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Canadian banks face risk from rising consumer debt vulnerability, says Moody's

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Staff Writer | March 14, 2018
The bank asset quality of the largest seven Canadian banks face several risks as consumer lending vulnerability has increased across different asset classes, Moody's Investors Service says.
Canadian bank
Canada   Credit card losses will come first
Those banks are Bank of Montreal (BMO, A1 negative), Bank of Nova Scotia (A1 negative), Canadian Imperial Bank of Commerce (CIBC, A1 negative), Royal Bank of Canada (A1 negative), Toronto-Dominion Bank (Aa2 negative), National Bank of Canada (A1 negative) and Desjardins Group (DG, Fédération des caisses Desjardins du Québec, Aa2 negative).

"The strong credit quality of Canadian consumer loans, thanks largely to record low unemployment in recent years, is under threat on several fronts: debt-servicing costs are increasing because of interest rate hikes, the proportion of riskier uninsured mortgages is on the rise, and longer auto loan terms point to greater borrower vulnerability," Moody's AVP Jason Mercer says.

"As debt-to-income levels continue to edge up, the first bite into bank asset quality will be felt in unsecured credit card portfolios."

A prolonged period of sustained low interest rates has kept Canadian borrowers' debt-servicing requirements manageable and low unemployment has helped keep consumer loan defaults very low but, high and rising household debt-to-income levels leaves borrowers and lenders vulnerable to an economic downturn.

Residential mortgage risk is still low, but will increase, Moody's says. Insured mortgages have fallen to 40% of total mortgage exposures from 50% five years ago as the government shifts the mortgage credit risk burden to the private sector.

Mortgage-servicing costs are likely to rise because nearly half of outstanding mortgages have interest rate renewals within a year and interest rates have recently increased.

Another growing risk stems from auto loans. Though credit quality is currently strong, lengthening loan terms signal growing risk. Longer consumer auto loan terms increase "negative equity," or the amount by which the remaining loan balance exceeds the collateral value since the vehicle values fall faster than the loan is repaid.

For the banks, credit card losses will come first. The banks will experience higher losses on credit card defaults than on secured consumer loans, because loss given default is 100%. However, the card portfolios of rated Canadian lenders are small.

"Credit cards lack supporting collateral and have a lower repayment priority than residential mortgages or auto loans; therefore, credit card loan losses tend to occur before, and are more severe, than other forms of consumer lending," Mercer says.