Evolving rate environment drives OSFI’s risk outlook

Given fast-rising interest rates and the slowing economy, the banking sector is facing an array of risks driven by tighter financing conditions. But so far, federal banking regulators are surprised by how well the industry is weathering those risks.

In its second annual risk outlook report, the Office of the Superintendent of Financial Institutions (OSFI) detailed the major threats facing the financial system in the year ahead, with the housing market, liquidity and funding concerns, and the commercial real estate market at the top.

These risks have risen in recent months as financial conditions have tightened and the economic outlook has deteriorated.

“The financial system is adjusting to a higher interest rate environment. Given the rapidity at which interest rates globally have increased, the risk has grown that such an adjustment may not be completely smooth,” the report noted.

OSFI flagged the housing market as its top risk, given its importance to the overall financial system and the increased stress in that market due to higher interest rates.

“This is a growing concern from a prudential perspective,” the report said. “Mortgage holders may not be able to afford continued increases on monthly payments or might see a significant payment shock at the time of their mortgage renewal, leading to higher default probabilities.”

Given these risks, the regulator said that its oversight work is focused on ensuring that banks’ risk management practices and lending standards are meeting expectations.

“We will continue monitoring mortgage asset quality closely for signs of credit deterioration,” it noted.

Peter Routledge, OSFI superintendent, said he’s been surprised with how well asset quality has held up so far, despite the sharp rise in rates.

One reason for this, he suggested, is the resilience of the economy and the strength of the labour market, which has meant that many households have been able to absorb the rising cost of debt.

While he cautioned that this may yet change as the effects of higher rates continue to work their way through the economy, the fallout from rapidly rising interest rates has, so far, been “more benign” than he would have expected, Routledge said.

Additionally, OSFI noted that the banks are much better prepared to face tougher financial conditions than they were going into the financial crisis in 2008, largely thanks to reforms to bank regulation in the wake of that episode.

Measures such as OSFI’s mortgage stress test are also expected to help ease the adjustment to tighter monetary policy, he noted.

“We will be intensifying our focus on supervisory assessments of [financial institutions’] capital, liquidity and risk profiles to ensure they remain prudentially sound,” the regulator said, adding that it will “respond early and proactively to address vulnerabilities.”

While the housing market is OSFI’s top concern, these same forces could create risks to banks’ liquidity and funding conditions, the report noted. As a result, OSFI is stepping up its focus on firms’ deposit stability, access to funding, liquidity and counterparty credit exposures, it said.

And commercial real estate is another top concern, given the lingering effects of the pandemic, such as reduced demand for office and retail space, and ongoing supply chain issues.

Here, too, OSFI has increased its monitoring for vulnerabilities.

It also noted that the recent implementation of post-crisis reforms included higher capital requirements for riskier commercial real estate exposures, which should help ensure banks can ride out these risks.

Alongside the top three risks, OSFI listed other concerns including the possibility of stresses spilling over from the shadow banking sector to the mainstream industry, corporate credit risk, climate risk, outsourcing risk and cyber risk.

Each of these areas are attracting their fair share of attention from the regulator, but the ongoing fallout from the tighter financial environment remains its top supervisory priority for the months ahead.