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Riskier Lending Practices Can’t Support Growth in Consumer Credit Forever

Aug 12, 2015
Kristelle Audet Kristelle Audet
Senior Economist
Canadian Industrial Outlook

Unlike many of its global peers, much of the Canadian financial sector emerged from the 2009 recession largely unscathed. Since then, a strong housing market has supported its expansion and profitability. However, the smooth sailing may be coming to an end. High household indebtedness is making it increasingly difficult for banks to expand their loan portfolios and grow their revenues. To overcome this challenge, some financial institutions have been adopting riskier lending practices—a clear sign they may be running out of options to grow consumer credit.

In the mortgage segment, the latest Bank of Canada Financial System Review revealed that certain financial institutions, especially those defined as smaller, federally regulated financial institutions, are using creative ways to issue uninsured mortgages to consumers without the necessary 20 per cent down payment. One approach is to partner with financial institutions that fall under different regulatory requirements than traditional banks, such as mortgage investment corporations. Traditional lenders would issue a mortgage worth 80 per cent of the purchase price, with the remainder of the required amount being financed by the mortgage investment corporation. Particularly worrying with this approach is the fact that it targets consumers with lower credit scores and weaker income documentation. According to the June Financial System Review, about one-third of uninsured mortgages provided by smaller financial institutions in recent years have been issued to sub-prime borrowers.

Riskier lending practices are also becoming more commonplace in the non-mortgage segment. During the 2000s, the sharp increase in lines-of-credit debt supported robust growth in non-mortgage debt. (See Chart). Rapidly rising house prices allowed consumers to borrow more against the equity in their homes. However, despite interest rates remaining at historically low levels, growth in lines-of-credit debt recently slowed, up by a mere 2.6 per cent since January 2013. Canadians may be listening to the government’s advice to reduce their debt levels and/or realizing that rates will not remain this low forever. Growing concerns over the future of housing prices may also be discouraging them from borrowing more on their lines of credit.

Facing slower growth in the lines-of-credit segment, which accounts for nearly 60 per cent of the total non-mortgage debt on banks’ balance sheets, financial institutions have looked elsewhere for growth. Instalment loans, commonly used to finance car purchases, have been a key targeted segment. As such, outstanding balances on personal loans increased by nearly 20 per cent in the past two years. Riskier lending practices appear to be in play to stimulate credit growth on this front as well. According to the Bank of Canada, more than two-thirds of auto loans issued in the past year were for a duration of more than six years, and loans made to sub-prime borrowers have grown faster than loans to credit-worthy consumers. Given this loosening of credit standards, it is not surprising that delinquency rates on auto loans have risen in the past year, according to Equifax.

Our conclusion? In an environment of high consumer indebtedness, financial institutions are now stretching the credit quality of their borrowers to sustain growth, using practices that risk becoming unsustainable in the long run. If the economy were to deteriorate significantly, banks and credit unions engaging in riskier lending practices would be the first ones impacted. As in all credit cycles, the recent loosening of financial institutions’ lending standards will eventually lead to higher losses from loans.