Canada Banking Outlook 2014: The Challenge Is To Find Growth Opportunities While Preserving Asset Quality

Primary Credit Analyst: Lidia Parfeniuk, Toronto (1) 416-507-2517; lidia.parfeniuk@standardandpoors.com Secondary Contacts: Tom G Connell, Toronto (1) 416-507-2501; thomas.connell@standardandpoors.com Michael Leizerovich, Toronto (1) 416-507-2510; michael.leizerovich@standardandpoors.com Robert Palombi, Toronto (1) 416-507-2529; robert.palombi@standardandpoors.com Nikola G Swann, CFA, FRM, Toronto (1) 416-507-2582; nikola.swann@standardandpoors.com

Table Of Contents
Rating Outlooks Are Stable, But Some Key Risks Warrant Surveillance Economic Outlook: Canada's Economic Recovery Is Likely To Keep Sputtering Canadian Banks Should Remain On Track For Moderate Growth Through 2016 Buildup In Consumer Debt And House Prices Pose Risks, But Country-Specific Factors Mitigate Them, And We Expect Them To Moderate This Year Regulatory Changes Are Another Factor Constraining Earnings Growth Canadian Banks Can Manage Moderately Higher Loan Losses Notes Related Criteria And Research
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Canada Banking Outlook 2014: The Challenge Is To Find Growth Opportunities While Preserving Asset Quality
Canadian banks are likely to face ongoing economic headwinds, intense competition, and limited revenue growth this year while adapting to more restrictive banking regulations. In Standard & Poor's Ratings Services' view, these factors will keep a lid on earnings growth and make it all the more crucial for banks to maintain effective competitive operations to preserve their credit profiles. Our current Canadian bank rating outlooks are stable (with the exception of HSBC Canada, which has a negative outlook), reflecting strong profitability and low loan losses. However, Canadian consumers' high average debt levels contribute to the potential for a decline in banks' operating performance, should a recession return. We will also consider, as the regulatory environment evolves, the rating implications of any bail-in policy features the Canadian government introduces, which we expect to be subject to a consultative process and phase-in period to avoid destabilizing bank funding markets. We remain watchful of banks' exposures to consumer credit; however, we recognize that recent policy measures appear to be slowing the build-up of mortgage-sector risk, in particular (the federal government holds a portion of these risks through mortgage insurance arrangements), which is likely to keep consumer loan growth at a moderate level as seen in 2013, in our view. Although losses on banks' uninsured mortgages and unsecured consumer loan portfolios have remained low, they may rise in the event of a substantial drop in household creditworthiness. We believe that Canadian financial institutions' risk tolerances are increasing to compensate for lower profitability by searching for yield through more aggressive lending in higher risk categories such as credit cards, auto financing, and leveraged lending, and receptivity to growth through acquisitions. Although we expect Canadian banks to maintain their generally sound asset quality metrics, higher provisions for loan losses have the potential to modestly hinder earnings growth. We believe that net interest margins (NIMs) of banks' personal and commercial businesses will stabilize with support from rising interest rates in 2014 or 2015 though limiting margin expansion through sustained price competition among the large banks. We expect banks to continue to focus on increasing their core customer deposit bases to amass cheap funding and strengthen their liquidity. Despite slower earnings growth, we expect that Canadian banks' capital positions will strengthen incrementally over the next year. Overview • High Canadian consumer debt levels and the possibility of global economic deterioration remain credit concerns for Canadian banks. • Banks are also facing more intense competition and continued regulatory changes. • Nevertheless, we believe the Canadian banks are well positioned, given their current level and stability of earnings, to handle moderate loan losses, and thus our outlook for the Canadian banking sector remains stable.

