Office of the Superintendent of Financial Institutions
Good day and thank you for making the time to join me.
Thank you for the kind introduction and to the C.D. Howe Institute for inviting me to speak. This is a wonderful venue for discussing important policy issues of the day.
Today I am going to talk about financial stability in Canada and the critical role played by the housing finance sector. More specifically, about how OSFI helps maintain the soundness of lenders and the stability of the Canadian financial system by protecting depositors and other creditors.
I think that all of us in this room have considered or obtained a mortgage. It can be as hopeful as it is stressful. We are also aware that if problems emerge in the mortgage market, then the Canadian economy, and by extension all Canadians, will suffer.
Sound mortgage underwriting helps both the lenders and borrowers involved in mortgage transactions, as well as the stability of the broader economy. Stability means that we must always be ready for the changes of the economic cycle. This requires vigilant monitoring of risks and being deliberate in meeting our prudential mandate.
While we focus on these objectives, we recognize that Canadians' ideal of homeownership is an aspirational goal for many and the largest single asset for others. Weak mortgage underwriting puts these dreams at risk.
We recognize that OSFI has influence on a narrow element of the larger issues in the Canadian housing market. Various federal agencies play a role, determined by their respective mandates. For example, the Financial Consumer Agency of Canada and the Canada Mortgage and Housing Corporation have some great information on their websites to support informed consumer choices.
To ensure the overall framework is coherent, federal agencies meet regularly to have frank discussions about the effectiveness of their respective tools and any planned adjustments to their strategies.
OSFI's aim is not to manage demand for housing or mortgage credit. Indeed, the attention given to these issues can lead to misunderstandings about the focus of our work. Instead, OSFI's job is to look beyond the immediate environment and to consider what can go wrong and take action according to the risks.
OSFI's actions over the past 10 years to promote sound mortgage underwriting have encouraged strong governance and risk management practices among lenders. This helps to protect against risks that arise with pressure to reduce lending standards when house prices are high. This benefits institutions and Canadians alike, and is the foundation of our work.
With that as a bit of context, let me begin by talking about a key piece of OSFI housing finance guidance – Guideline B-20.
So, why Guideline B-20? OSFI is focused on preserving sound mortgage underwriting practices at financial institutions. Diligent underwriting improves the financial condition of lenders and, therefore, the stability of the financial system at large. B-20 serves those ends.
We have seen the consequences of poor underwriting in recent history.
During the financial crisis, we all saw first-hand how lax mortgage underwriting in other countries wreaked havoc on the global economy, how it toppled some of the largest banks in the world, how it led to staggering numbers of job losses, how it emptied out neighbourhoods, and left devastated families in its wake.
Conservative underwriting by Canadian institutions prior to the crisis was one of the key sources of resilience. Following the crisis, we observed a loosening of standards that contributed to increased vulnerabilities. Our supervisory work was not moving the needle as much as we would have hoped for and it made sense to make our expectations public.
The original guideline B-20 was issued in 2012 in response to lessons from the global financial crisis, work done by the Financial Stability Board, and our own observations of changes in the Canadian mortgage market.
Subsequent revisions to B-20 over the years were all responsive to growing vulnerabilities that, in part, resulted from changing lending practices and uncertain housing market conditions.
Guidelines work best when the intentions are clear. To make sure lenders understand the message, we conduct information sessions for lenders on implementing B-20. In addition, we follow up through our regular supervisory reviews where we look at lenders' compliance with B-20. This includes looking at how lenders measure and assess a borrower's debt servicing capacity. Continually updating our risk data and reinforcing good practices helps preserve sound mortgage underwriting even while products and markets are changing.
In our view, the consequences of doing nothing in the face of these risks are much greater than trying to do something when conditions have already begun to deteriorate.
Economic conditions and market practices can change. That is why we pay attention and we listen to commentary from all sides of the debate on mortgage underwriting.
After considering comments and looking at the data we receive on mortgage underwriting from lenders, we continue to be guided by our mandate, lessons from history, and a range of plausible economic conditions. Striking the right balance for OSFI favours long-term prudence and early intervention where risks require action.
Before I talk about the impact of B-20, let me explain what it was designed to do, and what it has already accomplished.
Guideline B-20 is so much more than simply a qualifying rate for uninsured mortgages; usually referred to as the 'stress-test' which is often confused with a similar qualifying rate used for insured mortgages.
B-20 is actually a broader, risk management guide. It is the result of extensive analysis and lessons learned from the global financial crisis; a careful study of Canada's mortgage markets; and a detailed look at the underwriting practices at financial institutions.
It demands clear underwriting policies that require complete and reliable information on the borrower, rigorous income verification, and a thorough valuation of the underlying property.
Borrowers, as well as lenders, should understand their ability to repay the loan and be able to remain in their home if conditions change. It is prudent for the lender to assess the borrower's ability to withstand not just changes in interest rates, but also changes in property tax levels, utility rates, other debts and expenses and, most importantly, income or employment.
