Canada’s largest banks are better prepared to weather a homegrown housing crisis than they were two years ago, even though total losses from soured mortgages would be larger, according to a new report.
Moody’s Investors Service has updated its stress test for the country’s seven largest banks, which imagines a severe – though still unlikely – shock to the housing market.
The Moody’s stress test contemplates a dire, U.S.-style housing crash, assuming a punishing 11-per-cent default rate on banks’ mortgages coupled with housing price declines of 25 per cent to 35 per cent, as well as other compounding factors. In other words, this assessment isn’t testing for an ordinary downturn – it simulates a black swan event.
Stress tests such as this one offer a timely way to gauge banks' potential vulnerabilities at a moment when regulators have tightened rules to curb risky mortgage lending. Those changes came on the heels of separate measures implemented by federal and provincial governments to cool hot housing markets in Vancouver and Toronto, including new taxes on foreign buyers. As a result, home sales have slowed in both cities, raising concerns that a larger drop in real estate activity could affect the broader economy, dampening forecasts for GDP growth.
In the 2018 scenario, the banks would collectively lose $14.3-billion, up from $12.1-billion when Moody’s last ran the test in 2016. But in the interim, the banks have substantially padded their capital buffers – as measured by their common equity Tier 1 (CET1) capital ratios – leaving ample room to absorb higher losses.
“If we duplicate what we did two years ago, it looks like the banks are in a better spot than they were,” Jason Mercer, the report’s lead author, said in an interview.
On average, the banks would consume about 70 basis points of CET1 capital to swallow the predicted losses (100 basis points equal one percentage point). That would leave all seven banks above the minimum capital floor of 9.5-per-cent CET1 capital ratios set by Canada’s banking regulator, the Office of the Superintendent of Financial Institutions – and most of them comfortably so.
Of the seven banks, Canadian Imperial Bank of Commerce would fare the worst in Moody’s stress-test scenario, consuming 120 basis points of capital and reducing its CET1 ratio to 10 per cent. That’s because domestic lending – and mortgages in particular – make up a relatively large slice of CIBC’s overall business, compared with its peers.
The other banks tested in the Moody’s analysis are Toronto-Dominion Bank, Royal Bank of Canada, Bank of Nova Scotia, Bank of Montreal, National Bank of Canada and Desjardins Group.
The larger expected losses in the latest stress test are mostly because the banks’ mortgage portfolios have continued to grow, at a compound annual rate of 6 per cent since 2014. The main driver of that growth has been a steep run-up in house prices, particularly in Toronto and Vancouver, although prices in Toronto have recently shown signs of cooling. Also, a greater proportion of those loans reside in Ontario and British Columbia – where assumed loss rates are higher – than was the case two years ago, according to Moody’s.
The grim scenario envisioned by the stress test continues to seem like a long shot, at least in the short term. Despite unresolved concerns about Canadian housing, a strong labour market – with unemployment sitting at a mere 5.8 per cent – has helped keep banks’ credit portfolios healthy even as consumer debt relative to income has risen to 168 per cent.
That trend of a relatively benign credit environment is expected to continue when Canadian banks begin reporting third-quarter earnings next week.