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Rating Outlooks Are Stable, But Some Key Risks Warrant Surveillance
Our rating outlooks across the Canadian banking industry are stable. Earnings growth has clearly slowed over the past two years for the large Canadian banks, though profitability is still strong. We expect this general trend to continue over the next couple of years, reflecting modest revenue growth and slightly higher provisions for loan losses. We also expect banks to effectively manage costs, including through further staff reductions, which would partially offset slower revenue growth in 2014. However, should acquisition flow increase, expenses could become harder to control. We believe the banks will manage their risk exposures to produce a modest increase in risk-weighted assets (RWA) in 2014, and their risk-adjusted capital (RAC) ratios (as Standard & Poor's defines them) will strengthen based on strong, albeit moderating, internal capital generation. Should heightened industry and economic risks lead to a significant drop in revenues and earnings and a substantial increase in loan losses (notably above historical levels), we could lower individual bank ratings where warranted. Although we don't anticipate any upgrades in the near term, we would consider raising individual ratings if a bank's performance supported it. We believe the following risks have the highest potential to be sources of credit stress in the Canadian banking industry and could trigger changes to our ratings on specific Canadian financial institutions.

High Canadian consumer debt levels
High levels of consumer debt could cause Canadian banks' credit portfolios to deteriorate significantly in the event of an external shock (such as a severe global economic downturn) that triggers a spike in domestic unemployment and consumer delinquencies. We believe nonmortgage consumer credit losses could be more significant for Canadian banks than mortgage losses, for which the Canadian banks generally have insurance from government-backed providers, such as the Canada Mortgage and Housing Corp. (CMHC, a federal government-owned Crown Corporation; see full analysis published Jan. 30, 2014).

Intense competition
We expect that continued moderate pressure on margins and subdued loan growth will define the competitive environment in 2014. Individual banks' outcomes will differ depending on the potential trade-off between risk discipline and appetite for revenue or market share growth, as well as the banks' abilities to manage expenses, expand client relationships, or identify new growth opportunities. Banks that successfully compete on nonprice dimensions, such as operational effectiveness, customer service, and branding, may be able to mitigate some of the effects of tighter competition. Banks may also develop a heartier appetite for acquisitions to boost earnings, leading to integration risks and the potential for limited capital growth.

Regulatory changes
Since the beginning of 2013, Canadian banks have been operating under core elements of the Basel III capital framework and adapting to revised rules governing mortgage underwriting and insurance, covered bonds, and derivatives clearing. Regulatory changes, largely driven by Basel III, but as adopted and implemented by the Canadian government and the Office of the Superintendent of Financial Institutions (OSFI) will have further implications for capital management, leverage, funding, and liquidity. Banks (and investors) must adapt to revised rules on the ability of capital instruments to absorb losses, capital surcharges for systemically important banks, and the likely establishment

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of broader "bail-in" provisions (explicit mechanisms to impose losses on providers of bank financing in an extreme stress scenario) as an element of the resolution framework. In general, we anticipate that evolving regulations will have an incrementally positive impact on the Canadian financial system's stability over time. However, in our view, regulatory changes in aggregate will add to margin pressures while limiting banks' growth potential in certain areas, such as retail lending and trading activities.

The possibility of global economic or financial system deterioration
The risk of global economic deterioration has not disappeared, in our opinion, and a major global financial system disruption or significant worsening in the global economic outlook could hurt Canadian banks' creditworthiness. This could come through deterioration of funding conditions, failures of multiple large counterparties, or interdependence of the Canadian and global economies. Although external macroeconomic risks have lessened with accelerating growth in the U.S. and stabilization in Europe, vulnerabilities remain, including ongoing eurozone restructuring.

