As we have highlighted in numerous Hamilton Capital Insights, regulatory risk is a key risk in global banking, and one we attempt to minimize our exposure. It is most intense for the mega-banks in the U.S. and Europe, particularly those with global investment banking operations (i.e., C, BAC, JPM, CSGN.VX, UBS.VX, DBK.GY, BARC.LN). Although post-crisis, those global banks have been the epicentre of regulatory risk, the recent troubles facing WFC suggest the focus of regulators is shifting into commercial and consumer banking (see Is Wells Fargo Un-Investable (for Now)?). We are watching the largest U.S. regional banks – including USB, PNC, and CFG – for further evidence that regulatory risk is spreading to other parts of the banking system.
In contrast, Canadian banks and their investors have arguably enjoyed the most shareholder-friendly regulator in global banking. The most obvious example of this is that the Canadian banks operate at near the lowest CET1 ratios globally and the gap on this metric, relative to global peers, continues to widen (see On Capital, Canadian Banks Continue to Lose Ground vs. Global Peers).
That said, regulatory risk appears to be rising (further).
Recent developments suggest that the Canadian federal and provincial governments are concerned that rising housing prices are resulting in excessive consumer debt and declining affordability for first-time home buyers. We presume that the federal government is also concerned about the potential impact of a bursting real estate bubble on both the financial system and CMHC. Legislators appear to be focused on implementing policies to help remove speculative excesses from the housing market and/or engineer a soft landing (particularly in Toronto and Vancouver). New measures include requiring lenders to stress test new home buyers’ debt serviceability at higher interest rates, while a mechanism for risk sharing between CMHC and the lenders on claims resulting from defaults on insured residential mortgages is also under consideration. Separately, the B.C. government introduced a tax on foreign buyers, a measure many predict will be implemented by the Ontario government as well.
If efforts to slow the housing market are successful, Canadian banks will be affected. Although difficult to predict, the potential effects could be both direct (e.g. lower volume growth and net interest income, higher losses from rising defaults/declining collateral) and indirect (e.g. lower GDP growth from declining business activity, especially construction, lower consumer spending). Given that home values represent an important source of collateral on bank balance sheets, any policy action to bring down home prices is highly relevant.
Perhaps even more significant is the unknown impact of potential “risk sharing” between CMHC and the banks on losses incurred on government-insured residential mortgages. As of Q3 2016, the Big-6 banks held ~$1.2 trillion in residential mortgages, split roughly evenly between insured/uninsured. For decades, loss rates on these gigantic loan portfolios have been close to zero, with defaults resulting from the highest risk borrowers insured by the government and minimal losses on the uninsured mortgages given their very high collateral levels (i.e. lower loan-to-value ratios at origination, and strengthening collateral as home prices rise). This has resulted in the Canadian banks generating very large profits from a hugely important anchor product, while assuming immaterial credit losses. It would appear that the federal government is now concerned about a potential asymmetrical distribution of risk/losses should there be a material decline in home prices.
The possibility that these changes will be implemented in a way that is detrimental to Canadian bank earnings is not likely to be known in the near-term. However, the most important takeaway is that while regulatory risk for Canadian banks remains low relative to their global peers, it is creeping higher. If the post-crisis world has taught global bank investors anything it is that regulatory risk has been consistently higher than initially anticipated.