Competition in the Canadian Mortgage Market

• The Canadian mortgage market has changed
substantially in the past 20 years: trust companies
have been taken over by banks; small virtual banks
have offered new mortgage products; and brokers
now play an important role in matching borrowers
and lenders.
• The changing structure and practices of the
Canadian mortgage market have implications for
competition authorities and for financial system
regulation.
• Recent research suggests that the rate paid for a
mortgage depends on the borrower’s observable
characteristics, as well as their local market.
Unobserved bargaining ability also appears to play
an important role.
• Mortgage-rate discounting affects the speed and
degree of pass-through from changes in the
central bank’s key policy rate to mortgage rates.
Research also suggests that bank mergers do not
necessarily lead to mortgage-rate increases.
Competition in the Canadian Mortgage
Market
Jason Allen, Financial Stability Department*
At the end of 2010, the Canadian mortgage
market had grown to more than $1 trillion,
representing almost 40 per cent of total outstanding
private sector credit. The market is dominated
by Canada’s six major banks, although this has
not always been the case. Their most recent increase
in market share coincides with changes to the Bank
Act in 1992, which allowed chartered banks to enter
the trust business. They did this largely through acquisition.
1 Recent research at the Bank of Canada has
analyzed the Canadian mortgage market in this context.
The purpose of the research is to understand
how the interaction of market structure, product differentiation,
and information frictions determines rates
in the Canadian mortgage market. This article summarizes
the main findings.
Understanding how rates are determined in the
Canadian mortgage market is important for the central
bank, competition authorities, and financial regulation.
For example, the gap between posted rates
and transaction rates should be taken into account
when addressing some questions about the monetary
policy transmission mechanism. Do financial institutions
fully pass through changes in monetary policy
rates to mortgage rates, and do they move equally
fast from above and below equilibrium? Using posted
rates, Allen and McVanel (2009) find that the answer to
the first question is no and to the second, yes. But
using transaction rates, they find that the answer to
the first question is yes and to the second, no.
The changing market structure of the mortgage
industry has implications for competition, but the
analysis is complicated because banks are vertically
and horizontally differentiated. For example, the location
of branches determines the cost of shopping for
mortgages (horizontal differentiation), while the quality
of complementary services affects the value of
1 See Freedman (1998) for a discussion of the evolution of deregulation in Canada.
* I have benefited from discussions with and comments from Ian Christensen, Robert Clark,
Toni Gravelle, Darcey McVanel, Larry Schembri, and Mark Zelmer.
1 Competition in the Canad ian Mort gage Mar ket
ba nk of ca nada review winter 2010–2011
lenders, small foreign banks, including virtual banks,
entered the Canadian market in the 1990s, offering
new products to Canadians.
The Canadian mortgage market is
relatively simple and conservative,
particularly when compared with
its U.S. counterpart.
Mortgage products
The Canadian mortgage market is relatively simple
and conservative, particularly when compared with its
U.S. counterpart (Kiff 2009). Many Canadians sign
five-year, fixed-rate mortgages that are rolled over
with new five-year, fixed-rate contracts for the life of
the mortgage—typically 25 years (the amortization
period).3 The rate is renegotiated every five years. The
popularity of variable-rate mortgages has waxed and
waned over time. In this case, the monthly payment is
typically fixed, but the portion that is interest and not
principal changes with fluctuations in interest rates.
Longer-term mortgages, which are the norm in the
United States, were phased out of Canada in the late
1960s after lenders experienced difficulties with volatile
interest rates and maturity mismatch.
3 The percentage of mortgages with longer amortization periods has increased in recent
years. In the sample period covered by the analysis (1992 to 2004), however, almost
every mortgage was amortized over 25 years.
signing with a particular bank (vertical differentiation).
If consumers differ in their preferences for these services,
then changes in market structure can have
welfare effects that are more complex than those
typically assumed in merger analysis.
Financial regulators should also take a keen interest in
understanding how lenders price mortgages, especially
if mortgage-related instruments are to be
included under the umbrella of “system-wide prudential
regulation.” For example, the effectiveness of
changing the rules governing mortgage lending
depends on how lenders and borrowers negotiate
rates. The research summarized here shows that
borrowers do not simply take the posted rate as given.
