A housing market correction could, in turn, negatively impact the capital levels of the Canadian banks, says Fitch Ratings.
In a new report, the rating agency indicates that the regulatory capital ratios of the six big banks “have benefited from sustained increases in home prices over the last decade.”
However, it warns that “any future downturn in the housing market could put pressure on those banks’ risk-weighted assets (RWA) and regulatory capital ratios.” Indeed, Fitch says that the pro-cyclical nature of the new Basel III capital adequacy regime “could exacerbate the effects of potential losses on residential mortgages in any future housing market correction.”
Under the new Basel III regime, “Rising home prices over the last several years have helped keep regulatory capital ratios strong by, in effect, keeping loan-to-value (LTV) ratios in Canada artificially low,” it says, which has allowed the banks to optimize their RWA at lower levels, thereby reducing the amount of capital that the banks must hold against residential mortgage exposures.
Conversely, in a potential downturn, it says that “the impact on Basel III capital could be amplified if RWA levels increase rapidly in response to a housing price correction. This could drive LTVs higher. Together with increased charge-offs and additional provisioning in mortgage portfolios, this could push capital ratios down relative to international bank counterparts.”
Fitch says it believes that Canadian home prices are likely nearing a plateau “and could exhibit some weakness over a medium-term time horizon.”
“We believe a sharper than expected price correction would flow through to higher RWA levels, thereby putting further pressure on regulatory capital ratios at a time when rising credit losses will likely hurt retained earnings,” it warns.
That said, for now, the capital ratios for the top six Canadian banks all remain solidly above regulatory minimums, Fitch says. And, it says that it believes that the capital buffers for all six “are adequate to withstand a moderate to severe Canadian housing market price shock.”