OSFI monitors the Canadian mortgage market closely as part of its supervisory role. A few years ago, we saw borrowers taking on additional loans so they could make larger down payments, often to avoid the costs and rigours of qualifying for an insured mortgage.
OSFI most recently updated B-20 in 2017 to introduce several prudent measures, including a revised qualifying rate that applies to all uninsured mortgages issued by banks. It is fair to say that this was not a popular decision. These additional measures came into effect in 2018 with some saying it would crash the housing market. This certainly tested our mettle as prudential regulators.
We made these revisions to preserve the quality of underwriting standards irrespective of geography or economic conditions. When interest rates change, they change everywhere in Canada. When property taxes change, when jobs are regrettably lost, the effects are uneven and can happen in any local market - not just those that are overheated.
Sound mortgage underwriting should therefore consider more than just changes in house prices or interest rates. Lenders should be aware of the risks posed by changing economic conditions by ensuring that borrowers have a sufficient buffer for the unexpected no matter where they live.
In effect, wherever they live, all Canadians that dream of owning a home benefit from when the housing market is supported by good decision-making. Borrowers in Medicine Hat, Alberta, or Fredericton, New Brunswick can be impacted as much by the unexpected as borrowers in Vancouver or Toronto.
So where are we now? Has OSFI's Guideline B-20 had the desired effect of promoting sound underwriting and thereby reducing risk in the Canadian financial system? We believe so.
Earlier today we posted some updated information on our website.Footnote 1 I won't read it out here but let me touch on a few points.
First, we continue to see modest improvements in loan quality, and higher average credit scores among borrowers taking out new mortgages. While there are many reasons for this, better underwriting is a contributing factor.
Second, while not all credit metrics have reversed course, risks are not growing as quickly as they had been. Collecting evidence and continued vigilance helps OSFI and others respond to changing conditions when required.
The capacity of the borrower is a key consideration for lenders when writing and renewing mortgages. When a mortgage renews, the existing lender typically does not re-underwrite the loan as long as the borrower is current with their payments. OSFI sees this as a reasonable practice and does not require the re-underwriting of existing mortgages when they come up for renewal. However, we do expect lenders to update their risk analysis throughout the life of the loan.
This practice helps reduce borrower uncertainty and transaction costs, while encouraging institutions to be diligent within their own risk appetites.
Some have said that it forces borrowers to stay with their current lender, as switching would subject them to more rigorous underwriting practices, including a higher qualifying rate.
Critics claim that this lack of choice limits a borrower's ability to negotiate a competitive rate at the time of renewal. Yet, to date, OSFI's analysis of lender reporting does not provide evidence supporting this claim.
Changing lenders at renewal would mean obtaining a new mortgage, even if it is to pay for the same home. A new lender would quite appropriately want to assess whether the borrower is within its risk appetite. This means conducting its own due diligence, including the qualifying rate. Though, borrowers who have a good payment track record, steady income, and have not taken on a lot more debt, will have plenty of options if they shop around.
We will continue to look at this issue closely through regular reporting on rates for new originations and renewals. If we see outliers, then we will follow up directly with lenders to understand why this is happening and what they are doing about it.
There are more than just mortgages and renewals to consider. OSFI also looks at the evolution of home equity lines of credit (or "HELOCs") and combined loans that have so-called amortizing and non-amortizing components.
For many Canadians, the appeal of these loans is in the opportunities that this money can provide, post-secondary education for their children, helping a loved one buy a home, or home improvements.
Institutions offer a wide range of combined loan products, each with different features and options. Many lenders are willing to provide these loans during stable economic times but may be less open to this lending when the forecast darkens.
The evolution of combined loan products can make adding more risk easy for borrowers. OSFI is concerned that some lenders may be taking on more risk than they bargained for with these open-ended commitments.
Combined loan products can conceal ever increasing debt loads even though payments remain current. This can make assessing credit quality more difficult for lenders. The growth of combined loans also creates challenges for lenders, markets and regulators in making decisions during periods of stress.
We are working with the Bank of Canada to collect data to assess the potential vulnerabilities of these products as well as the larger market and economic issues.
Further, OSFI expects lenders to closely review the risks arising from their own combined loans and HELOC-mortgage structures. Of particular interest to OSFI is how lenders' HELOC account management programs track the portions of the loan that are "re-advanceable" when they are greater than 65% of the Loan-to-Value (or "LTV").
Watching these areas will help lenders track the emergence of broader vulnerabilities, including specific sensitivities to changes in the economy.
Through our monitoring of housing markets and supervising of institutions, we see lenders applying the B-20 qualifying rate as part of their underwriting standards for uninsured mortgages. We expect this to continue.
The qualifying rate is working. Firstly, one of the metrics (Loan-to-Income or "LTI") shows that fewer borrowers are becoming over-extended at origination. This is a modest improvement and we will continue to look at developments, as this metric continues to move in response to other factors.
Secondly, we have not seen lenders extending mortgage amortizations to avoid the impact of the qualifying rate. The proportion of uninsured mortgages with amortization periods greater than 25 years has remained largely unchanged.