This article first provides a brief examination of the
Canadian mortgage market, focusing on the evolution
of the market following legislative changes to the Bank
Act in 1992. This is followed by an overview of the
data, which is noteworthy in its own right because it is
very detailed. Key research by the Bank of Canada on
the Canadian mortgage market is then reviewed.
The Canadian Mortgage Market
Canada’s mortgage market is dominated by the “Big
Six” Canadian banks: Bank of Montreal, Bank of Nova
Scotia, Banque Nationale, Canadian Imperial Bank of
Commerce, Royal Bank Financial Group, and TD
Bank Financial Group. Together with a large regional
co-operative network—the Desjardins Movement—
and a provincially owned deposit-taking institution—
Alberta’s ATB Financial—this group controls 90 per
cent of the assets in the banking industry. Collectively,
these institutions are called the “Big Eight.” Chart 1
presents their market share of outstanding mortgages,
which grew from 60 per cent to 80 per cent
between 1992 and 2004 (the period for which we have
detailed data and conduct the majority of our analysis)
as banks entered the trust business. They all offer the
same types of mortgage products, as well as other
products, such as credit cards, personal loans, and
wealth-management advice. In fact, most Canadians
treat their primary financial institution as a “one-stop
shop” (universal bank) where they purchase the
majority of their financial services. This article argues
that this is one reason why Canadian banks compete
so fiercely in the mortgage market: a lender has many
opportunities for cross-product selling once a client is
locked in with a mortgage.2 In addition to the large
2 Consumers are said to be “locked in” if they do not switch to a seller offering a lower price.
This is because there are costs to switching sellers, in terms of financial costs and effort.
Chart 1: Market share of Canada’s major mortgage
lenders
Sources: CMHC and Genworth Financial
5
10
15
20
25
30
50
60
70
80
90
1992 1994 1996 1998 2000 2002 2004
% %
Big eight
(left scale)
other banks (right scale)
other credit unions and trusts
(right scale)
2 Competition in the Canad ian Mort gage Mar ket
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Genworth has an important share of the market. In
total, over 50 per cent of the mortgages on the balance
sheets of financial institutions are insured—a
proportion that has been relatively stable over time.
The insurers charge the lender a premium for insurance
that protects the lender in case of borrower
default. Typically, a lender will pass this cost on to the
borrower. To assess a loan for mortgage insurance,
CMHC and Genworth Financial collect detailed information
on the borrower and the property—information
related to the mortgage contract and to the borrower’s
ability and history in managing their debts, including
information on incomes and credit scores. Information
related to the contract includes the interest rate negotiated
between the lender and the borrower. The difference
between the contract rate and the posted rate
is the discount. There is also information on house
prices and loan amounts and, therefore, loan-to-value
(LTV) ratios. Collectively, these data help the Bank to
understand how mortgages rates are determined in
Canada.
Discounting
Allen, Clark, and Houde (2011) are the first to use data
at the individual level to document the use of mortgage
discounting in Canada. Discounting is a situation
where sellers, in this case lenders, post one rate but
are willing to negotiate a different rate. The practice
began in earnest in the early 1990s and is considered
the norm in today’s mortgage market. In its annual
report on the state of the residential mortgage market,
the Canadian Association of Accredited Mortgage
Professionals (CAAMP) indicated that in 2009 the
average consumer received a discount of 123 basis
points on a five-year, fixed-rate mortgage. A natural
question to ask might be why lenders post high rates
if they are going to offer discounts to the majority of
consumers. Allen, Clark, and Houde (2011) argue that
over time lenders have improved their ability to price
discriminate, that is, to offer discount rates to different
sets of consumers based on their willingness to pay.
Lenders can thus increase their profits through price
discrimination instead of offering a blanket reduction
in rates.
The increased use and magnitude of
discounting hides the fact that some
types of borrowers experience gains
while others are worse off.
Mortgage brokers
Although the 1990s saw the large Canadian banks
acquire nearly all of the country’s trust companies,
there were a number of important developments in
the mortgage industry that encouraged competition.
For example, mortgage brokers became important
participants in the lending process. Brokers typically
earn between 1 and 1.3 per cent of the value of mortgages
that they bring to a lender, which could be
anything from a small deposit-taking institution to a
large bank. Chart 2 presents the share of transactions
that were broker assisted over an eight-year
sample period. The share increases from less than
10 per cent to over 30 per cent between 1997 and
2004.4 This suggests that a large number of consumers
sought the help of a broker when shopping for
a mortgage. In addition to mortgage brokers, foreign
competitors entered the Canadian banking market,
although their market share remains small.
