(Bloomberg) -- Canada’s banking regulator imposed higher capital requirements on the country’s largest banks for the second time in about six months, signaling concern about economic and financial risks that lie ahead.

The Office of the Superintendent of Financial Institutions said it’s lifting the domestic stability buffer to 3.5% of risk-weighted assets from its current 3% level. The buffer is a rainy-day fund to protect banks in the event of future problems. The regulator increased it by the same amount in December.  

The change means the six largest Canadian banks will be required to hold Common Equity Tier 1 capital of at least 11.5% of risk-weighted assets. All six are currently above that level; Canadian Imperial Bank of Commerce is closest to the minimum. 

The S&P/TSX Commercial Banks Index dropped 0.6% as of 10:05 a.m. in Toronto, the biggest intraday decline since June 7. 

“Current vulnerabilities, including high household and corporate debt levels, the rising cost of debt, and increased global uncertainty around fiscal and monetary policy, coupled with Canada’s financial sector showing strength throughout the winter and spring has presented the opportunity for OSFI to build more resiliency in the system,” the bank watchdog said in a statement. The new capital requirement comes into effect Nov. 1. 

Canada’s banks are “profitable, sound, generating ample capital,” making this a good time to raise the buffer, Peter Routledge, the superintendent of financial institutions, told reporters. Loan delinquencies and unemployment remain low, he added. 

Rate Anxiety

The shift underscores anxiety in Canada about how households will handle the increase in borrowing costs in the years ahead — and the likelihood that banks’ loan losses will go up from current low levels. 

Last month, in its annual review of the financial system, the Bank of Canada said a rising number of homeowners have mortgages that consume at least a quarter of their income, and some are relying on credit cards to meet expenses in the face of steeper payments.

The regulator sets the stability buffer based on its view of financial risks, including levels of debt and economic forecasts.

“OSFI is trying to build even more resiliency into the Canadian banking system as it faces a host of key vulnerabilities, including high household and corporate debt levels, the rising cost of debt, and increased global uncertainty around fiscal and monetary policy,” Desjardins economist Royce Mendes said in a note to investors. 

Elevated office vacancies are also raising concerns that banks may be forced to take losses on commercial real estate loans. Commercial property represents about 10% of the loan portfolios of Canada’s six largest banks, surpassed only by residential mortgages, according to a recent analysis by National Bank of Canada analyst Gabriel Dechaine. 

While real estate risks at Canadian banks are growing, particularly in the office category, existing reserves are large enough to absorb losses, Bloomberg Intelligence analysts Paul Gulberg and Ethan Kaye said in a June 14 note. 

The updated capital requirements apply to the two Canadian lenders on the list of global systemically important banks, Royal Bank of Canada and Toronto-Dominion Bank. It also applies to the four other institutions on OSFI’s list of domestic systemically important banks: CIBC, Bank of Nova Scotia, Bank of Montreal and National Bank of Canada. 

Shares of CIBC declined the most among Canadian banks Tuesday morning, down 1.4%, after a report by the Globe and Mail newspaper that it’s facing regulatory scrutiny over mistakes in its mortgage department. The errors, which involve thousands of clients, are not expected to have a material financial impact on the bank, the newspaper said. 

What Bloomberg Intelligence Says

The Canadian bank regulator’s decision to increase the lenders’ capital requirement is prudent and credit positive, we believe, given still-elevated systemic vulnerabilities. The increased hurdle will cut the banks’ Common Equity Tier 1 capital surplus by C$12 billion, and the lenders may increase their CET1 ratio target to 12.5%.

— Bloomberg Intelligence credit analysts Himanshu Bakshi and Nicholas Beckwith  

--With assistance from Geoffrey Morgan and Erik Hertzberg.

(Updates with index move in fourth paragraph, quotes from Desjardins and Bloomberg Intelligence analysts, and additional information on CIBC in final paragraph)

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