Economic Outlook: Canada's Economic Recovery Is Likely To Keep Sputtering
We expect Canada's economic recovery to continue in 2014, albeit at a subdued pace, with real GDP increasing 2.5% for the year and staying below 3% in 2015. High consumer debt burdens are constraining the country's growth potential, while a slow recovery in international trade is weighing on Canadian exports. With businesses remaining cautious about hiring, a slowdown in job creation is curtailing income growth for households. In the second half of 2013, inflation eased to the bottom of the Bank of Canada's 1%-3% target range for CPI. Although the Bank of Canada's policy interest rate has been at 1% since September 2010 and is unlikely to increase in 2014, its decision not to use asset purchases, also known as quantitative easing (QE), to support the economy has curtailed the growth of its balance sheet and the amount of excess liquidity in the banking system. The ending of QE in the U.S., however, will involve a larger shift in the size of the central bank's balance sheet as the U.S. Federal Reserve continues tapering its asset purchases in 2014. This withdrawal of liquidity from the banking system could become a source of interest-rate volatility as global fixed-income market participants try to anticipate the potential consequences of the U.S. Fed buying fewer securities. In our baseline scenario for Canada, we're assuming that upward pressure on long-term interest rates in 2014 will raise companies' financing costs. The average effective interest rate that investment- and speculative-grade borrowers were paying to raise debt capital (3.36%) at the end of 2013 was near the ceiling of the 3.0%-3.5% range for the rate since 2010, but about 250 basis points (bps) below what borrowers were paying in 2008, when the financial crisis disrupted funding markets. We're assuming the rate could increase by 50-100 bps in 2014. Unlike in the U.S., where, until recently, the government shutdown and federal government spending cuts had a destabilizing impact on consumer and business confidence, Canada's modest government fiscal restraint has had a limited impact on consumer and business sentiment. The total budgetary deficit for federal, provincial, and municipal governments narrowed to 3.6% as a share of Canada's nominal GDP at the end of 2013, from a high of 6.4% in 2010. The timetable for restoring balanced budgets varies across the country. For instance, Ontario, with the largest deficit among provincial governments, won't balance its budget until 2018. We don't expect this moderate pace of deficit-cutting to significantly constrain Canadian GDP growth in 2014 or 2015.

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Canada Banking Outlook 2014: The Challenge Is To Find Growth Opportunities While Preserving Asset Quality

Canadian Banks Should Remain On Track For Moderate Growth Through 2016
Despite relatively weak economic growth over the past several years, along with stiffer competition, persistently low interest rates, elevated consumer debt, and enhanced regulatory bank oversight, we expect the Canadian banking sector to remain resilient and on track for moderate revenue growth over the next couple of years. We anticipate asset growth in the mid-single-digits through 2016, reflecting our expectation for modest organic growth in domestic retail loans, slightly more buoyant increases in commercial loans, and the impact of targeted acquisitions. We also expect overall loan growth to remain in the mid- to high-single-digit percentages in 2014, as Canadian consumers' appetite for leverage moderates in the face of continued economic uncertainty and expectations of rising interest rates. As a result, we believe that tougher competition for loan growth could prompt some banks to incrementally raise their risk tolerances. In our view, there is potential for modest acceleration in loan growth through 2016 propelled by strengthening Canadian economic performance. Net interest margins declined for the past few years, but we believe that they will stabilize in 2014 and then expand modestly in 2015 and 2016. We believe that banks' nonperforming loan levels could rise somewhat, contributing to a slightly riskier overall loan mix following continuing loan growth in recent years. As such, our current assumption that loan loss provisions will increase by about 8% in 2014, and by approximately 7% in both 2015 and 2016 captures our expectation of modest asset quality pressure.

Banks have demonstrated resilient earnings power through difficult times
Throughout the global financial crisis, Canadian banks demonstrated their capacity to adapt to the challenging economic conditions as well as the changing financial industry landscape, which was evident from their record earnings, driven by high leverage ratios and low credit costs. As banks continue to pursue earnings growth amid intense competition, we expect them to maintain focus on managing operating costs and realizing efficiency gains. While Canadian banks showed negative operating leverage of approximately 1.4% on average, over time we expect them to benefit from their ongoing cost management initiatives (see chart 1). We expect revenues and expenses to grow at about the same pace this year, and positive operating leverage should return in 2015 and 2016. For the most part, we view Canadian banks' earnings as relatively high quality, given the high proportion of net interest and fee-based income and the modest contribution of trading and other market-sensitive income. Accordingly, we expect average core earnings (as Standard & Poor's defines them) to grow every year through 2016 -- strengthening from the mid- to high-single-digit growth rates -- as the Canadian economy continues to recover and consumer incomes catch up with aggregate debt levels (see chart 2). The banks' projected level and stability of earnings offer a substantial cushion to absorb potential credit losses over the cycle. Based on our current estimate of normalized losses (which represent Standard & Poor's assumptions of average credit losses over a normal 12-year credit cycle), Canadian banks have an average three-year earnings buffer of approximately 1.5% of RWA, calculated in reference to the Standard & Poor's RAC framework, which we consider strong.

