Market Insight for March 28

The End of Canada’s Mortgage Stress Test?

In a move that could significantly reshape Canada’s housing market, the Office of the Superintendent of Financial Institutions (OSFI) is evaluating a shift away from the contentious mortgage stress test. Instead, it is considering a new portfolio-based framework for managing mortgage risk.

This prospective change represents a major shift in Canada’s regulatory landscape, transitioning from assessing individual borrower qualifications to overseeing risk at an institutional level.

Looking back, the stress test initially served its purpose of reinforcing Canada’s financial system during a period of low interest rates. However, today’s economic environment presents new hurdles. Rising inflationary concerns due to potential trade conflicts and tariffs, indicating limited scope for the Bank of Canada to enact substantial rate cuts, suggest that we are entering uncertain financial territory.

Since its implementation in 2016 and later expansion in 2018, the mortgage stress test has been regarded both as a prudent protective measure and a restrictive barrier to homeownership. Under the current regulations, borrowers must qualify at either 5.25% or their contract rate plus 2%, whichever is higher, a rule that has notably impacted purchasing power across the market.

The stress test’s role during the 2022-2023 rate hikes has been evident, as default rates remained relatively low. However, if inflation remains persistent due to ongoing trade disputes, interest rates may stay elevated longer than expected, necessitating a more adaptive approach to mortgage regulation.

In this evolving financial climate, OSFI’s proposed shift to portfolio-level risk management may be warranted. This strategy could introduce greater flexibility in managing market complexities where inflation and financial stability are both critical concerns. The key challenge will be implementing a new system that can adapt to these new economic realities while maintaining the protective benefits the stress test provides.

OSFI’s proposed framework reflects an advanced regulatory perspective. Instead of applying hypothetical higher interest rates to individual borrowers, this method would limit banks’ exposure to high-risk lending. Specifically, financial institutions would be restricted from issuing more than 15 per cent of their quarterly mortgages to borrowers whose total mortgage debt exceeds 450 per cent of their annual income.

This isn’t merely a technical adjustment—it represents a fundamental shift in managing housing market risk. While the stress test was designed with good intentions, critics argue that it has created artificial barriers while failing to curb excessive household debt. OSFI’s own research indicates that, despite the stress test, many borrowers have still managed to take on mortgages surpassing 450 per cent of their income.

Canada’s cautious mortgage regulation stems from past experiences. The 1982 housing market collapse led to the failure of 36 federally insured loan and trust companies, along with two banks, forcing the government to provide $1.3 billion in deposit insurance payouts. These historical financial crises continue to shape today’s regulatory strategies.

The proposed shift could have widespread effects on Canada’s housing sector:

• Strategic Portfolio Management: Banks may need to rethink their mortgage lending strategies,
  leading to more selective lending practices.
• Mortgage Accessibility: Some borrowers could find it easier to qualify for a mortgage, while
  others may face new restrictions based on their debt-to-income ratio.
• Risk distribution: Instead of placing the burden on individual borrowers, financial institutions
  will take on a larger role in managing mortgage-related risk.

This regulatory shift comes at a pivotal moment for Canada’s housing sector. With affordability concerns at an all-time high and economic uncertainties impacting specific industries—evidenced by lending restrictions affecting workers in steel and aluminum—the timing of these adjustments could significantly shape market trends.

OSFI’s cautious approach—allowing for a full year of review before a final decision is made—is indicative of the complexity and significance of this potential transition. Regulators must carefully balance financial stability with the objective of maintaining a robust and accessible housing market.