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Finance Minister Jim Flaherty gives a thumbs up as he takes part in a TV interview after tabling the federal budget in the House of Commons on Parliament Hill in Ottawa, Thursday March 21, 2013.

Adrian Wyld/The Canadian Press

Ottawa is aiming to curtail taxpayers' exposure to risks from the mortgage market, limiting the ability of banks to rely on government-insured loans in a bid to constrain residential lending.

And in an unexpected move, the federal government says it wants to bolster competition in the financial sector by encouraging the entrance of new players to compete with Canada's Big Banks.

The federal budget that Finance Minister Jim Flaherty tabled Thursday aims to reduce the financial risks the government faces from the market.

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It cracks down on the ability of banks to make bulk purchases of mortgage insurance to reduce their capital requirements, and also curtails the use of government-backed insurance in securities sold by the private sector.

It also lays the groundwork for a new set of risk-management rules to govern the country's biggest banks that will reduce Ottawa's exposure in the event that one of them failed.

Ottawa has been concerned about the growth of mortgage insurance for some time.

Last year, it capped the total amount of mortgage insurance that Canada Mortgage and Housing Corp. can have in force at $600-billion.

As a result CMHC, which was already creeping up toward that level, began rationing its sale of bulk insurance while maintaining sales levels of standard mortgage insurance.

At the same time, the federal government will look at whether to make it easier for new banks and insurers to enter the market and to grow.

But that comes as Mr. Flaherty has been verbally pressuring banks not to further cut mortgage rates, a stance that has been broadly characterized as anti-competitive.

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Earlier this week he went as far as to rebuke Manulife Bank into reversing a planned mortgage rate cut.

Adding competition to the Canadian banking sector is easier said than done. Jim Peterson, chair of the House of Commons Finance Committee from 1993 to 1997, said the federal Liberal government tried to encourage more competition in the sector, but it didn't happen as expected.

"There have been very few banks that have started up," he said. The government tried lowering capital requirements for smaller banks, but steps like that are not palatable for regulators looking to ensure the system won't fail in a crisis.

But he said Mr. Flaherty's decision in recent weeks to slap banks on the wrist for lowering mortgage rates, in his effort to prevent a price war and an escalation in consumer debt, goes against promoting more competition. "I'm not sure that telling banks what interest to charge on their portfolios is a way to encourage banks to start up."

Mr. Flaherty has been very vocal about his concerns about rising consumer debt levels and overheated house prices. But he suggested Thursday that his recent actions have at least as much to do with taxpayer risk.

Because Ottawa backstops mortgage insurance, taxpayers are highly exposed to the market.

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Any time a consumer buys a house with a down-payment of less than 20 per cent, the mortgage must be insured. Bulk insurance, also known as portfolio insurance, is another product that banks can buy to insure large swaths – or portfolios – of mortgages with low loan-to-value ratios (high down payments) that aren't required to be insured.

Banks started buying more bulk insurance during the financial crisis because it makes it easier for them to package their mortgages off into securities, which ultimately reduces their funding costs and helps them to lend more. But they've also been upping their purchases because by insuring mortgages they can reduce the amount of capital they have to hold. Now, banks hold a large number of insured mortgages for which consumers had large down-payments, finance department officials suggested.

Mortgage insurance ultimately compensates the bank for losses from consumer defaults. It was originally intended as a way of making it easier for consumers with low down payments to enter the housing market, by ensuring lenders they would be compensated for losses.

One of the new rules will gradually limit the sale of insurance on low loan-to-value mortgages to those that are being used in a CMHC securitization program, such as Canada Mortgage Bonds. That will prevent banks from insuring large low-ratio portfolios simply to reduce their capital requirements.

And Ottawa plans to stop the use of any taxpayer-backed insured mortgage (even high ratio) as collateral in securities that aren't sponsored by CMHC. Volumes of such private-sector asset-backed securities were more significant before the financial crisis and are not currently large, government officials indicated. But the move will limit Ottawa's potential exposure as banks seek cheaper ways to fund their mortgage portfolios.

The risk management framework that the budget proposes for the nation's systemically important banks – those major players whose failure could pose a risk to the entire economy – will require those banks to hold more capital than others.

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The Canadian Bankers Association offered tentative support for the government's efforts to encourage new players. "But it will be important to ensure … that the safety and soundness of Canada's banking system remains," CBA president Terry Campbell said.

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