The Bank of Canada today published its latest financial system review, warning that credit markets remain fragile.

The report notes that while there has been some improvement in credit conditions over the past several weeks, “strains in global credit markets have broadened” since December.

“Global credit markets remain very fragile, although there has been some general improvement in market conditions over the past month or so,” it says. “Investors remain wary of re-entering illiquid markets where further downside potential exists, even though market participants largely agree that credit assets have already undershot any conventional measure of fair value.”

It worries that forced selling by leveraged investors may again push asset prices lower. “Against this background, the situation remains highly uncertain,” it cautions. “Further shocks could expose a number of vulnerabilities in the financial system. Such a shock could emanate either from within the financial system itself, such as the collapse of a hedge fund resulting in the sudden forced liquidation of a large portfolio of assets, or from a much deeper and more protracted downturn in the U.S. economy.”

That said, the Bank’s report also suggests that enhanced disclosure of potential losses by several large global banks and efforts to strengthen their balance sheets are beginning to reduce counterparty concerns.

Nevertheless, the Bank suggests that the key risk appears to be the economic situation in the US. “If the U.S. economic recovery proved slow to gain traction amid low levels of business and consumer confidence, the “adverse feedback loop” between the real economy and financial markets could intensify,” it says. “This would likely result in tighter lending criteria, leading to a more widespread deterioration in the underlying credit quality of consumer and corporate loan portfolios. This, in turn, could trigger additional liquidity problems in financial markets.”

Again, losses in such a scenario would further erode bank capital, leading to renewed concerns over counterparty risks and higher funding costs in interbank markets. “Further rounds of forced deleveraging by financial institutions and by leveraged investors could deepen the liquidity and credit crunch. Equity markets could also experience sharp falls in response to the deteriorating economic outlook, and the U.S. dollar could experience sharp downward pressure,” the report warns.

This could also lead to knock-on effects such as lower commodity prices and the resumption of bank write downs, it warns. “While the probability of such outcomes materializing is relatively low, they nonetheless warrant careful consideration by financial institutions because of the potentially large negative repercussions,” it says. “On the whole, major Canadian financial institutions appear to have the margins for coping with such outcomes, and the Canadian financial system’s ability to weather these potential adverse developments remains sound.”

Indeed, Canadian credit markets have been less affected than those in the US, and the strong balance sheet positions of the Canadian financial, non-financial, and household sectors have helped them to weather the turbulence, it adds.