Without skin in the game, banks won't tighten lending standards - Appeared in Financial Post and The Province

In a year-end interview, Finance Minister Jim Flaherty noted, “I find it just strange that I get some of the financial institutions telling me to mind my own business on regulatory matters — and then we have some worries about the level of consumer debt, and the banks are saying the government needs to move in and tighten standards.” The Minister’s remarks followed calls by some bank CEOS for the government to tighten lending standards for residential mortgages such as a reduction in amortization periods.

The debate over whether lending standards need to be tightened has gained attention over concerns about rising household debt. Mark Carney, Bank of Canada Governor, continues to flag the escalation of household debt as a risk to financial stability if interest rates rise. The International Monetary Fund also weighed in last December, when it flagged stretched household balance sheets as a near-term risk to Canada’s financial system.

The question is, why don’t banks set their own tighter credit standards? The answer is, because they are protected by government backed mortgage insurance, which is mandatory for all mortgages with a loan to value ratio in excess of 80 per cent. The government backing is provided through either the Crown owned Canada Mortgage and Housing Corporation (CMHC) or a private mortgage insurer that has been extended a government guarantee. Hence, the conventional incentive for banks to set their own underwriting standards and monitor risk exposure has simply been washed away. Rather than screening mortgage applications for risk, bank staff simply tick the boxes required by government. At most, banks have an indirect interest in assessing credit risk since households with too much mortgage debt may be more at risk of defaulting on other loans such as credit cards.

Nevertheless, the objective of getting banks to be more engaged in setting their own standards for mortgage loans is a good one. Managing credit risk is a core competency of banks, and it makes sense to engage their risk management expertise rather than rely on that of federal bureaucrats to tinker with the rules. Changing the one-size-fits-all federal risk standards is a crude mechanism. There may be credit-worthy borrowers that simply don’t fit into a standard set of prescribed rules.

If the Canadian government sees rising household debt levels as a real concern and bank underwriting standards as the solution, the logical course is to exit the business of mortgage insurance and stop guaranteeing residential mortgages with public money.  Such a move would protect taxpayers from a business they do not need to be in. Australia has shown that a mortgage finance system can operate successfully without government backing of mortgage insurance or any other form of government guarantee while U.S. experience has shown that even just implicit guarantees can create a giant fiscal black hole for taxpayers. Despite a lack of government guarantees, Australia’s mortgage finance system has contributed to high levels of home ownership comparable to the rates both in Canada and the U.S., showing that such guarantees simply are not necessary.

But another benefit is that Canadian banks will have a real incentive to actively manage risk when extending mortgage loans. How would the system work in a world without government guarantees? Even when credit mitigation is used, such as mortgage insurance, banks would still nevertheless have reason to take more seriously the risk in their mortgage portfolios because they are exposed to counterparty risk, the risk that the provider of credit mitigation defaults. The banks would need to manage this risk and set aside capital against this exposure to satisfy the requirements of Canada’s solvency regulator (OSFI), but also market participants such as credit rating agencies. Private mortgage insurers would also influence bank credit underwriting standards through their contractual arrangements with the banks as part of their own risk management practices. OSFI would exercise oversight over all the mortgage insurers including how they manage their insurance risk. Currently, CMHC, the dominant mortgage insurer, is not subject to OSFI oversight.

As long as the government insists on backstopping the risk of high ratio mortgages with taxpayers’ money, banks simply won’t have any skin in the game and will react half heartedly at most to calls for them to tighten lending standards to address concerns over rising household debt. Instead, the banks will simply sell as much high ratio mortgages as they can knowing that taxpayers will ultimately pay the price if rising household debt creates problems in the future. Ideally, the government should move towards exiting the mortgage insurance business and providing government guarantees. But if unwilling to do so, it should consider other steps that will help ensure banks have some skin in the game when they provide mortgages.