Bank of Canada sees the risks to the financial system as elevated, but stable

The Bank of Canada released its Financial Systems Review (FSR) this morning, in which it highlights risks tied to the Canadian economy and financial system. The Bank judges that Canadian economic conditions have firmed in the second half of the year and risks to the financial sector have remained unchanged since the June FSR. While financial vulnerabilities edge higher, increased financial regulation has made the financial system more resilient.

Some key developments since the last FSR in June include: increased financial volatility due to an economic slowdown in China and other emerging markets; a rate hike by the U.S. Federal Reserve has become more likely (pushing up Canadian longer-term yields), while Europe has embarked on more quantitative easing (divergent monetary policy); and corporate bond spreads have widened, particularly for those tied to commodities. However, financing conditions remain accommodative for households and businesses.

The Bank of Canada has highlighted three key vulnerabilities in the Canadian economy. The first two are the usual suspects: elevated household debt and rising housing market imbalances due to rapidly growing home prices. The third was "uncertain liquidity" in Canada's fixed income market. The Bank is highlighting that it is uncertain how demand and supply of Canadian bonds will be affected by economic and financial conditions going forward, given changes to financial regulation among other things.

The Bank also offered some additional information on vulnerabilities in the household sector. The Bank noted that most of the mortgage growth over 2015 has been concentrated in uninsured mortgages (with more than 20% down). However, there are still growing vulnerabilities. Household debt is growing faster than income, particularly for younger Canadians who may be less prepared to deal with a negative income shock. At the same time, the likelihood of a household missing a debt payment increases when a household debt-to-income ratio rises above 250% after a negative economic shock. Risks rise further when the debt-to-income ratio exceeds 350%. The share of households with a debt-to-income ratio of more than 350% has risen to 8% from 4% pre-2008 crisis. In addition, the mortgage market has become more complex with lenders relying more on less regulated mortgage lenders. These lenders still insure their mortgages, but have less qualification guidelines than the federally regulated chartered banks. Underwriting standards are also a concern for these lenders.

On the flipside, the Bank of Canada removed its reference to an overvaluation in home prices. Sharply rising home prices are concentrated in Toronto and Vancouver and are likely being driven by supply constraints in the wake of rising employment and migration. Along that line, the Bank believes that there is little risk of overbuilding in Canada and therefore the probability of an across-the-board home price correction is low. The Bank also noted that while the impact of recent mortgage insurance qualifying guidelines are uncertain, they will help ease some of the growing vulnerabilities tied to housing.

Household vulnerabilities are regional. Much of the highly indebted households are in B.C., Ontario and Alberta. Meanwhile, sharply rising home prices are mostly concentrated in Toronto and Vancouver. Given these vulnerabilities, the Bank of Canada listed four key risks to the Canadian outlook. First is a negative economic shock that would trigger a sharp downturn in household debt and the housing market. This risk is rated as elevated, but remains a low probability event. Second is the spillover effects from weak global economic growth and financial stability (divergent monetary policy in the U.S. and Europe), which could raise risk premiums in Canada. This is a moderate but low probability event. Third, is a deeper slowdown in China and other emerging markets, risks of which are elevated, have a medium probability and could severely impact the Canadian economy.