Cri­sis high­lights a ma­jor prob­lem – cities have no power

De­spite les­sons learned from Lehman Broth­ers col­lapse, reg­u­la­tors con­tinue to have an im­per­fect view of risk

The Globe and Mail (Prairie Edition) - - FRONT PAGE - RITA TRICHUR

Ayear af­ter he was ap­pointed Canada’s top bank­ing watch­dog, Jeremy Rudin shared his re­flec­tions on the chal­lenges of the postcri­sis era. Speak­ing to a Toronto busi­ness crowd back in June, 2015, Mr. Rudin said the fail­ure of Lehman Broth­ers and its af­ter­math opened eyes around the world to lapses in bank­ing reg­u­la­tion.

Lehman Broth­ers, once the fourth-largest in­vest­ment bank in the United States, filed for bank­ruptcy 10 years ago this week­end, on Sept. 15, 2008. Its col­lapse fu­elled a fi­nan­cial cri­sis that changed the way reg­u­la­tors around the world keep watch on fi­nan­cial in­sti­tu­tions. Banks have had to re­build. They’re now re­quired to keep more cap­i­tal on hand, un­dergo more rig­or­ous stress tests to en­sure they can sur­vive an­other fi­nan­cial dis­rup­tion and spend ever-in­creas­ing amounts on com­pli­ance.

But although reg­u­la­tors now have bet­ter over­sight of fi­nan­cial in­sti­tu­tions, they still have an im­per­fect view of risk. “Su­per­vi­sors are used to look­ing where the light is shin­ing: at or­ga­ni­za­tional charts, at risk lim­its, at quan­ti­ta­tive mod­els and so on,” Mr. Rudin said dur­ing his speech.

“But to be ef­fec­tive, we also have to look at things that won’t be found un­der the lamp­post, in- clud­ing how cul­ture re­in­forces or im­pedes re­spon­si­ble risk man­age­ment.” In other words: The darker cor­ners of the fi­nan­cial sys­tem mat­ter, too.

The events of the past three years un­der­score the pre­science of his re­marks. In fact, you can draw a di­rect line be­tween Lehman’s col­lapse and moves Mr. Rudin’s of­fice has made in more re­cent times. The fi­nan­cial cri­sis led to a deep re­ces­sion fol­lowed by a slow re­cov­ery. The slow re­cov­ery has re­sulted in a pro­longed pe­riod of low in­ter­est rates. Low rates en­cour­aged the tak­ing of big­ger risks by bor­row­ers and lenders, es­pe­cially in the real es­tate mar­ket. And to tamp down that lend­ing ac­tiv­ity, un­der Mr. Rudin’s lead­er­ship, the Of­fice of the Su­per­in­ten­dent of Fi­nan­cial In­sti­tu­tions has taken re­peated ac­tion to curb credit risk at do­mes­tic banks.

Ten years af­ter Lehman, we have an ex­plo­sion in mort­gage and con­sumer debt in Canada. Some of that is well un­der­stood. But what lurks in reg­u­la­tors’ blind spots still poses a threat to the fi­nan­cial sys­tem.

Tougher mort­gage rules im­ple­mented by Ottawa have pushed most of the lower-qual­ity loans out of the most heav­ily reg­u­lated part of the sys­tem – that is, out of the banks – to the al­ter­na­tive lend­ing space. While that has ring-fenced ma­jor banks, the changes have shunted more risk to dimly lit mar­kets. The worry is that gov­ern­ment is ac­tu­ally push­ing home buy­ers to turn to al­ter­na­tive lenders with looser stan­dards, from which they can bor­row too much at a time when in­ter­est rates are fi­nally on the rise.

Part of what’s hap­pen­ing is a prob­lem of Cana­dian fed­er­al­ism. OSFI’s man­date is lim­ited to fed­er­ally reg­u­lated fi­nan­cial in­sti­tu­tions. Some other kinds of mort- gage lenders are reg­u­lated by the prov­inces. Fur­ther com­pli­cat­ing mat­ters is that fed­eral and pro­vin­cial watch­dogs have been known to en­gage in turf wars with one an­other in­stead of shar­ing in­for­ma­tion.

OSFI’s new rules, which took ef­fect on Jan. 1, tar­get unin­sured mort­gages. To get one of those loans, bor­row­ers with down pay­ments of 20 per cent or more must pass a stress test to prove they can af­ford their pay­ments if their mort­gage rate rises. To be el­i­gi­ble, they must qual­ify at the greater of the five-year bench­mark rate pub­lished by the Bank of Canada or the con­trac­tual rate, plus two per­cent­age points. The bench­mark rate is now 5.34 per cent.

