Canada's financial regulator is sending an "early warning" to the country's banks about lending, concerned they will lower risk standards in an effort to find more borrowers amid the economic slowdown.
The regulator has started stress testing the sector's exposure to various forms of consumer debt, and is focusing on the housing sector. The test will examine the mortgage business, and take a particularly close look at home equity lines of credit.
In a low-interest-rate environment, consumers may be tempted to borrow more than they should at a time when banks, already facing shrinking lending profit margins, are also clamouring for business. The head of the Office of the Superintendent of Financial Institutions said it's a potentially dangerous mix, and urged banks to maintain prudent lending practices.
"The concern is that the conditions are such that there will be tremendous pressure on banks to loosen those standards," Julie Dickson, head of the regulator, said after a speech to the financial community in Toronto. "It's kind of an early warning."
A key worry for OSFI is the prospect of a worsening economy and rising unemployment, coupled with a drop in housing prices. That would have a disastrous impact on Canadians who have large amounts of money borrowed against their home.
Some analysts interpret the move as a sign OSFI wants to keep a lid on rapid expansion of home equity lines of credit (HELOCs) in advance of a downturn, and a potential drop in housing prices.
"What they're probably thinking is, if we go into a deeper recession, lending is going to go up, and property values are going down. And that could exacerbate any problem," said Peter Routledge, an analyst at National Bank Financial.
During the onset of the 2008 recession, Canadians increased their home equity lines of credit on average, even as they paid down other forms of debt, such as credit cards.
Should the economy worsen, Canadians would likely turn to their HELOCs once more. A corresponding drop in real estate prices would potentially leave many homeowners in a bind, along with their banks.
OSFI is scrutinizing loan-to-value ratios, which are the amount of money someone has borrowed against the value of their home. The stress testing comes after the Department of Finance took steps to curb household borrowing last year, including scaling back amortization periods, increasing mandatory down payments, and reducing how much people can take out against their home through a line of credit.
The changes had a significant impact, with mortgage refinancing activity falling nearly 40 per cent since the spring. Canadians can only borrow up to 85 per cent of the value of their home on a line of credit, down from 90 per cent.
If house prices fall, those ratios could be thrown off balance. Canadian banks should be focusing on these issues "more so than they have historically," Ms. Dickson said.
"Institutions should guard against loosening historical underwriting standards, for example, by moving to higher loan-to-value ratios or waiving due diligence requirements.".
Last year, Bank of Canada Governor Mark Carney warned that Canadian household debt had climbed to a record 146 per cent of personal disposable income and suggested the time had come to start paying down loans.
However, deputy chief economist Benjamin Tal at Canadian Imperial Bank of Commerce said curtailing lending in a sluggish economic environment could cause problems because it saps consumers ability to spend and invest, slowing down a recovery.
"I would make the point that we need a little bit of borrowing right now given that the economy is so fragile. We need the consumer to help a little bit."
Extremely low interest rates are expected to stay for longer after the United States said recently it would keep rates depressed until at least 2013, in a bid to spur economic growth. Canada is unlikely to raise rates significantly with its neighbour keeping them low.
Lending margin compression has been a drag on bank earnings for much of this year, as the difference between what banks make on loans and the amount they pay out on deposits gets narrower. This has prompted some banks to try to boost profit by boosting their loan volumes -- by issuing more lines of credit and mortgages.