The most likely outcome for global financial markets and credit conditions in Canada is gradual improvement as the various extraordinary measures aimed at resolving the crisis take hold. But uncertainties remain around the timing of the return to more normal financing conditions, the Bank of Canada says.

In the latest issue of the Financial System Review, the central bank stresses that it has implemented a range of extraordinary facilities focused on restoring confidence and re-establishing the normal functioning of the financial system. Canada also remains committed to the G-7 Plan of Action, which entails a number of initiatives to restore the flow of credit, it says. “With the policy actions that have been taken to provide liquidity and funding support, financial institutions are increasingly expected to have the capacity to re-enter markets,” it says.

However, the bank identifies five potential risks to this outlook: funding and liquidity; capital adequacy; household balance sheets; the global downturn; and global imbalances and currency volatility. The bank cautions that the continued reluctance of lenders to enter the market, owing to uncertainty over their future funding needs and existing risk exposure, “risks delaying the return of confidence and more normal financing conditions, which could aggravate the adverse feedback loop between the financial system and the real economy.”

Higher capital needs, exacerbated by a deep, or prolonged, downturn in the economy could entail new challenges for Canadian banks, it says, as they may have to curb balance sheet growth more aggressively. “This could result in a significant tightening of lending conditions for both households and businesses that would exacerbate weakness in the economy and increase difficulties for financial institutions,” it says.

Household indebtedness could also act as a channel of contagion spreading losses through the Canadian financial system and causing a further tightening of credit conditions, it notes. Although the bank adds that the impact on the balance sheets of financial institutions would be substantially mitigated by mortgage insurance and the associated government guarantee.

A deeper, or more persistent, recession than currently expected in the U.S. would also have a substantial impact on Canadian businesses, households, and financial institutions. “While the level of capital at the major Canadian banks is sufficient to absorb the large losses associated with such an outcome, actions taken by the banks to continue to meet regulatory requirements could exacerbate pressures on the Canadian economy,” it says.

Finally, the bank points out that international financial and trade imbalances cannot persist indefinitely. “The appreciation of the U.S. dollar since July 2008 could impede the gradual adjustment process of the past few years, increasing the risk of a disorderly resolution of these imbalances at some point in the future,” the bank says. “An abrupt and sizable decline in the value of the U.S. dollar would give rise to sharp movements in asset prices, additional volatility in financial markets, and a renewed rise in risk premiums.”

IE