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Canada Banking Outlook 2014: The Challenge Is To Find Growth Opportunities While Preserving Asset Quality

Chart 1

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Chart 2

Capital levels continue to improve but leverage remains high
At year-end 2013, the average estimated Standard & Poor's RAC ratio for Canadian banks was more than 7.5%, and we believe this average could increase to about 8% by 2016. Our forecast takes into account ongoing growth in RWA across the banks and a gradual increase in bank dividend payout ratios within the range of 40% to 50% (and likely nearer the high end of that range), with ongoing share buybacks augmenting the rise. We also consider Canadian banks' quality of capital to be relatively high, with less than 15% of total adjusted capital (TAC, a Standard & Poor's measure used as the numerator for the RAC ratio) made up of non-common capital instruments (see chart 3). Given the recent issue of Basel III-compliant preferred shares (by both Royal Bank of Canada and National Bank of Canada), we expect that banks will take steps toward renewing the portion of their funding consisting of preferred shares while phasing out previously issued instruments along with their capital eligibility. The average Canadian bank's leverage, as a ratio of tangible common equity to adjusted assets, was approximately 4% at year-end 2013, indicating a relatively high degree of leverage. We believe Canadian banks' leverage ratios are reflective of the advantage posed by insured mortgages, which are lower risk assets.

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Canada Banking Outlook 2014: The Challenge Is To Find Growth Opportunities While Preserving Asset Quality

Chart 3

Buildup In Consumer Debt And House Prices Pose Risks, But Country-Specific Factors Mitigate Them, And We Expect Them To Moderate This Year
In our opinion, high Canadian consumer leverage in general, and housing debt in particular, coupled with a run-up in some measures of house prices are key risks to the Canadian banking system. In fact, they are the main reason for our negative trend on economic risks within the context of our Banking Industry Country Risk Assessment (BICRA) on Canada (published Jan. 27, 2014). In our opinion, the continual rise in Canadian consumer leverage since the early 1990s, which the increasing household debt to disposable income ratio illustrates (see chart 4), could amplify the impact of any negative shock to consumers' credit quality on banks, as consumer-sector exposure accounts for nearly three-fifths of Canadian bank loans. In addition, some home price measures -- for example, the ratio of house prices to disposable income, which is currently at about 5x and has risen substantially and steadily during the past 10 years --suggest increases in the likelihood and the degree of a potential correction. We expect a mild correction to begin in 2014, with a 2% decline in house prices this year. We do not expect such a decline to exceed 10% this year, even in a reasonable macroeconomic downside scenario (see BICRA).

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Canada Banking Outlook 2014: The Challenge Is To Find Growth Opportunities While Preserving Asset Quality

Chart 4

On the other hand, we believe the situation is more nuanced than a few commonly referenced metrics might imply; there are several factors that continue to distinguish the risks to Canadian mortgage finance from those of peer countries, and the U.S., in particular.

Relatively few mortgages are in arrears, and borrower performance has been very strong for more than a decade
First, Canadian mortgage borrowers have a very strong track record of credit performance and credit characteristics. Residential mortgages in arrears remain a very small proportion (less than 0.5%) of the total outstanding, as has been the case in each of the past 15 years, including during the global financial crisis (GFC; see chart 5). This distinguishes Canadian mortgage borrowers from those in many countries, particularly the U.S., where arrears reached almost 10% during the GFC. Although we believe low and stable interest rates in recent years helped keep arrears low, in addition, Canadian financial institutions have extended consumer credit overwhelmingly to those borrowers most able to handle it, according to the national credit-scoring system (see chart 6). The share of non-prime mortgage borrowers in Canada remains relatively small, at about 7% compared with the pre-crisis level of about 20% in the U.S. Moreover, lacking some of the systemic incentives that tend to encourage U.S. borrowers to incur and maintain larger mortgage balances (in Canada mortgage payments are not tax-deductible, the rate on fixed-rate mortgages generally resets in five years at most, and almost all mortgages are full-recourse), Canadian homeowners tend to pay down mortgage debt more

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Canada Banking Outlook 2014: The Challenge Is To Find Growth Opportunities While Preserving Asset Quality

quickly, according to age-specific data presented by the Bank of Canada.
Chart 5

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Canada Banking Outlook 2014: The Challenge Is To Find Growth Opportunities While Preserving Asset Quality

