Pedestrians walk in the financial district in downtown Toronto on May 15.Abhijit Alka Anil/The Globe and Mail
Canada’s banking regulator is warning that high interest rates and market uncertainty will continue to strain homeowners, consumers and businesses, prompting banks to adjust their lending practices.
In its annual risk outlook Wednesday, the Office of the Superintendent of Financial Institutions said that it is scrutinizing risks stemming from stress on real estate and mortgages, corporate and commercial real estate debt, liquidity and funding, and foreign interference.
While inflation has eased globally, central banks are still working to reduce those levels. OSFI expects elevated borrowing costs to cause higher mortgage renewal risk, as well as lower consumer spending and business investment.
Canada’s inflation rate is easing, increasing the chances that the Bank of Canada will start cutting interest rates in the months ahead. On Tuesday, Statistics Canada reported that the Consumer Price Index rose 2.7 per cent on an annual basis in April – which means that inflation has been within the Bank of Canada’s target range of 1 per cent to 3 per cent for four consecutive months.
But it could take years before borrowers see meaningful relief. Even if the central bank starts reducing interest rates this summer, senior bank executives and economists have said that they expect rates to fall slowly over the next few years.
OSFI said that lenders are adjusting their approach to loan renewals, pricing products and investment plans. However, changing institution and consumer behaviour could affect how lenders assess the financial risks in their portfolios and design policies.
The higher interest-rate environment – which typically benefits banks by allowing them to charge more on loans – has weighed on profits in recent years. As Canadians adjust to more expensive borrowing costs, demand for loans has decreased while more borrowers are defaulting on debt, including credit cards and auto loans. In response, banks have increased provisions for credit losses – money that lenders set aside for potential loan losses.
Higher mortgage payments are taking up a major chunk of household income, causing some borrowers to miss payments on other types of loans, according to the regulator.
More than 75 per cent of the outstanding mortgages in February will come up for renewal by the end of 2026, according to OSFI. Homeowners who took out mortgages from 2020 to 2022 will face a payment shock under significantly higher interest rates, and the regulator expects this to lead to more loan defaults.
To mitigate this stress going forward, OSFI said it is capping the amount of highly leveraged loans in banks’ residential portfolios. In April, the regulator told the banks to limit the number of mortgages that exceed 4.5 times the borrower’s annual income, which is also known as a loan-to-income (LTI) ratio of 450 per cent.
“Should residential real estate markets weaken, this could lead to higher defaults, lower recovery rates, and, therefore, higher credit losses for institutions,” OSFI said in its outlook.
OSFI publishes the annual risk outlook each year in the spring. Superintendent of Financial Institutions Peter Routledge said the regulator is “taking a more focused approach” to the report.
The regulator cited four key risks, striking the list in half from last year’s report. The regulator said the list is not exhaustive, identifying only the risks that OSFI considers most critical.
OSFI also cited uncertainty with corporate debt and commercial real estate, integrity, security and foreign interference, and liquidity and funding – which measures whether banks have sufficient cash and assets that can quickly be turned into cash to meet unexpected obligations.
The federal government has expanded the regulator’s oversight to include risks stemming from integrity and security weaknesses, and foreign interference. The new mandate seeks to address character and culture issues, and geopolitical tensions that could lead to special economic sanctions, cyberattacks, foreign interference or money laundering.
Several risks from last year’s outlook were consolidated into an “other risks” category, including cyber and technology, climate change, third-party outsourcing and issues stemming from the non-bank financial intermediaries sector – which are financial service providers that are not regulated as banks.