus two percentage points. The benchmark rate is now 5.34 per cent.
It’s not yet known how many home buyers are flunking that test, but one estimate has suggested that up to 10 per cent of prospective home buyers could be disqualified. The central bank warned in June that if rejected borrowers seek out lenders with less stringent lending practices, it could frustrate efforts to weed risk out of the financial system.
Of chief concern are less-regulated private mortgage lenders that lend money to subprime borrowers at higher rates than traditional banks. Maureen Jensen, chair of the Ontario Securities Commission, recently warned about the growth of syndicated mortgages and mortgage investment corporations. Both pool money from investors to fund high-interest mortgages or purchase real estate.
Ms. Jensen has also acknowledged that regulators need to do a better job of co-ordinating with each other to gauge risks in shrouded parts of the mortgage market. Although that might seem obvious, getting federal and provincial regulators to work more closely together is tricky.
“It’s kind of like porcupines mating – you have to be very careful and everyone’s a little worried where the boundaries are,” Ms. Jensen said during a panel discussion on financial stability and postcrisis reforms in May.
But if there’s one takeaway from the financial crisis, it ought to be that regulators need to be pushed to look beyond their own narrow mandates. Passing the buck on risks is no longer acceptable. That is, in part, how subprime mortgages took off in the United States in the early years of this century, eventually leading to the build-up of so much bad debt that it caused a widespread financial crisis.
Last year’s near-demise of alternative mortgage lender Home Capital Group Inc. highlighted the pitfalls of subprime lending and the perils of information hoarding by regulators.
Back in 2015, two years before a funding crisis pushed Home Capital to the brink, OSFI staged an intervention at the lender’s main operating subsidiary, Home Trust Co., because of problems with its anti-money-laundering controls and its risk-management practices, The Globe and Mail reported in 2017.
The fact that Home Trust was already on OSFI’s naughty list, and had been on two other occasions since 2005, wasn’t shared with other regulators, including the OSC, which had launched a separate regulatory probe of Home Capital’s disclosure of mortgage-documentation fraud. (Home Capital has since settled with the OSC.)
If OSFI and the OSC had better co-ordinated their supervision of Home Capital over the past 13 years, perhaps they could have nipped its problems in the bud and prevented its near-death spiral altogether.
Now consider this: If Home Capital can be brought to the brink of failure while under heightened scrutiny by regulators, imagine the carnage that could be wrought by the implosion of less-supervised subprime lenders.
The fact is, we aren’t even sure how big the subprime market really is in Canada. Regulators and policy-makers are still struggling to quantify its size because not all lenders are even lightly regulated.
Lax underwriting of subprime loans was one of the main culprits of the global financial crisis. It can’t be allowed to happen here. In order to make Canada’s financial system safer, provinces need to step up their regulation of the alternative lending market.
Provincial regulators should also ensure that private mortgage lenders adequately stress-test loan applicants. It’s worth noting that some credit unions, which are also overseen by the provinces, have voluntarily adopted measures that are similar to OSFI’s new rules.
Ottawa, meanwhile, must work with the provinces to ensure robust information-sharing among regulatory agencies. After all, as Mr. Rudin rightly pointed out, regulators are only effective when they broaden their field of view.