Chart 6

Federal regulations constrain mortgage lending, and have been gradually tightening
Another important distinction of the Canadian mortgage market is the set of governmental arrangements regarding mortgage insurance. Canadian law requires all federally regulated lenders (almost all the significant banks) to purchase third-party mortgage insurance on high-ratio mortgage loans (those with loan-to-value ratios exceeding 80%). This insurance may only be purchased from CMHC or one of the government-approved private-sector mortgage insurers. Such mortgage insurance benefits from a goverment guarantee that we believe is credible, both because it is explicitly and clearly stated in law and because we believe the Canadian sovereign has sufficient balance-sheet capacity to absorb the related costs in a reasonable downside scenario without compromising its own credit quality (see full analysis on Canada published Nov. 26, 2013). Moreover, in light of our expectation that a downside-scenario house price decline will not exceed 10% in 2014, only an estimated 4% of Canadian homeowners have homeowners' equity positions of less than 10%, according to data from the Canadian Association of Accredited Mortgage Professionals (as of spring 2013). Furthermore, since at least the start of the GFC, we believe Canadian federal authorities have focused on the increasing risks from consumer leverage and housing markets, leading them to gradually tighten macroprudential policy levers several times since 2008 (see Notes). We believe these eligibility-tightening policy measures may have already slowed the rise in consumer leverage and house prices and are increasingly likely to, as the new rules influence

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Canada Banking Outlook 2014: The Challenge Is To Find Growth Opportunities While Preserving Asset Quality

a larger share of mortgages, with time (the new rules apply only to new loans). We expect household demand (including for housing) will remain lukewarm this year. Given the time lags in policy initiatives and our expectation that monetary policy will remain highly accommodative in 2014, we expect nominal growth in residential mortgages outstanding to decelerate to 2%-4% in 2014 (from 10% in the mid-2000s) and aggregate loan growth to moderate slightly, to about 5%-6% in 2014 (from about 7% in 2012 and 2013). Although we expect house prices to decline during 2014, continuing the sporadic pattern of 2013, the cumulative buildup in broad housing price indicators and affordability is still a significant risk. However, if a housing market correction does occur, the support Canadian banks receive from government-backed mortgage insurance could partly offset the impact. Currently, we expect total credit losses (including retail, commercial, and corporate) of about 34 bps in 2014, compared with 31 bps in 2013, which is generally in line with the rates in some peer countries (such as Australia) but higher than in others (such as Sweden).

Regulatory Changes Are Another Factor Constraining Earnings Growth
The use and nature of hybrid capital instruments (which have features of both debt and equity, and are structured to absorb losses without leading to an overall default) as an element of bank capital will change in the next few years. Canadian capital regulations introduced in 2013 require these instruments to incorporate contractual mechanisms for loss absorption, such as conversion to common equity if and when an institution approaches a point of non-viability (referred to as "non-viability contingent capital," or NVCC, instruments). Recently, Royal Bank of Canada and National Bank of Canada issued the first such instruments (although CIBC had converted three issues outstanding to be Basel III-compliant in 2011). We expect other large Canadian banks to follow their lead. Hybrid capital instruments currently make up between 10% and 15% of the large Canadian banks' TAC, but previously issued instruments (not incorporating conversion features) are subject to a regulatory phase-out through 2022. As such, banks have begun phasing out these instruments. We exclude hybrids from our TAC calculation as regulatory recognition is withdrawn, or as the banks redeem issues because of their ineligibility as regulatory capital. The recent establishment of market access for NVCC instruments may help to sustain the diversity of funding sources available to Canadian banks. However, given the anticipated introduction of a general bail-in framework, it remains uncertain how broad and deep the market appetite will be for NVCC preferred shares, and perhaps to a greater extent for subordinated debt, which also must incorporate an NVCC mechanism. (For more information on the evolving views of Standard & Poor's on hybrid capital instruments , please see "RFC: Assigning Issue Credit Ratings To Bank And Prudentially Regulated Finance Company Hybrid Capital Instruments," published Feb. 6, 2014.) Potential future requirements for broader inclusion of "bail-in" loss-absorption features in Canadian banks' funding arrangements could have implications for the risks inherent in different bank funding instruments, including, potentially, senior debt. The rating implications of expanded bail-in provisions would depend on many factors, including the delineation of instruments included and excluded from such provisions, how bail-in triggers would be defined, and many other features. Provisions of this kind may have notching implications for senior debt, and may also have implications for how we factor government support into bank issuer credit ratings.

