While the mix of risks facing the financial system has evolved in the last six months, overall vulnerability has not, as improvements in financial system functioning are being undermined by global economic weakening, suggests a new report from the Bank of Canada.

In the latest issue of the semi-annual Financial System Review released Monday, the Bank of Canada observes that some confidence in financial markets has been restored by policymakers’ actions, and the functioning of credit markets has improved, but it warns, “the global financial system remains under significant stress.”

“The ongoing dislocations in financial markets are being exacerbated by the unusually synchronized and deep contraction in global economic activity triggered by the financial turmoil,” it says, adding that the economic outlook still faces “considerable uncertainty”.

The Bank of Canada says that the global financial system has started to emerge from its most severe crisis since the 1930s. “Canadian financial institutions remain well capitalized, and the improvement in financial conditions has encouraged them to maintain their central roles as intermediaries and to expand their market-making activities. Nonetheless, the deterioration in the economic outlook has raised the potential for damaging feedback to the financial system,” it notes. As a result, it calls for continued efforts by policymakers to address financial market, and economic, weaknesses.

In the December issue of the FSR, the Bank identified five key sources of risk to the stability of the Canadian financial system. In today’s paper, the Bank notes that risk has decreased in two of those areas (funding and liquidity, and capital adequacy), but that it has increased in two others (household balance sheets, and the global economy), and stayed the same in the final area (global imbalances and currency volatility).

“The potential for substantial credit losses on Canadian household loan portfolios, which could transmit stress to the broader financial system, remains a low-probability risk,” it explains. “Nonetheless, given the onset of the recession, the likelihood of this risk materializing is judged to have increased.”

It also notes that the risk of a deep and prolonged global recession, which it warned of in the December FSR, has now partially materialized. “The sudden, severe, and synchronized downturn in the world economy at the end of 2008 has been remarkable by historical standards, fueled by a crisis of confidence that spread the shock far beyond its epicentre in the U.S. banking sector,” it says.

The Bank of Canada also observes that the eventual recovery may also prove more sluggish than expected, amid the deleveraging of private sector balance sheets. “The weight of past excesses will take time to dissipate, and there is a risk that some governments may face difficulties in implementing appropriate policy actions to generate a sustainable recovery in a timely manner,” it says.

“There remains a risk that the downturn will prove to be even more severe, or persistent, than currently envisaged,” it warns. “Canada’s close trade and financial linkages with the United States and with the broader global economy make it particularly susceptible to a deterioration in external conditions.”

“If this risk materializes, a growing number of Canadian households and businesses would experience financial difficulties, which would translate into lower earnings and an increase in loan-loss provisions at financial institutions,” it says. “Writedowns of investments held by those institutions would also likely increase, and income from trading activities could suffer from a renewed intensification of market turmoil.”

Overall, it concludes, “Developments in these risks over the past six months largely reflect the competing influences of improved financial market conditions on the one hand, and a deterioration in the economic outlook on the other. With these factors taken into account, the overall level of risk to the Canadian financial system is judged to be broadly unchanged [since December].”

IE