July 30, 2014 / 8:02 PM / 3 years ago

Fitch: Canadian Banks' Notable Cap Ratio Link with Home Prices

(The following statement was released by the rating agency) CHICAGO, July 30 (Fitch) The capital ratios of Canada's largest banks are poised to exhibit some volatility should Canadian home prices enter a significant correction, says Fitch Ratings. The capitalization levels of Canada's seven largest banks are presently well positioned within our expectations for each of the banks' current Issuer Default Ratings and Viability Ratings (VRs); however, we believe there are noteworthy influences from Canada's housing markets on bank capital ratios. As explained further, housing prices impact bank ratios pro-cyclically, improving capital ratios more as home prices peak, and weakening capital ratios more as home prices correct. The linkage between bank capital ratios and housing prices results from the use of housing price indices (HPIs) as key determiners of mortgage risk weightings under Basel III Advanced Approaches methods for calculating risk weighted assets (RWA). Canada's primary HPIs, such as those provided by Teranet, track the substantial housing price increases that have occurred across Canada, particularly in the Toronto and Vancouver markets. This HPI is a key driver in determining the projected, base case percentage loss severities, or "loss given defaults" (LGDs) on a bank's uninsured mortgage loans. Uninsured mortgages typically make up between 35% and 50% of the total mortgage assets on large Canadian banks' balance sheets. Insured mortgages backed by the Canadian Housing and Mortgage Corporation (CMHC), comprise the majority of Canadian mortgages, but carry zero risk weights under Basel III. Mortgage loan loss severities are among the multiple factors used in calculating the mortgage contribution to total RWAs under Basel III Advanced Approaches. Canadian banks typically use a mix of Standardized Approaches and Advanced Approaches under Basel III for uninsured Canadian and non-Canadian mortgages. Standardized Approaches tend to be tougher on capital ratios, and, when possible, Advanced Approaches can provide preferred levels of precision (but potentially wider variations) in RWA determinations. Different allowances for the input variables, particularly on LGDs, pose the possibility that certain banks may be more impacted by a possible housing decline than others. The HPI-RWA linkage has a pro-cyclical effect on RWAs that tends to make mortgages smaller contributors to total RWA (the denominator in regulatory capital ratios) when housing prices rise (favorably impacting capital ratios). Conversely, the linkage tends to make mortgages larger contributors to RWAs when housing prices decline (unfavorably impacting capital ratios). Some Canadian banks, such as ScotiaBank and Toronto-Dominion Bank, disclose probability of default and LGD levels for mortgages, a favorable practice in our view. Bank of Montreal, Royal Bank of Canada, and Canadian Imperial Bank of Commerce disclose ranges of probability of defaults, but not LGDs. Justin Fuller, CFA Senior Director Financial Institutions +1 312 368-2057 70 West Madison Street Chicago, IL Matthew Noll, CFA Senior Director Fitch Wire +1 212 908-0652 33 Whitehall Street New York, NY Media Relations: Brian Bertsch, New York, Tel: +1 212-908-0549, Email: brian.bertsch@fitchratings.com. The above article originally appeared as a post on the Fitch Wire credit market commentary page. The original article can be accessed at www.fitchratings.com. All opinions expressed are those of Fitch Ratings. ALL FITCH CREDIT RATINGS ARE SUBJECT TO CERTAIN LIMITATIONS AND DISCLAIMERS. PLEASE READ THESE LIMITATIONS AND DISCLAIMERS BY FOLLOWING THIS LINK: here. IN ADDITION, RATING DEFINITIONS AND THE TERMS OF USE OF SUCH RATINGS ARE AVAILABLE ON THE AGENCY'S PUBLIC WEBSITE 'WWW.FITCHRATINGS.COM'. PUBLISHED RATINGS, CRITERIA AND METHODOLOGIES ARE AVAILABLE FROM THIS SITE AT ALL TIMES. FITCH'S CODE OF CONDUCT, CONFIDENTIALITY, CONFLICTS OF INTEREST, AFFILIATE FIREWALL, COMPLIANCE AND OTHER RELEVANT POLICIES AND PROCEDURES ARE ALSO AVAILABLE FROM THE 'CODE OF CONDUCT' SECTION OF THIS SITE. FITCH MAY HAVE PROVIDED ANOTHER PERMISSIBLE SERVICE TO THE RATED ENTITY OR ITS RELATED THIRD PARTIES. DETAILS OF THIS SERVICE FOR RATINGS FOR WHICH THE LEAD ANALYST IS BASED IN AN EU-REGISTERED ENTITY CAN BE FOUND ON THE ENTITY SUMMARY PAGE FOR THIS ISSUER ON THE FITCH WEBSITE.

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