Canadian banks: Safe as houses?

Canadian banks: Safe as houses?

Canadian banks: Safe as houses?

The end of the US housing boom was a death blow for a number of US banks – including Wall Street banks, regional and local lenders. With the Canadian housing market precarious outlook, many have wondered if it could happen here. Global rating agency Fitch says it’s highly unlikely.

Fitch has a bearish view on residential property – in line with that of other agencies – but it says Canada’s banks are safer than houses. A sharp downturn would test their balance sheets, but not in a catastrophic way. Applying stress tests to each bank's mortgage portfolios, it said: “we believe that capital buffers for all six are adequate to withstand a moderate to severe Canadian housing market price shock.”

Confidence in the banking sector is shared by Larry Jacobson, an advisor with Vancouver fee-only firm Macdonald Shymko & Co, who holds both banks and property.

“The bank’s portfolios that are at the higher risk are CMHC insured and other than that I think they are going to be ok,” said Jacobson. “I have no fear about the banks, I’m a buyer of large caps and the banks would be a part of that.”

Jacobson added that he is also broadly confident in Canadian real estate, which he says is rebounding in Vancouver, a market which many consider frothy.

“We use REITs in our portfolio so we get a really broad-based representation of real estate in our portfolio – from Vancouver to Newfoundland – and because we’re so well diversified we have commercial, residential, large and small shopping centers,” he said. “REITs have cooled down a little bit because of interest rates, but I’m quite comfortable retaining that position.”

Although Fitch’s report is a vote of confidence – and welcome in the face of hyperbole about risks to the banking sector – it’s still far from good news for the big six. A housing contraction, Fitch said, would mean they would have to reassess risk-weighted assets and allocate more capital against risk, straining profitability.

Fitch noted that regulatory capital ratios for the big six has benefited from sustained increases in home prices over the last decade, but a future downturn in the housing market would put pressure on the banks' risk-weighted assets (RWA) and regulatory capital ratios.

The agency said that pro-cyclical nature of global capital adequacy measures could exacerbate the effects of potential losses on residential mortgages in any future housing market correction. Under Basel III rules – global capital-adequacy and liquidity risk regulations – rising home prices over the last several years have helped keep capital ratios strong by, in effect, keeping loan-to-value (LTV) ratios in Canada artificially low.

Lower LTVs, in turn, have allowed Canadian banks to optimize RWA at lower levels, lowering the amount of capital the banks need to hold against residential mortgage exposures, Fitch said.

In a potential downturn, the impact on capital ratios could be amplified if RWA levels increase rapidly in response to a housing price correction. This could drive LTV ratios higher, Fitch said, and together with increased charge-offs and additional provisioning in mortgage portfolios, this could push capital ratios down relative to international bank counterparts.

The agency said it believes that a sharper than expected price correction would flow through to higher RWA levels, putting further pressure on regulatory capital ratios at a time when rising credit losses will likely hurt retained earnings.

Nevertheless, the agency said that the current Basel III Tier 1 common equity ratios for the big six Canadian banks all remain solidly above regulatory minimums. Fitch puts the levels at between 8.3% and 9.7% as of the end of the second quarter.