New report suggests shift from mortgage to business lending

Restrictive rules holding back innovation in the financial sector should be updated to bolster Canada’s productivity, says a new report from the C.D. Howe Institute.

In “Productivity and the Financial Services Sector – How to Achieve New Heights,” authors Farah Omran and Jeremy Kronick note that over the past 15 years Canada has lagged behind many Organisation for Economic Co-operation and Development  (OECD) countries in terms of productivity. The authors concluded that the financial services sector has much more potential than its current contributions to Canada’s productivity growth, and that regulatory changes could improve the contribution of the financial sector to productivity by increasing competition through the development of FinTechs and by focusing less on mortgage lending and more on business lending to small and medium sized enterprises.

One way the authors see this happening is through changes to the incentive structure.

“A central finding in the literature is that robust productivity growth occurs when regulations and policies foster competition for, and spur innovation in, the delivery of financial services, and attract and efficiently allocate capital,” the authors write. “Although regulations are necessary to protect consumers and maintain the stability of the financial system, they should be balanced between protecting against potential risks and ensuring appropriate competition (often from niche new entrants), which is crucial for the generation of innovative ideas and, in turn, productivity growth.”

High operational costs can also be improved through policy. In Canada, where the alternative to business lending (i.e., “less productive” residential mortgage lending) is without risk thanks to the 100% insurance that CMHC provides lenders of insured mortgages, the authors believe that operational costs might be more binding, therefore “crowding out” credit for small and medium sized businesses. In the period leading up to the financial crisis, mortgage loans increased as a percentage of GDP while business loans decreased. During the post-crisis housing recovery period, although both mortgage and business loans have been growing as a similar percentage of GDP, there remains a large gap between the two, favouring mortgage loans.

“This crowding-out effect can occur when banks are constrained in their choice of lending channels. For instance, banks can find themselves constrained in raising new capital, and must choose one form of lending over the other. In periods of house price booms, mortgage lending emerges as the more attractive lending option. Banks can also face a personnel constraint, whereby eventually they find it difficult to further expand their workforce to deal with increases to aggregate demand and volume of lending activity. As such, they again are forced to choose one form of lending over another, with mortgage lending again likely to win out during house price booms. Both these constraints are naturally exacerbated when mortgage lending is risk free,” the authors write.

Because the CMCH guarantee eliminates the risk of mortgage loans, however, it appears as if the effect of the current lending structure provides room for more business lending—at least in theory. But as mortgage insurance has proven to be an effective tool to protect the system in the event of a housing crash, how can the incentive structure be changed at the margins?

One option, the authors conclude, is to focus on mortgage insurance premiums, which do not examine the differences in default risk across mortgages with the same loan-to-value ratio. CMHC charges a flat percentage based on LTV regardless of the individual borrower profile, and pricing based on risk ensures a more efficient allocation of capital. In the case of mortgage insurance premiums, using the various borrower risk profiles to charge lenders different premiums would better allocate credit in the mortgage space that emanates from the CMHC guarantee and perhaps free up more lending for productivity enhancing businesses in Canada.

Innovation and productivity are key for long-term sustainable economic growth. Canada’s financial services sector, which has a comparative advantage over other developed economies, should be a priority for policymakers and regulators alike. Without these changes, the authors say, Canada will be unable to attract foreign investment and achieve an efficient allocation of capital.

Changes recommended:

• a flexible regulatory approach that is both function-based and proportional to functional risk
• regulatory mandates that include more explicit competition mentions as a way of spurring innovation
• monitoring the new rules around the flexibility of banks to participate and invest in FinTechs and other innovative technology-led institutions
• improving the collection and sharing of financial market data between federal and provincial regulators
• improving SMEs’ access to affordable capital
• changing the incentive structure so that financial institutions move away from a focus on mortgage lending to one on business lending