Canada’s financial system at risk, Bank of Canada warns

According to the review, the main risks are: further escalation of the European sovereign debt crisis; an economic downturn in advanced economies that could be amplified by remaining weaknesses in the balance sheets of global banks; a disorderly resolution of global current account imbalances; financial stress in the Canadian household sector; and, a prolonged period of low interest rates, which may encourage imprudent risk taking and/or erode the long-term soundness of some financial institutions.

The report notes that the key risks to financial stability are highly interconnected and mutually reinforcing. “In particular, a further intensification of the sovereign debt crisis in Europe can be expected to weaken global economic growth. The more fragile global outlook would, in turn, fuel sovereign fiscal strains, impair the credit quality of bank loan portfolios, and raise the probability of an adverse shock to the income or wealth of Canadian households,” it warns. “Diminished growth prospects also foster expectations of continued low interest rates, potentially further eroding the financial positions of insurance companies and defined benefit pension plans, and boosting household borrowing in Canada.”

Mitigating the risks to the stability of the international financial system requires a wide range of additional policy actions, the BoC says. “In the near term, the most pressing issue is to address funding, fiscal and governance challenges in the euro area,” it says, adding that measures to provide financial assistance to governments with liquidity problems and to solidify the banking sector are urgently needed. “The measures taken to date have repeatedly fallen short of what is needed,” it says.

In Canada, the elevated levels of household debt and housing prices require continued vigilance and close co-operation among Canadian authorities, the BoC says. Notwithstanding changes to the rules for government-backed insured mortgages designed to slow debt accumulation by households, credit continues to rise as a share of personal disposable income, and the overall financial situation of households remains strained, the Bank says.

In addition, it stresses that it is essential to maintain the momentum of regulatory reform. A key element is the implementation of enhanced international prudential standards for the banking sector by the Office of the Superintendent of Financial Institutions, but the BoC says that enhanced prudential standards are not sufficient to preserve financial stability.

It notes that the Financial Stability Board is also working to ensure that credible frameworks for resolution are in place so that all bank failures can be resolved in a timely and orderly way. Also, work is ongoing to reform over-the-counter derivatives markets.