The Data: Mortgage Insurers
The data used in this research are provided by the
Canada Mortgage and Housing Corporation (CMHC)
and Genworth Financial, Canada’s two mortgage
insurers over the course of the sample period, which
runs from 1992 to 2004 (consent for the Bank of
Canada to access the data was provided by individual
financial institutions). During this time, borrowers who
contributed less than 25 per cent to the purchase
price of a house were required to purchase mortgage
insurance (today that number is 20 per cent). The
majority of borrowers are insured by the CMHC, but
4 Survey evidence from CAAMP post-2004 shows the market share of mortgage brokers
reaching as high as 40 per cent in 2008, before falling to 35 per cent in 2009.
Chart 2: Broker-assisted transactions
Sources: CMHC and Genworth Financial
10
20
30
40
1997 1999 2001 2003 2005
0
%
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branches imply more market power. It could also
imply that consumers prefer banks with an extensive
branch network and are therefore willing to pay more
to do business with such a bank.
The results also indicate that, ceteris paribus, higherincome
households pay higher rates, on average, than
lower-income households. High-income households
are likely less inclined to spend the time shopping for
and negotiating a mortgage. Since information on the
age of the borrowers was not available, proxies are
used: previous homeowners are classified as the oldest
category, current renters as the middle category, and
mortgage applicants living with their parents as the
youngest category. The results show that the youngest
borrowers receive the largest rate discount. This is
consistent with the larger literature on price discrimination
(e.g., Goldberg 1996) since banks, like most firms,
try hard to attract new, younger customers because
they can potentially lock them in for a long period.
Chart 3 illustrates the evolution of discounting from
1992 to 2004 for the five-year, fixed-rate mortgage.
Over this period (and, according to survey data, beyond
this period), discounting increased. However, the
markup in the posted rate also rose, so that the
average margin between the transaction rate and the
five-year bond rate (which proxies the cost of funding)
is relatively constant over time. Chart 4 shows the
dispersion in the discounts over periods 1992–95 and
2000–02. In both periods, different borrowers paid
different rates, but more so in the latter period.
Therefore, although the average consumer is as well
off under a zero-discount environment as they are in a
high-discount environment, the increased use and
magnitude of discounting hides the fact that some
types of borrowers experience gains while others are
worse off.
Allen, Clark, and Houde (2011) examine factors that
might explain differences in mortgage rates. The key
variables considered are loan, borrower, and market
characteristics. They also control for time trends and
unobservable characteristics of the banks and neighbourhoods
that do not change over time. Allen, Clark,
and Houde find that over the period 1999 to 2004
consumers living in less-competitive markets (high
Branch HHI) pay higher rates than consumers living in
competitive markets.5 In addition, banks with large
branch networks charge higher rates than banks with
smaller branch networks. This could be because more
5 HHI stands for Herfindahl-Hirschman Index. It is the sum of the square of the share of
each bank’s branches in a market. The result ranges from 0 to 1, where a low number
indicates that the market is highly competitive, and a high number indicates that the
market is not competitive.
Chart 3: Evolution of mortgage rates in Canada
Sources: CMHC and Genworth Financial
20
40
60
80
100
120
50
100
150
200
250
1992 1994 1996 1998 2000 2002 2004
Basis points Basis points
Average posted rate minus
bond rate (left scale)
Average mortgage rate
minus bond rate (left scale)
Average discount (right scale)
Sources: CMHC and Genworth Financial
0
5
10
15
20
25
%
-200 -100 0 100 200 300 400 500
0
5
10
15
%
-200 -100 0 100 200 300 400 500
Chart 4: Dispersion of discounts on fi ve-year,
fi xed-rate mortgage
Basis points
b. 2000–02
a. 1992–95
probability (discount ≤ 0)=35%
probability (discount ≤ 0)=13%
4 Competitio n in th e Canadia n Mo rtgag e Ma rket
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an integral part of lenders’ pricing strategies in
Canada. Since discounting has increased over time, a
downward bias potentially exists in previous measures
of pass-through. Taking into account the upward
trend in discounting and using data from 1991 to
2007, Allen and McVanel show that pass-through is
indeed complete in the long run.