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Canada Banking Outlook 2014: The Challenge Is To Find Growth Opportunities While Preserving Asset Quality

Changes to funding practices are ongoing
Canadian banks' funding practices continue to evolve gradually in response to pressures arising from regulatory and market factors. The banks benefit from advantageous domestic and cross-border access to funding markets and actively use a diverse set of funding sources. OSFI is finalizing the implementation of its Liquidity Adequacy Requirements and plans to implement them on Jan. 1, 2015. OSFI has targeted implementation of the Basel Net Stable Funding Ratio for Jan. 1, 2018, but hasn't yet finalized its provisions. We believe that the large Canadian banks are positioned to meet the Basel III Liquidity Cover Ratio (subject to its pending finalization); they operate under OSFI's Net Cumulative Cash Flow framework, which addresses the potential for maturity mismatches between assets and liabilities over a horizon of less than one year. We expect that the net effect of these standards will be to accentuate the value of stable funding sources and liquid, low-risk assets for Canadian banks. Our funding and liquidity assessments of the large Canadian banks incorporate their fairly high dependence on wholesale funds, which is somewhat offset by a number of additional quantitative and qualitative factors, including the consideration of National Housing Act mortgage-backed securities reported as loans in our assessment of banks' funding and liquidity profiles. As banks position themselves to operate within the new standards, we expect that competition will continue for the finite supply of core deposits, which could weigh on deposit pricing and net interest margins. Also, limits on the mortgage insurance available from CMHC and restrictions on the use of insured mortgages may incrementally limit access to and pricing for mortgage-backed secured funding. Our general expectation is that over time, the implementation of more stringent liquidity and funding standards will contribute to the stability of individual bank credit profiles and the system overall. Even so, banks may have to bolster their liquidity or moderate their reliance on short-term wholesale funding as government-backed mortgages contribute less to banks' liquidity management, at the same time that regulatory standards for funding and liquidity are tightening.

Canadian Banks Can Manage Moderately Higher Loan Losses
Our stable outlooks across Canada's banking sector reflect our view that the current ratings can accommodate dips in performance arising from our current expectations around competitive margin pressures, slower loan growth, regulatory changes, and potential erosion in asset quality owing to high consumer debt. And while consumer leverage remains a credit concern, we expect the buildup of debt will continue to moderate. Furthermore, we do not believe that elevated house prices and consumer indebtedness are themselves sufficient to trigger a downturn in the Canadian economy. Should the Canadian economy experience a renewed downturn, however, Canadian consumers' leverage would deepen the impact of a recession, including the extent of Canadian banks' cyclical losses. If there is no extreme downturn, we believe that the current earnings and capital positions of Canadian banks can readily absorb a moderate increase in losses as the credit cycle proceeds.

Notes
Between 2008 and 2012, the government tightened the minimum underwriting standards to qualify for mortgage insurance on a newly originated high-ratio loan (which is necessary to issue such a loan) in four progressive steps. Current rules include the following adjustments:

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Canada Banking Outlook 2014: The Challenge Is To Find Growth Opportunities While Preserving Asset Quality • A reduction in the maximum loan-to-value to 95% (from a peak of 100%); • A reduction in the maximum amortization period to 25 years (from a peak of 40); • The elimination of high-ratio loans for refinancings and non-owner-occupied properties (such loans could be made up to 95% of value, at their peak); • The establishment of maximum ratios for both the "gross debt-service ratio" (numerator including property taxes and heating costs, in addition to mortgage payments) and the "total debt-service ratio" (numerator including items in the first ratio plus all other debt service), at 39% and 44% of income, respectively; and • Tightening of the required credit score and documentation standards for borrower income and property valuation.

Related Criteria And Research
Related Criteria
RFC: Assigning Issue Credit Ratings To Bank And Prudentially Regulated Finance Company Hybrid Capital Instruments, Feb. 6, 2014

Related Research
• Canada, Nov. 26, 2013 • Banking Industry Country Risk Assessment: Canada, Jan. 27, 2014 • Canada Mortgage and Housing Corporation, Jan. 30, 2014

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