It’s not yet known how many home buy­ers are flunk­ing that test, but one es­ti­mate has sug­gested that up to 10 per cent of prospec­tive home buy­ers could be dis­qual­i­fied. The cen­tral bank warned in June that if re­jected bor­row­ers seek out lenders with less strin­gent lend­ing prac­tices, it could frus­trate ef­forts to weed risk out of the fi­nan­cial sys­tem.

Of chief con­cern are less-reg­u­lated pri­vate mort­gage lenders that lend money to sub­prime bor­row­ers at higher rates than tra­di­tional banks. Mau­reen Jensen, chair of the On­tario Se­cu­ri­ties Com­mis­sion, re­cently warned about the growth of syn­di­cated mort­gages and mort­gage in­vest­ment cor­po­ra­tions. Both pool money from in­vestors to fund high-in­ter­est mort­gages or pur­chase real es­tate.

Ms. Jensen has also ac­knowl­edged that reg­u­la­tors need to do a bet­ter job of co-or­di­nat­ing with each other to gauge risks in shrouded parts of the mort­gage mar­ket. Although that might seem ob­vi­ous, get­ting fed­eral and pro­vin­cial reg­u­la­tors to work more closely to­gether is tricky.

“It’s kind of like por­cu­pines mat­ing – you have to be very care­ful and ev­ery­one’s a lit­tle wor­ried where the bound­aries are,” Ms. Jensen said dur­ing a panel dis­cus­sion on fi­nan­cial sta­bil­ity and postcri­sis re­forms in May.

But if there’s one take­away from the fi­nan­cial cri­sis, it ought to be that reg­u­la­tors need to be pushed to look be­yond their own nar­row man­dates. Pass­ing the buck on risks is no longer ac­cept­able. That is, in part, how sub­prime mort­gages took off in the United States in the early years of this cen­tury, even­tu­ally lead­ing to the build-up of so much bad debt that it caused a wide­spread fi­nan­cial cri­sis.

Last year’s near-demise of al­ter­na­tive mort­gage lender Home Cap­i­tal Group Inc. high­lighted the pit­falls of sub­prime lend­ing and the per­ils of in­for­ma­tion hoard­ing by reg­u­la­tors.

Back in 2015, two years be­fore a fund­ing cri­sis pushed Home Cap­i­tal to the brink, OSFI staged an in­ter­ven­tion at the lender’s main op­er­at­ing sub­sidiary, Home Trust Co., be­cause of prob­lems with its anti-money-laun­der­ing con­trols and its risk-man­age­ment prac­tices, The Globe and Mail re­ported in 2017.

The fact that Home Trust was al­ready on OSFI’s naughty list, and had been on two other oc­ca­sions since 2005, wasn’t shared with other reg­u­la­tors, in­clud­ing the OSC, which had launched a sep­a­rate reg­u­la­tory probe of Home Cap­i­tal’s dis­clo­sure of mort­gage-doc­u­men­ta­tion fraud. (Home Cap­i­tal has since set­tled with the OSC.)

If OSFI and the OSC had bet­ter co-or­di­nated their su­per­vi­sion of Home Cap­i­tal over the past 13 years, per­haps they could have nipped its prob­lems in the bud and pre­vented its near-death spi­ral al­to­gether.

Now con­sider this: If Home Cap­i­tal can be brought to the brink of fail­ure while un­der height­ened scru­tiny by reg­u­la­tors, imag­ine the car­nage that could be wrought by the im­plo­sion of less-su­per­vised sub­prime lenders.

The fact is, we aren’t even sure how big the sub­prime mar­ket re­ally is in Canada. Reg­u­la­tors and pol­icy-mak­ers are still strug­gling to quan­tify its size be­cause not all lenders are even lightly reg­u­lated.

Lax un­der­writ­ing of sub­prime loans was one of the main cul­prits of the global fi­nan­cial cri­sis. It can’t be al­lowed to hap­pen here. In or­der to make Canada’s fi­nan­cial sys­tem safer, prov­inces need to step up their reg­u­la­tion of the al­ter­na­tive lend­ing mar­ket.

Pro­vin­cial reg­u­la­tors should also en­sure that pri­vate mort­gage lenders ad­e­quately stress-test loan ap­pli­cants. It’s worth not­ing that some credit unions, which are also overseen by the prov­inces, have vol­un­tar­ily adopted mea­sures that are sim­i­lar to OSFI’s new rules.

Ottawa, mean­while, must work with the prov­inces to en­sure ro­bust in­for­ma­tion-shar­ing among reg­u­la­tory agen­cies. Af­ter all, as Mr. Rudin rightly pointed out, reg­u­la­tors are only ef­fec­tive when they broaden their field of view.

But if there’s one take­away from the fi­nan­cial cri­sis, it ought to be that reg­u­la­tors need to be pushed to look be­yond their own nar­row man­dates.


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