May 18, 2023 | 11:30
BoC Financial System Review — Higher Rates are Working
The Bank of Canada's Financial System Review (FSR) lays out some key vulnerabilities set against a backdrop of much higher interest rates across the developed world. Perhaps most pressing and timely are issues surrounding bank-sector stress and the state of the Canadian mortgage market.
On bank stress, the FSR details the impact that higher interest rates have had on the U.S. bank sector, with attention paid to the failure of a few regional banks. For Canada, the BoC notes that "to date, spillover effects in Canada from the recent stresses in the global banking sector have been limited". That reflects quick action by policymakers; limited direct exposure among Canadian banks to any of those particular institutions; and, generally sound risk management and regulatory practices. That said, the tightening cycle is having an impact on funding costs and market liquidity. The BoC observes that wholesale funding costs have risen meaningfully for Canadian banks, while demand deposits have been shrinking in favour of term deposits over the past year. All told, the BoC continues to view the banking system as fundamentally sound, but observes some symptoms that are consistent, and expected, within a tightening cycle.
Meantime, the BoC digs into the current state of Canada's mortgage market, with a particular focus on the vulnerability of mortgage holders who will be resetting into higher interest rates. Simulations based on the current expected path for rate hikes show that, relative to February 2020, about 47% of all mortgages will have experienced an upward payment adjustment by the end of this year. The adjustment process will run through the end of 2026, when all mortgages will have been reset to (presumably higher) interest rates. What's going on here? A small segment of the mortgage market with adjustable-payment variable-rate mortgages has seen payments reset in real time. Those with fixed-payment variable-rate mortgages are now amortizing over significantly longer periods (if not interest only), but the bulk won't see payments reset until 2025 and 2026 (with payment increase of around 40% based on the current expected path of interest rates). Meantime, resetting past fixed-rate mortgages will trickle into to payments that look 10%-to-25% higher over the coming few years.
These characteristics of the Canadian mortgage market have been extremely important in containing the early damage from the tightening cycle (e.g., the lack of immediate payment shock is a key reason we are not seeing forced selling in the housing market). It also buys households and the economy time to absorb higher rates. After all, a lot can happen by 2025 and 2026, including a turn back down in interest rates and a few years of income growth to catch up and temper the jump in debt service ratios. As we have long argued since the tightening cycle began, the mortgage market is not a time bomb, but more of persistent headwind that will blow for a few years going forward. We're already seeing the proof of that on the ground, although the path of the job market will certainly dictate the ultimate outcome.
Finally, the BoC delves into some other areas of risk, including cybersecurity, climate change and cryto.
Bottom Line: Canadian banks have so far seen limited fallout from U.S. bank stress and, while the mortgage market will deliver a pretty stiff headwind in the years ahead, the impact is spread out over time. This all suggests that monetary policy is working, and the BoC is comfortable on hold for now, pending any changes in the path for inflation and the job market in the months ahead.