A downturn in Canada's housing market could put pressure on the six largest Canadian banks, according to Fitch Ratings.
Rising home prices in Canada have kept regulatory capital ratios strong by keeping long-to-value ratios low. As a home price rises, the loan-to-value ratio falls. Under the Basel III capital rules, lower loan-to-value ratios have let Canadian banks "optimize" risk-weighted assets.
Translation: Rising prices have allowed Canadian banks to hold less capital against their residential mortgage exposure, Fitch said in a note Tuesday.
In a downturn, the opposite dynamic would kick in. Falling home prices would raise loan-to-value ratios, which would result in higher capital requirements. When you couple this with charge-offs and additional provisioning for losses in mortgage portfolios, you get strong pressure on the capital ratios of Canada's banks.
"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," Fitch said.