If discounts are not factored in,
Canadian lenders appear to be
extremely slow to pass on changes in
the Bank Rate to their customers.
Once discounting is controlled for, however, the
authors uncover another interesting facet of mortgage
rates. They find that in the short, run five of the six
largest Canadian banks adjust their rates upward
more quickly when there are upward cost pressures
than downward when costs fall.6 There are a few
reasons why there might be an asymmetric price
response to changes in input costs. First, if banks
have some market power, there is scope for banks to
coordinate implicitly or explicitly. If costs rise, then
banks will all want to increase their prices. If costs fall,
however, there is an incentive to wait before passing
on the lower costs in the form of lower rates because
all the banks can earn higher profits. Second, if
search is costly, banks can maintain high rates even
after their costs have fallen because it takes time for
mortgage shoppers to realize that rates should have
fallen. The difference between posted rates and transaction
rates in this market is further evidence that
search costs are important.
Mergers
Most researchers that examine the effect of competition
on prices take the same approach as Allen, Clark,
and Houde (2011). That is, they regress prices on a
measure of concentration. This approach does not
directly address the effects of competition on mortgage
rates, however, but measures correlation. The positive
correlation between mortgage rates and branch concentration
strongly suggests that rates are higher in
6 This is in line with previous research on the U.S. mortgage market (Arbatskaya and
Baye 2004) or the market for deposits (Hannan and Berger 1991). More generally,
Peltzman (2000) finds asymmetric price adjustments in most consumer and producer
prices that he examines. Anecdotally, the Bank of Montreal’s chief economist was
quoted in The Globe and Mail (18 November 2009) as saying, “It’s a safe thing to say
that [mortgage] interest rates tend to move higher a lot faster than they move lower.”
With respect to LTV ratios, which are discussed in the
Box on page 6, the authors find that borrowers who
make the minimum down payment pay a rate premium
over those able to put more equity into the
house. Borrowers with larger equity in their houses
have better bargaining positions than borrowers with
minimum equity. Lenders compete for these borrowers
more fiercely not only because they are less
risky, but also because they are more profitable.
Borrowers with more equity in the house are more
likely to be in a position to take advantage of the lender’s
complementary services (such as wealth management
or personal loans) than the most financially
constrained borrowers and are thus more attractive to
lenders. Lenders must therefore compete for this type
of borrower by offering them larger discounts, while
the most constrained borrowers pay a premium.
The authors also find that borrowers with better credit
scores receive larger discounts. Banks also offer
larger discounts to new clients than to existing clients.
Consumers willing to switch financial institutions when
shopping for their mortgage will see, on average, an
additional discount of 7 basis points from the posted
rate. The results also indicate that borrowers who use a
mortgage broker pay less, on average, than borrowers
who negotiate with lenders directly. This average discount
is about an additional 19 basis points.
Finally, the authors find that a substantial amount of
discounting cannot be explained by observable characteristics.
The results are consistent, however, with
a model of consumer heterogeneity in search and
bargaining efforts/abilities, where the latter is unobserved.
Borrowers who both search for and bargain
more intensively with lenders can achieve larger
discounts than other borrowers.
