If the Canadian housing market suffers a significant correction, the capital ratios of Canada’s largest banks would face some volatility too, says Fitch Ratings in a new report.

The rating agency says that, while the capitalization levels of Canada’s seven largest banks are well positioned within their current credit rating levels, the housing market could have a significant effect on bank capital ratios. Fitch says that housing prices in Canada impact bank ratios pro-cyclically, which means that capital ratios improve as home prices rise, and weaken more as home prices correct. So, if the market slides, capital ratios will too.

“The linkage between bank capital ratios and housing prices results from the use of housing price indices (HPIs) as key determiners of mortgage risk weightings” under the Basel III capital rules for calculating risk weighted assets (RWAs), Fitch explains; noting that the linkage has a pro-cyclical effect on RWAs that tends to favourably impact capital ratios when house prices rise, but hurts capital levels when housing prices decline.

Additionally, Fitch says that different allowances for the input variables, particularly on defaults, “pose the possibility that certain banks may be more impacted by a possible housing decline than others.”

It also notes that some Canadian banks, such as Scotiabank and TD Bank, disclose probability of default and “loss given default (LGD)” levels for mortgages. Fitch says this represents “a favourable practice,” noting that the other big banks disclose ranges of probability of defaults, but not LGDs.