OSFI reinforces prudent residential mortgage risk management

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In light of Canada’s evolving housing market, the Office of the Superintendent of Financial Institutions (OSFI) has advanced its supervisory expectations for prudent residential mortgage underwriting practices and mortgage insurance operations, ensuring that the internal controls and risk management practices of federally-regulated financial institutions (FRFIs) are substantial amid continuous market developments.

The OSFI identified some issues mortgage lenders and insurers ought to consider: income verification, non-conforming loans, debt services ratios, appraisals and loan-to-value (LTV) ratio calculations, and institutional risk appetite.

The agency emphasized the need for mitigating measures in these areas, as underpinned by the OSFI Guideline B-20 – Residential Mortgage Underwriting Practices and Procedures and OSFI Guideline B-21 – Residential Mortgage Insurance Underwriting Practices and Procedures.

Risks and vulnerabilities

With Canada’s household debt levels and house prices rapidly increasing while interest rates remain exceptionally low, the prudential risks and vulnerabilities for FRFIs have heightened.

With the ever-changing housing market in mind, financial institutions may dodge significant loan losses through: a) thorough and adequate income verification of an eligible borrower as this greatly affects credit risk assessment and mortgage insurability; b) establishing a 65 percent loan-to-value (LTV) upper limit for ‘non-conforming’ loans; c) full assessment of a borrower’s ability to service its obligations and endure plausible financial and economic shocks; d) having processes that challenge assumptions and concerns in property valuation appraisals for a conservative LTV calculation; and e) strong alignment between risk appetite and actual mortgage insurance underwriting.

Moreover, the OSFI also sought to keep the FRFIs informed of the agency’s various initiatives aimed at strengthening capital requirements held by the major banks and mortgage insurers, more specifically: risk sensitive floors, capital requirements for mortgage insurers, and the Basel Committee on Banking Supervision’s (BCBS) revisions to the standardized approach for credit limit.

For banks using the Internal Ratings-Based (IRB) approach for credit risk, an implementation of a Loss Given Default (LGD) sensitive to the local housing market conditions is recommended. For the protection of policyholders and creditors, additional capital may be imposed when house prices are relatively higher to borrower income. And for more risk-sensitive residential real estate loans, the BCBS proposed standardized approaches for credit risk, scaling capital requirements to the LTV of individual residential mortgage loans.

Once these are finalized, the agency sought to start implementation of the said capital policy initiatives to the Canadian market, targeted in November this year.

-With files from the Office of the Superintendent of Financial Institutions’ (OSFI) website