Fitch: Canadian Housing Correction Could Hit Banks' RWA Levels

Regulatory capital ratios for the largest six Canadian banks have benefited from sustained increases in home prices over the last decade, but any future downturn in the housing market could put pressure on those banks' risk-weighted assets (RWA) and regulatory capital ratios, according to Fitch. The pro-cyclical nature of Basel III Tier 1 common capital measures could exacerbate the effects of potential losses on residential mortgages in any future housing market correction. Under the Basel III Advanced Approaches (applying to the six largest banks in Canada and other banks globally), rising home prices over the last several years have helped keep regulatory capital ratios strong by, in effect, keeping loan-to-value (LTV) ratios in Canada artificially low. Lower LTVs, in turn, have allowed Canadian banks to optimize RWA at lower levels, reducing the size of the denominator in risk-based capital measures. This has the effect of lowering the amount of capital banks hold against residential mortgage exposures. In a potential downturn, the impact on Basel III capital could be amplified if RWA levels increase rapidly in response to a housing price correction. This could drive LTVs higher. Together with increased charge-offs and additional provisioning in mortgage portfolios, this could push capital ratios down relative to international bank counterparts. Basel III Tier 1 common equity ratios for the top six Canadian banks - TD

, RBC

, Bank of Montreal

, CIBC, Bank of Nova Scotia

and NBC - all remain solidly above regulatory minimums (between 8.3% and 9.7% as of 2Q13). Fitch generally believes that Canadian home prices are likely nearing a plateau and could exhibit some weakness over a medium-term time horizon. We believe a sharper than expected price correction would flow through to higher RWA levels, thereby putting further pressure on regulatory capital ratios at a time when rising credit losses will likely hurt retained earnings. That said, Fitch applied stresses to each bank's mortgage portfolios and we believe that capital buffers for all six are adequate to withstand a moderate to severe Canadian housing market price shock.