Regulator warns higher interest rates and weaker commercial real estate are increasing risks at banks

Canada’s banking regulator is warning that higher interest rates and a deteriorating commercial real estate market are inflating risks at the country’s largest lenders.

In an update to its annual risk outlook released Thursday, the Office of the Superintendent of Financial Institutions said that the rising cost of borrowing is putting greater pressure on the ability of consumers and companies to pay down their debt. It also cited mounting issues in commercial real estate as high rates cool the construction market and office vacancies rise.

In April, OSFI released its annual risk outlook for 2023-2024, outlining nine key risks that it would watch for in the year ahead. The potential for a housing market downturn and commercial real estate risks topped the list. In its fall update, it stressed that those issues remain the same, but a “continuing shift in the risk environment” has prompted greater concern in two of its biggest risk categories.

“The most significant developments are a domestic inflation rate that remains above the Bank of Canada’s target rate, the resulting monetary policy tightening and elevated interest rate environment, and signs of weakening credit quality, particularly in the commercial real estate (CRE) market,” OSFI said in the report.

While all commercial property types are vulnerable to higher interest rates, the office, construction and development segments pose the greatest risks, the regulator said. It added that falling real estate investment trust valuations and rising U.S. commercial mortgage-backed securities delinquencies point to a challenging outlook.

“Construction markets show signs of a slowdown. Office CRE valuations have come under pressure as the industry grapples with rising vacancies,” OSFI said. The regulator added that ratings downgrades on these types of properties are not keeping pace with changes in the risk environment.

As a result, banks have adjusted their lending practices and are increasingly using “participation” agreements and other co-lending agreements that spread the risk across multiple lenders. These types of debt arrangements tend to lack certain contractual elements that affect lenders’ rights, and that could present “additional risk to lenders based on legal, operational and structural complexities.”

Offices make up a small portion of the banks’ loan portfolios, comprising about 10 per cent of their commercial real estate books and about 1 per cent of their total loans. But many of Canada’s biggest banks cited increasing credit risk in commercial real estate when they reported third-quarter earnings in late August.

Royal Bank of Canada’s provisions for credit losses – the money that banks set aside for loans that could default – were boosted by large provisions for financings in the office and multifamily segments. Canadian Imperial Bank of Commerce booked impairments in its U.S. office space portfolio and the bank said that it is lowering its exposure to the segment.

In its risk outlook, OSFI said that financial institutions “should expect further engagement” on segments that are more vulnerable to declining property valuations, and that it is working with organizations to gather more data to monitor ratings and valuation changes.

Higher interest rates are also continuing to affect retail, corporate and commercial borrowers’ ability to service debt, the regulator said.

In recent months, OSFI has been stressing that borrowers with variable-rate mortgages are too reliant on lengthening mortgage amortizations to help them cope with surging costs. Some banks offer variable-rate mortgages that allow the loan to negatively amortize to help borrowers adjust to higher rates by temporarily extending the time frame to pay it off. The unpaid interest is added to the principal, boosting the size of the mortgage and, in the long term, the cost of the monthly payments.

Many of these mortgages are coming up for renewal over the next few years, when the extended amortization will snap back to the original length, leaving borrowers with higher payments.

In July, Canada’s financial consumer watchdog, Financial Consumer Agency of Canada, issued new guidelines for lenders aimed at helping financially distressed mortgage borrowers, in part by discouraging banks from charging interest on interest when the time frame for paying off a loan is extended.

Next week, OSFI plans to release the results of its public consultation on mortgage underwriting practices. The regulator said that a potential option that it explored is the adoption of loan-to-income thresholds to “help financial institutions better manage the risks associated with significant buildups of household debt in their loan books.”