A fundamental public policy question is how to address the possibility of inflated real estate values and excessively high levels of household indebtedness.
December 14, 2015
A fundamental public policy question is how to address the possibility of inflated real estate values and excessively high levels of household indebtedness.
There is little question that these trends have been fuelled by exceptionally low interest rates. However, the Bank of Canada’s mandate is to set monetary policy to achieve the 2-per-cent inflation target. In recent years, that objective has called for exceptionally low interest rates.
This has been supportive to the economy through a number of channels, such as reducing the cost for business investment and helping with international competitiveness through a weaker Canadian dollar. But what if the seemingly low-forever interest rates are fuelling a domestic real estate and household balance sheet imbalance?
Bank of Canada Governor Stephen Poloz gave a clear answer to this question during a speech in October. He said the first line of defence is prudent behaviour by borrowers and lenders. The second line of defence is through financial system regulation. Only the last line of defence is monetary policy.
In other words, if there are worries that the first line is not delivering the desired outcome, the most effective response is to tighten regulation on credit flows and target regulation where potential imbalances might develop. This is precisely what happened Friday morning through co-ordinated announcements by the Government of Canada, the Office of the Superintendent of Financial Institutions and the Canada Mortgage and Housing Corp.
The exact details of Friday’s regulatory changes can be read elsewhere, but the main points are that a larger down payment will be required when buying homes between $500,000 and $1-million with less than 20 per cent down, which requires the purchase of mortgage insurance. And, financial institutions that are regulated by OSFI (the largest lenders in the Canadian financial system) may need to hold more capital in the future on mortgages in markets where home prices have climbed rapidly or when the mortgages are high relative to borrower incomes.
These actions will build on four prior rounds of mortgage regulatory tightening, which have proven effective in tempering debt growth but have not resolved the risks.
In my opinion, the latest announcements are likely to prove prudent. In a recent report for the C.D. Howe Institute, Paul Jacobson and I investigated the growth in mortgage debt on primary residences. We looked at the mortgage trends by income, age and region.
Our central conclusion was that the expansion of primary mortgage debt has been broadly based and that there was a significant and growing minority of Canadians taking considerable financial risk. The share of Canadian households with a primary mortgage in excess of 500 per cent of after-tax income climbed to 11 per cent in 2012 from 3 per cent in 1999. And the highest mortgage debt-to-income ratios were in the provinces that have the highest home prices. Moreover, we found that one in five households with mortgages in 2012 had less than $5,000 in assets that could be tapped in the event of a financial stress. One in 10 had less than $1,500.
The implication is that while most Canadians have been financially responsible, there are growing pockets of risk. We stressed that if further regulatory action was taken, it should be targeted in nature. This is what was delivered Friday. These measures should act to cool activity in the highest-priced markets. Those taking mortgage insurance will be encouraged to purchase lower-priced homes or have a greater equity stake in the investment. Meanwhile, lenders may have to hold more capital in future years against mortgages in high-priced markets or mortgages made at higher ratios relative to the borrowers’ income.
The regulatory actions taken since 2008 have demonstrated one of the great strengths of the Canadian financial system – prudent and well-co-ordinated regulatory oversight that strives to limit future macroeconomic and financial risks.
Craig Alexander is vice-president for economic analysis at the C.D. Howe Institute.
Published in the Globe and Mail
