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.
On Thursday, the Canadian Real Estate Association will release official sales numbers for the Canadian market. Local reports show that the housing market is still booming despite official efforts to calm things down. The Globe and Mail reported over the weekend that Vancouver existing-home sales had jumped 40.4 percent from last July. Sales are up 17 percent in Calgary and 16 percent in Toronto.
(Read more: Is the Canadian housing market falling apart?)
Fitch notes that the 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.
Of course, regulatory minimums sometimes under-count the actual capital requirements imposed by counter-parties worried about the health of banks. During the financial crisis in the U.S., many banks found themselves under fire for having weak capital positions despite exceeding required ratios.
(Read more: A warning about Canadian banks)
Interestingly, The Globe and Mail has put a positive spin on this report, writing that "Fitch says Canada's big banks can withstand a downturn." Well, sure. But it's never really a good diagnosis when the doctor begins by telling the family that the patient will probably survive.
—By CNBC's John Carney. Follow me on Twitter @Carney