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The Bank of Montreal in Toronto's Financial District on Tuesday, April 4, 2017.Aaron Vincent Elkaim

Canada's banks continue to lower their estimates for the proportion of their loans that are likely to go sour, defying mounting concerns about the added stress that consumers are sure to feel as interest rates rise.

Even with sky-high housing prices and record consumer debt levels, the sums that banks set aside to cover soured loans keep creeping downward. At Bank of Montreal, impaired loans totalled only 19 basis points – or 0.19 per cent – in the first quarter, on a $375-billion portfolio.

The question is, why? What makes banks so confident that their loan books are sound, even if credit markets take a turn for the worse?

Bank analyst Mario Mendonca of TD Securities Inc. probed the issue on a Tuesday conference call discussing BMO's earnings. In response, the bank's chief risk officer, Surjit Rajpal, delivered a lesson in the way banks think about risky loans.

Mr. Mendonca:

Every quarter, I'm sort of stunned to see how low credit losses are in Canada. Has something changed over the six months that is leading to even lower losses?

Mr. Rajpal:

Well, the economy, for one, has been doing really well. Unemployment has been low and so that, I think, is the principal reason. I'm mindful of what can possibly go wrong – effectively, I'm a risk guy. But our portfolio's of high quality as well, and so it serves us quite well in good and bad times.

Mr. Mendonca:

When you see an article in some [newspaper] or [from] some think tank that talks about Canada and the over-leveraged Canadian consumer, and they offer an outlook that is clearly different from what we're seeing from BMO or the rest of the banks, would you reconcile your results and your outlook with that outlook by referring us to the quality, specifically, of your bank's loan book?

Mr. Rajpal:

There's a bit of that, but I think more than that is the immediacy of the dire outcome. A lot of folks outside of Canada that make assessments on Canada assume that something's going to break, and break fast, and everything is going to collapse all at once. And that's never the case. And I think it's easy to write about, and it's sensational. When housing as well as debt levels get spoken of, there is some merit to saying that they are high. But the issue here is that the unemployment levels are low, and with the kind of economy that you are facing, even if there was a correction, things would happen slowly. I think there's also a lack of understanding of the mortgage industry itself and how it manifests itself in bank results. And I don't believe that people have that understanding outside of Canada.

We still look at our track record over a long period of time, over the last 20-something years. In fact, when I look at the numbers over the past several years, our track record has been quite outstanding, and it's been in that same category of [a loan loss ratio] a little bit over 20 basis points [100 basis points equal 1 percentage point]. I think we've had a history that has proven that we do know how to manage the risks that we take on our books.

Mr. Mendonca:

You made the point that things don't collapse immediately. The challenge that I get from people is that there is no scenario when bubbles burst gradually – the whole point is that they burst immediately, and it's an abrupt adjustment. So when you say you don't think it would be immediate, what scenario are you contemplating?

Mr. Rajpal:

Let me explain what I meant, and I'll have to qualify the word "collapse." Let us say house prices come down, let's say that is the bubble people talk about. When we stress [test] our portfolios, given our loan-to-value ratio on average is about 50 per cent [meaning the bank's average mortgage is for half the value of the home], you don't see any adverse results. The relationship between what caused that collapse and how that will manifest itself in unemployment rates is the one that we need to watch more closely. Yes, a collapse is generally all of a sudden; there's a market correction. But what does it lead to? What are the economic indicators that are going to be impacted as a result of that? Is it just that people are going to lose money that they thought they had, or is it going to result in unemployment? If the economic fundamentals stay good, the house that you're living in, or you invested in, would go down in value, and so that's more a wealth effect than it is an economic effect, right away. Yes, there'd be a slow trickle, people may not build houses any more and the housing industry may not have as much spending, but all these things are phased in much, much slower.

This exchange has been condensed and edited.

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