Financial market conditions have improved noticeably in recent months, but the Canadian financial sector continues to face several substantial risks, Bank of Canada Governor Mark Carney said in a speech on Thursday.

Carney said it’s premature to assume that a slowing rate of economic decline and other recent “green shoots” in the global economy indicate that sustainable growth is now underway.

“Much hard work remains, and external forces can profoundly influence the outcome,” he said, speaking to the Regina and District Chamber of Commerce in Saskatchewan.

Carney said that the Canadian financial system remains one of the soundest in the world, and noted that conditions have improved in the past few months.

“Markets seem to be turning their backs on worst-case scenarios. The panic that engulfed global financial markets last fall is over,” he said.

But he warned that the overall level of risk to the Canadian financial system is broadly unchanged since last December, and said the system will continue to be tested.

The three main risks to Canada’s financial stability include the liquidity and funding positions of banks, the adequacy of their capital, and the financial health of Canadian households, according to Carney.

He noted that liquidity and funding conditions have improved with the help of government policy initiatives, resulting in a decline in the spreads on bank financing in money markets, a moderate extension of maturities, and a substantial reduction in the cost of term funding for Canadian banks.

Still, Carney said the central bank has drawn important lessons from this experience. “The performance of core funding markets during the crisis intensified the financial panic and helped trigger the recession,” he said. “This is totally unacceptable.”

As a result, Carney said a new priority for the bank is to promote institutional changes to create more robust core funding markets. “As the ultimate provider of liquidity to the system, the Bank is thinking through whether to adapt its facilities to support continuous private liquidity creation,” he said.

On bank capitalization, Carney said Canadian banks have benefited from high initial capitalization and high quality capital. But he added that continued market pressures on the banks to maintain inordinately high capital ratios could force the banks to curb balance sheet growth and tighten market conditions.

Carney said he is optimistic that recent improvements in market sentiment will help relieve pressure on the banks to maintain such high capital ratios.

The Bank of Canada is working to develop a capital regulatory regime that is more simple, coherent, and dynamic, with buffers and provisions moving through the cycle.

In terms of the financial health of Canadian households, Carney said the recession is taking its toll and stresses are rising. This directly affects the resilience of the financial system, he said.

“Income growth has slowed, and personal wealth levels have been eroded by lower house prices in some regions; credit growth has continued to outpace income growth, contributing to higher debt levels,” he said.

Moving forward, Carney said the Bank of Canada would work with domestic and international partners to build a stronger financial system capable of absorbing blows.

“Canada has a strong system, but this crisis has proven that even the best is not good enough,” he said.

IE