Published in the Financial Post on April 11, 2012
By Philippe Bergevin and James MacGee
As a percentage of income, Canadian household debt levels are higher than at any point in recent history and now higher than those of U.S. households. This raises concerns over the sustainability of household finances, the risks to the broader economy and the merits of government intervention.
Recent debate has understandably focused on the housing market and on the risks associated with household mortgage debt. But consumer credit, which excludes mortgages but includes household debt such as auto loans, credit card debt and lines of credit, has risen by more than a factor of five since the late 1970s and, at 43% of disposable personal income, is more than double its level of 20 years ago. This appears to have increased the number of Canadian households with stressed finances, as evidenced by the jump in personal bankruptcy filings to near U.S. levels during the recent recession.
Consumer credit has changed substantially over the past 20 years with the rapid rise of borrowing via home equity loans and lines of credit (HELOCs), as well as personal lines of credit. Consumer credit now accounts for roughly 45% of total household interest payments. And because HELOCs and personal lines of credit are typically variable-rate products, coming increases in the Bank of Canada rate are likely to translate quickly into higher interest rates on consumer credit. The rapid expansion of new consumer credit products such as HELOCs therefore raises concerns about whether lenders and borrowers have been overly optimistic about the associated risks.
These are real concerns, yet unlike in the United States, HELOCs offered by Canadian banks are limited to a maximum loan-to-value ratio of 80% and have minimum payment options that are higher — and hence safer from a financial-stability perspective. In addition, since a recent change to the federal government’s mortgage insurance rules, banks cannot purchase government-backed mortgage insurance to cover home equity lines, which should encourage lenders to review their credit-risk standards.
The overall message is that consumer debt is cause for concern but not panic. While the recent U.S. experience has highlighted the risks of overextended consumers, more prudent lending standards in Canada suggest that, under the most likely scenario, consumer debt levels should remain manageable. Nonetheless, high debt leaves Canadians vulnerable to a possible, but at the moment unlikely, large economic shock — notably a sharp rise in interest rates or an economic downturn.
Meanwhile, lenders and regulators need to evaluate carefully whether the current capital levels at financial institutions are sufficient to guard against these risks. And policymakers should continue to ensure that regulations related to household credit are appropriate and consistent over the entire business cycle. But they should refrain from attempting to tune regulations in a countercyclical manner, because such an approach poses the danger of increased politicization of credit rules.
There does not seem to be a strong case for restrictive regulation of consumer credit products, such as tight caps on interest rates or limits on borrowers’ debt-service ratios. Such interventions are likely to have a significant effect on the availability of credit, especially for lower- and middle-income borrowers, making it more difficult for them to smooth out transitory income or household expense shocks. Similarly, it seems that the trend toward making bankruptcy less attractive to middle- and upper-income households with stable incomes has gone far enough. While these reforms likely have helped lower the cost of borrowing for such households, they have also resulted in higher costs for households wishing to escape from poor credit choices or bad luck. Finally, with increased borrowing options, there is a need for improved financial literacy — indeed, even financially literate households can find comparing different products challenging.
Consumer debt and bankruptcy in Canada are problems — but probably not big ones, as long as the economy keeps plugging along.
Financial Post
Philippe Bergevin is a Senior Policy Analyst at the C.D. Howe Institute. Jim MacGee is a Bank of Montreal Professor and Associate Professor of Economics at the University of Western Ontario. His report “The Rise in Consumer Credit and Bankruptcy: Cause for Concern?” is available at www.cdhowe.org.
