As Canadians continue to pile on more debt, and particularly consumer credit, policymakers should consider incremental reforms to improve consumers’ ability to make informed borrowing decisions, a new paper from the C.D. Howe Institute suggests.
In The Rise in Consumer Credit and Bankruptcy: Cause for Concern?, released on Wednesday, author James MacGee notes that debt levels associated with consumer credit are higher than at any point in recent history, and are now higher than those of American households.
While recent debates have largely focused on the housing market and on the risks associated with household mortgage debt, MacGee’s research looks more specifically at consumer credit – auto loans, credit card debt, and lines of credit – and personal bankruptcies.
The market for consumer credit products has expanded rapidly in recent years, with home equity lines of credit and products becoming increasingly prevalent. Consumer credit now accounts for roughly 45% of total household interest payments, according to the paper. And since these loans often feature variable interest rates, it argues that they leave borrowers more vulnerable to higher interest rates.
This raises concerns about the sustainability of household finances and poses risks to the broader economy, MacGee says.
“At present, there is no cause for panic,” he says, “but there are warning signs in the numbers that are reason for concern, and merit close watching.”
While the recent U.S. experience highlights the risks of overextended consumers, MacGee argues that consumer debt levels in Canada should remain manageable given the more prudent lending standards in this country. Nonetheless, he says these high levels of debt leave Canadian consumers vulnerable to large economic shocks – especially a sharp rise in interest rates or an economic downturn.
Financial literacy is a key part of the solution, MacGee says.
“While [increased borrowing] options give informed consumers the opportunity to better tailor borrowing choices to ‘smooth’ consumption over time, they also mean that poorly informed consumers can make bad choices,” the paper says. “Improved financial literacy is essential if more consumers are to take full advantage of credit products.”
He calls for lending contracts and other disclosure documents to be improved and simplified to allow consumers to more easily find the information they’re looking for, and compare products.
On the regulatory front, MacGee says there does not seem to be a strong case for restrictive regulation of consumer credit products, such as tight caps on interest rates or limits on borrowers’ debt-service ratios.
“These types of interventions are likely to have a significant effect on the availability of credit, especially for lower- and middle-income borrowers, making it more difficult for them to smooth out transitory income or household expense shocks,” the paper says.
However, MacGee says policymakers may want to tweak the rules related to household credit to ensure they’re consistent over the business cycle, rather than constantly attempting countercyclical regulation. In addition, he urges lenders and regulators to evaluate carefully whether current capital levels of financial institutions are sufficient to guard against risks associated with high household debt levels.