The possibility of a housing market downtown poses the greatest risk to Canada's financial system over the coming year.
The Office of the Superintendent of Financial Institutions (OSFI) has released its Annual Risk Outlook for 2023-2024, which outlines the nine most significant threats to Canada's financial system.
"The financial system is adjusting to a higher interest rate environment. Given the rapidity at which interest rates globally have increased, the risk has grown that such an adjustment may not be completely smooth," OSFI said. "This phenomenon places a premium on Canada’s notable financial system resiliency."
After reaching record highs during the pandemic, home prices across Canada declined significantly in 2022. The substantial changes over the last year have led OSFI to prepare for the possibility that the housing market will experience "continued weakness" throughout 2023.
The rapid rise in interest rates -- the Bank of Canada hiked the overnight rate from 0.25% to 4.5% in 10 months -- has eroded debt affordability. Mortgage holders may not be able to afford higher monthly payments, or may get a serious shock at the time of renewal, leading to higher default probabilities.
"Given the significant impact of real estate secured lending activities in the Canadian financial system, a housing market downturn remains a key risk," OSFI said.
In response to the risk, OFSI is ensuring that federally regulated financial institutions' (FRFI) risk management practices are responsive to changing market conditions, and that the lending standards are aligned with Guideline B-20, which outlines residential mortgage underwriting practices.
The regulator is currently in the process of reviewing the guideline, and is considering introducing new debt serviceability measures that would better control prudential risks stemming from high consumer debt. Proposed changes include loan-to-income and debt-to-income restrictions; if implemented, they would limit what some borrowers qualify for.
In addition to the housing market, other risks to Canada's financial system include cyber attacks, climate-related risks, and growth and uncertainty in unregulated non-bank financial institutions.
Commercial real estate was also deemed a substantial risk, with construction and development and office assets facing the highest degree of uncertainty. High inflation, potential rise of borrower defaults, and ongoing supply chain issues will put pressure on the former, while hybrid work arrangements and reduced staffing levels will affect demand of the latter.
While industrial properties have seen significant increases in valuations, sustainability of the trend is uncertain due to supply and demand changes. Consumer spending may have a negative impact on retails' post-pandemic recovery.
In response to the risk, OSFI is conducting targeted monitoring across the commercial real estate sector to identify signs of borrower and portfolio vulnerabilities.
"Since the end of the Global Financial Crisis of 2008-09, OSFI has required that FRFIs increase their safety buffers to support their ability to operate through intensified bouts of financial system volatility," the regulator said.
"Canadian FRFIs are now well-prepared to persevere through difficult situations, much more so than they were prior to the Global Financial Crisis."
