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Pigeonholing “Shadow Banks”

Shawdow banking FB“Shadow banking” is one of the most misapplied terms in financial services today. Apart from a few private lenders and small MICs, which comprise just 2-4% of Canada’s mortgage market,1 no Canadian lender is operating in the shadows.

There is a problem with the definition of shadow banking and it creates real difficulties for Canada’s non-bank lenders.

The Bank of Canada refers to shadow banking as

…Credit intermediation that takes place at least partly outside the traditional banking system.

The BoC lumps government-insured mortgage securitization into that mix, which is somewhat preposterous given that the Department of Finance, the banking regulator (OSFI) and CMHC set, monitor and enforce the quality of mortgages permitted in government-sponsored securitization programs.

The media, bankers and even (sadly) the Bank of Canada itself slap the “shadow banking” label on a host of lenders where it shouldn’t apply. Take mortgage finance companies (MFCs), for example, which fund 12% of Canadian mortgages.2 According to the BoC, MFCs like First National or Street Capital “are not subject to the same level of scrutiny as banks and in some instances don’t have access to as stable and diversified sources of funding.”

Well sorry, the fact that MFCs are not regulated directly by OSFI and rely on major Financial Institutions (FIs) for funding doesn’t mean they operate in the shadows.

For one thing, MFCs in Canada are typically National Housing Act approved lenders originating insured mortgages. Default insurers are OSFI regulated and must continually ensure that mortgages from MFCs meet OSFI standards (which they do and typically exceed).

Secondly, MFCs are funded by OSFI-regulated institutions and/or through CMHC securitization programs. Those entities are required to ensure that the lenders they fund or buy mortgages from meet OSFI requirements, including OSFI underwriting standards. Says OSFI,

Federally regulated financial institutions (FRFIs) that acquire residential mortgage loans that have been originated by a third party should ensure that the underwriting standards of that third party – including due diligence on the borrower, debt service coverage, collateral management, LTV ratios, etc. – are consistent with the FRFI’s RMUP and compliant with [Guideline B-20].

Funders and insurers constantly monitor lenders for compliance and benchmark their underwriting quality. Lenders are audited and those that fail see their funding taps closed or significantly tapered, depending on the nature of underperformance.

Very few lenders are short-sighted enough to take shortcuts and systematically approve prime mortgages that should not be approved. Lenders that have failed their audits in the past have seen their lifeblood (mortgage funding) meaningfully curtailed. As a lender, it doesn’t take you long to realize the importance of being conservative when a major FI or insurer threatens to stop accepting your mortgages.

In the post-financial crisis era, there is no evidence that prime mortgages originated through Canadian MFCs bear higher overall default rates than bank mortgages. In other words, mortgages initiated by a non-bank lender are no more risky to the financial system than a mortgage from a bank outside the “shadows,” like RBC or TD.

That said, if the Department of Finance wants to incentivize prudent underwriting for MFCs, all it has to do is publicly post the names of lenders that exceed and underperform acceptable standards for metrics like first-year arrears, credit deterioration post-funding, and so on. No lender, and definitely no lender’s board or shareholders, wants to jeopardize their funding and see their name near the bottom of the list.

Anyone who writes about the Canadian mortgage industry and is tempted to apply the “shadow banking” moniker should understand all this. This label should be limited to lenders that are unregulated or much less regulated: private lenders and MICs. And no, just because a lender is not directly supervised by a federal or provincial ministry of finance doesn’t mean it’s unregulated.

Fortunately, Canada’s true shadow lenders, which perform a vital role for borrowers, by the way, represent a tiny fraction of mortgage lending, a fraction the Bank of Canada correctly surmises does “not pose systemic risk.”

1 Source: TD Securities
2 Source: Bank of Canada