Other challenges in the industry require continued diligence. There has been progress at institutions to improve income verification (self-run businesses, equity lending) and in detecting and deterring mortgage misrepresentation.
Based on lender reviews, OSFI has observed that income verification requirements are generally well documented in policies. However, some lenders should clarify their policies related to "full financial picture" and use/definition of "declared" versus "verified" income.
Most lenders have removed references to Non-Income Qualifying ("NIQ") / Stated Income mortgages in their policies. Nonetheless, we continue to see deficiencies in independently verifying income, and in ensuring that the source of verification is difficult to falsify.
We have been supervising lenders' income verification practices for some time and will continue to do so. When we see that a lender's controls do not adequately reflect risk of misrepresentation we act. We pay particular attention to the purchased mortgages. The further the lender is from underwriting the mortgage the more robust those controls and processes need to be.
OSFI is reinforcing with lenders the importance of robust mortgage misrepresentation strategies. These would include clear descriptions of measures to prevent and detect misrepresentation and how third party management/software and originations are overseen.
Income verification and mortgage misrepresentation are issues that get down to the individual lending decisions made by institutions. Lenders' internal policies need to be monitored and exceptions scrutinized. As practices vary across institutions, and sometimes even at the Branch level, continued lender vigilance will remain important.
The aim of sound underwriting is to have good information to support good lending decisions. The rules we set – in particular, the qualifying rate, need to be robust to changing economic conditions, while considering severe but plausible scenarios.
This means that we need to remain vigilant and focussed on our mandate. While we are aware of contrary opinions, the majority of market participants and commentators understand and support the amendments we implemented through Guideline B-20 in 2018. According to CMHC's latest consumer survey, two-thirds of buyers said that the qualifying rate would keep more Canadians from taking on a mortgage they could not afford.Footnote 2
So, two years on, we are now more likely to hear that the qualifying rate has worked and it is valuable, and that any changes should only be considered very carefully. This is helpful input for context, but being a regulator is about making the right decisions not popular ones.
Institutions, markets and borrowers have all come to see the value of a qualifying rate even if there remains debate about the appropriate level of responsiveness.
Guideline B-20 is based on five key principles.Footnote 3 Those principles are foundational. They have stood up to scrutiny and the tests of changing markets. The benefits of sound mortgage underwriting are clear.
The measures contained in B-20 continue to protect against risks that remain relevant today by supporting prudence regardless of where we are in the economic cycle. This is why our ongoing supervisory work remains focused on reviewing these standards by testing the underwriting practices of lenders and requiring regular reporting on a range of risks to understand how mortgage lending is evolving.
Principle three of the guideline focuses on a lender's evaluation of the borrower's capacity to service their debt obligations. OSFI remains confident that the contract rate plus 200 basis points is a reasonable measure to qualify a borrower for an uninsured mortgage. This helps borrowers and lenders manage a sudden change in circumstances such as an income loss, increased interest rates, and/or additional expenses. This will therefore remain a key part of OSFI's guideline B-20.
We also believe that without a floor on the qualifying rate, some borrowers could select variable or shorter-term loans that may not be appropriate for their risks.
Guideline B-20 uses a benchmark rate to set this floor. We chose the best available rate at the time, which is the five-year conventional mortgage rate published weekly by the Bank of Canada.Footnote 4 This benchmark rate is based on the posted rates from the big six banks in Canada.
For many years, our data showed the difference between the benchmark rate and the average contract rate was about two per cent. This provided a healthy buffer. However, the difference between the average contract rate and the benchmark has been widening more recently, suggesting that the benchmark is less responsive to market changes than when it was first proposed.
We are reviewing this aspect of our qualifying rate, as the posted rate is not playing the role that we intended. As always, we will share our results with our federal partners. This will help to inform the advice OSFI might provide to the Minister, as requested in the mandate letter to him.
In closing, OSFI's mandate is very clear: protect depositors, policyholders and other creditors while allowing institutions to compete effectively and take reasonable risks. We do this by developing and revising guidance that is thoughtful, effective and prudent.
By closely supervising institutions, we can also identify potential issues early and take action to stop more serious problems from taking root. However, we do not want our rules to unduly disrupt markets.
For OSFI, B-20 is having the desired effect of improving sound mortgage underwriting at banks. But, when we see evidence of the need to make changes, we are open to adjustments that support our mandate.
The Canadian financial system, financial institutions, borrowers and all Canadians benefit from strong mortgage underwriting. No one knows when or where the next crisis or downturn will come from. By acting prudently, making evidence-based decisions, engaging with regulatory partners, and being clear about our expectations of lenders, OSFI is building a foundation of stability regardless of what lies ahead.
Thank you for your time today.
Guideline B-20 Information Sheet
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Affordability was the Key for Homebuyers in 2019, CMHC, November 15, 2019
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Guideline B-20: Residential Mortgage Underwriting Practices and Procedures - effective January 1, 2018
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The qualifying rate for all uninsured mortgages is the greater of the contractual mortgage rate plus 2% or the five-year benchmark rate published weekly by the Bank of Canada in Series V80691335.
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