Banks ordered to set aside billions more amid high debt

Canada’s banking regulator has ordered big banks to set aside billions more in rainy-day funds amid growing concern over consumers and bankers defaulting on debt, including lines of credit, credit cards and mortgages.

The Office of the Superintendent of Financial Institutions announced Tuesday that it was raising the Domestic Stability Buffer to 3.5 per cent from three per cent of a bank’s total assets — the highest it’s been — as of Nov. 1.

It’s the second time in six months OSFI has increased the amount banks are required to set aside. In December, OSFI raised it to three per cent from 2.5 per cent, and also raised the top potential rate to four per cent.

“We are in a period of rising interest rates and home prices have begun to climb again. Households and corporates remain highly leveraged, making them more vulnerable to economic shocks,” OSFI head Peter Routledge said in announcing Tuesday’s change.

The stability buffer, introduced for Canada’s six largest banks in 2018, is effectively a rainy-day fund, designed to keep the financial system stable by ensuring banks have enough money to cover losses from defaults in mortgages, lines of credit and other borrowing. The rate typically rises when OSFI sees trouble down the road, and falls when the trouble hits and the banks need the money.

It was dropped to one per cent during the early days of the COVID-19 pandemic, then raised to 2.5 per cent in June 2021. Dropping it to one per cent put an extra $300 billion of liquidity at the banks’ disposal, OSFI estimated at the time.

Raising the buffer again so soon after December’s hike shows that OFSI is concerned about growing consumer and corporate debt, said Pedro Antunes, chief economist at the Conference Board of Canada.

“What OSFI is saying is that they’re concerned about the increased risk of insolvencies for both consumers and businesses,” said Antunes, who added that there’s still more household financial stress to come because of the Bank of Canada’s campaign of interest rate hikes designed to keep inflation under control.

Last March, the bank began an aggressive rate-hike campaign in a bid to drive inflation down, pushing its key overnight rate to 4.5 per cent from 0.25 per cent. After a brief pause, the bank raised rates again June 7, to 4.75 per cent.

The theory is that by making it more expensive to borrow money, consumers — and businesses — will spend less, driving prices down and slowing the economy.

Roughly 70 per cent of Canadian mortgages haven’t yet faced renewal since the rate hikes started, Antunes said.

“We still haven’t seen anywhere near the full effect of higher interest rates on mortgages,” said Antunes.

And those interest rates are a large part of what’s already putting pressure on household finances, said Carl De Souza, senior vice-president at credit rating firm DBRS Morningstar.

“There’s a lot more pressure, especially because of the rising interest rates, but also because of the inflation we’ve seen,” said De Souza. “Canadians already have the highest household debt levels in the G7, and higher interest is adding more pressure.”

Expectations of trouble could become a self-fulling prophecy for OSFI, said Claire Celerier, an associate professor of finance at U of T’s Rotman School of Management.

Households struggling to pay their debts might find banks lowering credit limits or not renewing lines of credit in the wake of the stability buffer increase.

“There’s always the risk that doing this amplifies the effect of the interest rate hikes. Because when banks have to put that extra capital aside, that means less money for them to lend out,” said Celerier.

Still, if it keeps banks stable, the buffer is ultimately a positive, Celerier argued.

“In the short term, this might have a tightening effect. But in the longer term, if it means the system is more stable — that’s a good thing,” Celerier said.

Still, argued DBRS Morningstar’s De Souza, the big six banks won’t ultimately need to change too much — they don’t need to go smashing open any piggy banks to find extra funds to set aside.

“They’re generally speaking in good shape, and they’ve already got this money on hand. OSFI is just telling them to keep it there,” De Souza said.

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