Policy measures to bolster financial stability in Canadian Banks

 Policy Measures to Bolster Financial Stability
39. Additional required capital for mortgage exposures, along with measures to increase
risk-based differentiation in mortgage pricing, are desirable. While overall banks’ capital buffers
are adequate, severe macrofinancial shocks might create capital shortfalls at mortgage insurers. The
capital requirements for mortgage exposures at lenders and mortgage insurers should be tightened
to properly account for through-the-cycle credit risk that may exceed Canadian historical
experience. Larger required capital would also help incentivize mortgage pricing that better
differentiates borrowers’ risk profiles. For lenders, this could be accomplished by higher risk weights
(e.g., through prudential adjustments to credit risk modeling). For mortgage insurers, their required
capital should be enough to absorb tail-risk shocks 

(e.g., the FSAP adverse scenario). In addition,
risk-based pricing of insured mortgages should be improved by increasing the risk sensitivity of
insurers’ capital requirements or guarantee fees paid to the government and limiting insurance
coverage of loans that fund insurance premiums.
40. Enhanced risk monitoring is essential especially in the areas of emerging
vulnerabilities. These include (i) banks’ external, foreign-currency funding, (ii) extensive use of
derivatives, (iii) rising risk-taking by life insurers, pension funds and other nonbanks, 

(iv) non-prime
mortgage lending outside the regulatory perimeter and HELOCs, and (v) spillovers from overseas
operations and cross-border exposures. Continued efforts to address data gaps—particularly related
to cross-sectoral exposures, unregulated nonbank financial intermediation, and funding market
activities (e.g. securities lending)—would help gather a more complete picture of risk buildups.
41. The top-down stress testing capacity for banks and insurers should be enhanced. A
priority should be given to further development of the BOC’s bank solvency stress testing
framework; the lack of granular data impedes the ability to project key financial items by significant
42. Given their systemic relevance, strengthening oversight of large public pension funds,
would be helpful. Increasing the detail, standardization, and reporting frequency of financial

 See Appendix IV for the methodological details of interconnectedness analysis.
disclosures, as well as introducing standardized liquidity stress testing requirements, would improve
risk monitoring and assessment.
43. The policy framework for managing a housing market downturn should be developed.
Such policy responses should provide effective countercyclical support for the economy and
financially distressed households while allowing economic adjustments, limiting moral hazard and
safeguarding taxpayers’ interest. One option would be to create a professionally managed
government-sponsored mortgage reinsurance fund, which could be funded by existing guarantee
fees. The government should also limit the use of portfolio insurance as a crisis management tool,
except at punitive premiums. The perception that this tool is an option for future downturns may
interfere with risk-pricing of uninsured mortgages. In addition, an appropriate level of exposures to
mortgage insurance should be identified, and mechanisms should be put in place to ensure that the
exposures remain within those limits.

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