Discounting and monetary policy
Mortgage-rate discounting has implications for the
transmission of monetary policy (Allen and McVanel
2009). Central banks rely on assumptions about the
rate of pass-through of changes in the Bank rate to
lending rates because it affects how much they
should raise or lower rates when macroeconomic
conditions change. These assumptions are usually
based on estimates using historical data—typically
the average posted mortgage rates. Allen and
McVanel show that ignoring Canadian mortgagediscounting
practices leads to a significant underestimation
of pass-through. That is, if discounts are not
factored in, Canadian lenders appear to be extremely
slow to pass on changes in the Bank Rate to their
customers. As noted earlier, however, discounting is
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An LTV ratio is defi ned as the loan amount divided
by the appraised value of the house at the time of
the loan. Currently, mortgages with an LTV ratio
below 80 are conventional mortgages that do not
require mortgage insurance. Those with LTV
ratios above 80 require insurance, which is provided
by CMhC or genworth Financial. The maximum
allowable LTV ratio in Canada is 95 per
cent. A borrower can therefore contribute 5 per
cent of their own equity to borrow 95 per cent of
the purchase price from a lender for the purpose
of buying a house. Since the 2007 U.S. subprimemortgage
crisis, LTV ratios have become an
important source of discussion as a potential tool
for system-wide risk management (e.g., CgFS
2010). Requiring borrowers to increase the
amount of equity that they contribute when purchasing
a house (e.g., lowering the maximum LTV
ratio from 95 to 90), would likely have a dampening
effect on house prices in the short-run. This
is because in the short run fewer people would
enter the housing market, and those who did
would buy less-expensive houses.1
Chart A shows the LTV ratios of insured borrowers
over two periods, 1992 to 1998 and 1998
to 2003, that correspond to two different insurance-
premium regimes. in both cases, the
majority of households are clustered at LTV ratios
of 90 and 95, suggesting that most insured borrowers
are highly leveraged. Changes to the maximum
LTV ratio are thus likely to affect a large
share of new insured mortgages. in 1998, the
cost to the borrower of insuring a 95 LTV mortgage
relative to a 90 LTV mortgage increased by
50 per cent. This led some borrowers to increase
the equity portion of their mortgage, since the
fraction of borrowers in the 95 LTV bin fell, and
the fraction of borrowers in the 90 LTV bin
increased. This suggests that, in addition to
altering the LTV ratio, changes to mortgageinsurance
premiums have the potential to infl uence
household decisions to take on increased
leverage.
1 Note that a quality-based house price index might actually increase if consumers
drive up the value of low-quality houses, even though the value of more
expensive houses is falling because of the policy.
Loan-to-Value Ratios
Chart A: Loan to value ratio at time of issuance
Sources: CMHC and Genworth Financial
%
0
10
20
30
40
70 75 80 85 90 95
Loan to value ratio
0
10
20
30
40
%
70 75 80 85 90 95
Loan to value ratio
b. June 1998 to 2003
a. 1992 to May 1998
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addition to estimating equation (1), column (2) presents
estimates from the following regression, which
allows for the effect of the merger to vary across
different markets:
(2)
where is the Herfindahl-Hirschman measure of
branch concentration.
Here we see that rates in the most competitive neighbourhoods
fell after the merger, while they increased
significantly in the most concentrated markets.
Rates in the most competitive
neighbourhoods fell after the merger,
while they increased significantly in the
most concentrated markets.
The aggregate results can be explained once the
merger effect is broken down into its two components:
the direct effect, which is the rate impact on the
set of consumers who banked with the merging institutions
pre- and post-merger, and the indirect effect,
which is the rate impact on the set of consumers who
banked with the merging institution’s competitors
pre- and post- merger. The estimating equation is
given by:
(3)
less-competitive markets, but there might be some
unobservable reason for the correlation. Another
approach is to look at mergers to directly measure the
effects of changes in local market competition on
rates. In this section, we follow this strategy by examining
the impact of a merger between a bank and a
trust company.
In the 1990s, Canadian banks acquired virtually all of
the existing trust companies, together with hundreds
of their branches across the country.7 Consequently,
these mergers and acquisitions created a discrete
change in the structure of local banking markets. In
particular, when two neighbouring branches merge
because of a national acquisition, competition in the
local market is immediately reduced, since banks
begin internalizing the impact of their actions on each
other’s profits. That is, branches that once competed
stop doing so once the merger is announced.8
Since most Canadian mortgage shoppers negotiate
their contracts directly with local bankers, the potential
impact of a merger is determined by the number of
available local bank branches. Therefore, the most
direct approach is to study the impact on rates of
removing lender options from the choice set of consumers.
9 The effect of this change in competition on
rates is captured by comparing the rates paid by the
consumers affected by the merger (“treated”) with
those paid by a base group as follows:
(1)
where is the discount; is equal to 1 if household
has the merging institutions in its neighbourhood
and 0 otherwise; indexes the merger and is therefore
equal to 1 post-merger and equal to 0 premerger;
and is the coefficient of interest, which
captures the aggregate effect of the merger on prices.
Table 1 summarizes the key results. From column (1)
it is clear that overall the merger did not have a significant
impact on rates. The coefficient is small, about
1.6 basis points, and not statistically significant. In
7 Examples include TD-Central Guaranty Trust (1992), Royal Bank-Royal Trust (1993),
BMO-Household Trust (1995), CIBC-FirstLine Trust (1995), Scotiabank-National Trust
(1997), and TD-Canada Trust (2000).
