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Top banking regulator points to joint credit agreements and delayed rating changes as increased risks
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Published on Oct 12, 2023 • Last updated 4 hours ago • 3 minutes reading time
Canada’s top banking regulator is taking note of practices in the commercial real estate market. Photo by Peter J. Thompson/National Post Files
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Canada’s top banking regulator says commercial real estate loans pose a greater risk than previously thought as higher interest rates persist and a practice known as co-lending grows.
The Office of the Superintendent of Financial Institutions, in an Oct. 12 update to its list of the top risks facing the sector, warned that ratings could quickly become outdated in a rapidly changing environment and that trends such as shared lending Default risk and recovery could increase values.
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Among OSFI’s concerns is that rating changes appear to lag market conditions, suggesting that the risk ratings and collateral ratings used by financial institutions “may not adequately reflect the risk environment.”
The regulator has alerted banks that it is taking a closer look at the way they manage commercial real estate loans, releasing an interim regulatory guidance on September 29 that sets out detailed expectations for processes and procedures, including Underwriting practices, debt service capacity assessments and portfolio management.
“The outlook remains challenging as strategic defaults increase in the office segment, real estate investment trust values decline relative to their historical net asset value estimates, and defaults on U.S. commercial mortgage-backed securities and special administrative rates increase, particularly in the office segment,” OSFI said in its October 12 update.
In addition, the regulator notes concerns about practices in the commercial real estate market, particularly an increasing use of co-lending arrangements such as layering and “participation” arrangements, where risk is “spread” between multiple lenders and companies.
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“They can impact lenders’ rights and remedies, thereby affecting the likelihood of default and the level of recovery values,” OSFI said, noting that these agreements are a key reason why commercial real estate is deemed by the regulator to be “a “Higher risk object” was in April.
“These arrangements do not always have standardized contractual language and therefore may pose additional risk to lenders due to legal, operational and structural complexities,” the regulator said.
The commercial real estate sector is a broad asset class for financial institutions and includes loans secured by income-producing properties used for business purposes such as shopping centers and office buildings and loans made for their construction or acquisition, as well as loans on residential properties with five or more units such as apartment buildings whose repayment depends on sales or rental income, and properties held for rental to third parties.
OSFI noted that while office properties have been particularly hard hit by the shift to remote and hybrid work, the entire commercial real estate category, including malls and apartments, needs to be reviewed for increased risks amid higher inflation and interest rates.
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In September guidance for banks and other financial institutions, OSFI warned that economic conditions were contributing to an increased potential for a rise in loan defaults.
OSFI is also taking a look at home loans to address the problem of rising mortgage balances resulting from a popular product that keeps monthly payments the same even as interest rates rise. With these fixed-rate mortgages with variable interest rates, what is known as negative amortization occurs when the fixed monthly payments no longer even cover the interest owed.
The regulator plans to publish the results of an initial public consultation on its Directive B-20, which covers debt repayment measures, on October 16.
OSFI said it is considering using loan-to-income ratio thresholds to help financial institutions better manage the risks associated with significant accumulation of household debt on their loan books. Although this is a common tool in other jurisdictions, the regulator suggested it may not work in Canada, where lenders have different risk appetites and differentiated products in a highly competitive mortgage market.
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OSFI said the results of its annual review of the mortgage stress test, which the regulator introduced to measure a borrower’s ability to cope with rising interest rates, will be released on December 12.
“Our primary goal is to ensure Canadian homeowners can afford to service their mortgages in good times and difficult times,” OSFI said. “As a secondary goal, we want to ensure that OSFI’s actions have a proportional impact on our regulated constituents so that all lenders in the federal financial system, regardless of size, can compete and take appropriate risks.”
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