8 For an econometrician trying to identify the effects of competition on prices, these
changes in competition can be viewed as exogenous to the local market conditions.
9 The impact on rates of removing one bank option can be identified because not all
consumers face the same bank options. Some consumers live in markets offering many
bank choices, including the two merging banks, while others live in markets containing
neither of the merging banks or only one of them. The last two groups of consumers
are not affected by the merger and therefore constitute the base group. The first set
of consumers (“treated”) is affected by the merger, since their shopping options are
reduced post-merger.
Table 1: Effects of mergers on mortgage rates
Variables Equation (1) Equation (2) Equation (3)
Aggregate effect 0.0161
(0.0107)
0.0527†
(0.0180)
Aggregate effect X HHI 0.184†
(0.0695)
Bank-specifi c effects
Merging FIs 0.0850†
(0.0166)
Competing FIs - 0.0342†
(0.0108)
† Signifi cant at 1 per cent
Note: Standard errors are in parenthesis.
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Conclusion
This article summarizes key research on the Canadian
mortgage market currently being undertaken at the
Bank of Canada in conjunction with external academics.
Overall, the findings are consistent with a
model where consumers have different preferences
and skills when shopping and bargaining for a mortgage
and where lenders maximize profits based on
observing these preferences and skills. The results
indicate that high-income borrowers pay more for
their mortgages, as do loyal consumers, consumers
who search less, and those that value large branch
networks. Unobserved bargaining ability also appears
to play an important role in determining mortgage
rates.
Results also suggest that mortgage-rate discounting
affects the speed and amount of pass-through of
changes in the central bank’s policy rate to mortgage
rates. In particular, once discounting is taken into
account, the major mortgage lenders in Canada are
slower to cut rates than to increase them. This asymmetry
has implications for monetary policy because it
means that the actions of the central bank might need
to be adjusted, depending on whether it is cutting or
increasing interest rates. The reasons for the asymmetric
responses of mortgage lenders should also be
investigated.
Finally, this research suggests that bank mergers can
lead to asymmetric effects on mortgage rates. The
merging parties, because of market power, can
increase rates, while the competition actually
decreases rates in order to attract consumers. This
result is non-standard in the industrial-organization
literature where both sets of lenders would typically
increase prices because of market power. Given the
preference of consumers for factors other than low
rates (e.g., branch-network size), however, the competitors
actually decrease rates, because post-merger
they are relatively smaller than the merging entities in
terms of their branch network.
Together, these findings are important to the central
bank and to competition authorities because of their
impact on our understanding of the factors affecting
competition and the monetary policy transmission
mechanism.
where is an indicator variable for whether or not the
lender is one of the merging institutions or one of its
competitors. The coefficients of interest are , since
these capture the merger effects.
The results suggest an interesting asymmetry.
Consumers dealing with the merging bank saw a
significant increase in rates post-merger—about
8.5 basis points—while consumers dealing with the
competition saw rate decreases, by approximately
3.4 basis points.
The results suggest at least two channels of influence
from the merger. The asymmetric price responses
could be explained by a quality increase. If the
merged bank provides higher-quality service (e.g., a
larger network of branches and ATM machines), then,
ceteris paribus, it can charge higher rates and still
attract customers, while its competitors must offer
larger discounts. An alternative interpretation of the
price results (perhaps complementarily) is that banks
in neighbourhoods that experienced a merger might
be attracting a different mix of consumers. For
instance, by exerting a larger degree of price control,
the new entity might be less likely to attract consumers
willing to shop intensively for their mortgages.
This would explain the result that rates are higher at
the merging bank and lower at the competing banks.
The asymmetric price effect of the merger suggests
that the relationship between bankers and consumers
is complicated. The merging banks are able to raise
rates post-merger, extracting more from borrowers
than pre-merger. Given that the mortgage is the largest
purchase for most households, the costs of the
merger are not negligible. These borrowers value
more than the price of the mortgage, however,
because they have the option of paying a lower rate at
a competing lender in the same neighbourhood.
Competition agencies may want to consider this
possibility in analyzing any future mergers.
8 Competition in the Canad ian Mort gage Mar ket
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