Debt is central bank’s biggest fear

Bank of Canada building in Ottawa

Bank of Canada says household debt and European crisis present the biggest risks to country’s financial stabil

Jeremy Torobin

Ottawa Globe and Mail Update Published on Monday, Jun. 21, 2010 10:45AM EDT Last updated on Monday, Jun. 21, 2010 12:53PM EDT

Risks to Canada’s financial stability have gone up over the past six months because of the possibility that the European debt crisis and “severe tensions” in global markets could threaten the worldwide recovery, the Bank of Canada said Monday.

In their semi-annual review of Canada’s financial system, policy makers said it continues to function well and has actually strengthened since their last assessment in late 2009. However, they reiterated concerns about the amount of household debt that Canadians have built up amid historically low borrowing costs, and outlined how Canada’s strong economy could fall victim to fiscal troubles across the Atlantic Ocean if they fuel stricter lending standards among banks and a drop in demand.

“Many aspects of the Canadian macrofinancial environment have improved since last December, with the economic recovery proceeding as expected and conditions in Canada’s financial system generally strengthening,” the central bank’s governing council said in its latest risk assessment. Still, policy makers said, “near-term risks” to Canada have increased because of “heightened concerns that worldwide fiscal strains have the potential to cause tensions in interbank funding markets, to derail the global economic recovery, or to trigger a disorderly resolution of global imbalances.”

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Policy makers said the level of risk has increased in three of five categories that they look at for their review, namely: funding and liquidity; the so-called imbalances in the global economy that exacerbated the financial crisis of 2008; and the current economic outlook.

Canadian banks’ capital levels, and the quality of what they possess, has improved since December, the central bank said, while the risks posed by household balance sheets remain “roughly unchanged” even as households’ financial vulnerability to economic shocks is growing. The rising debt-to-income ratio among Canadians, which policy makers such as Bank of Canada Governor Mark Carney have been warning about for several months, also could pose a risk to banks and the economy as a whole, should borrowers default on their loans and force banks to hold back on extending credit.

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“In the event of a significant economic downturn, the credit quality of household loan portfolios could be undermined, prompting banks to tighten credit conditions and some households to reduce spending,” the central bank said. “Ultimately, this could result in mutually reinforcing declines in real economic activity and in the health of the financial sector.”

Measures being taken by European governments to get their fiscal houses in order need to be sufficient to keep investors satisfied that the problems are being addressed, the central bank said, while warning that “economic and political constraints” could complicate those efforts and lead to another period of “severe stress” in markets.

“Concerns over fiscal imbalances could also result in an abrupt increase in risk premiums and volatility for a wide range of assets and currencies,” the central bank said. “While Canada’s position is relatively strong, our financial system could be adversely affected by growing fiscal strains elsewhere.”

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Also, sweeping new rules that Group of 20 policy makers are crafting for the financial sector could have “unintended consequences”’ or cause challenges for banks as they transition to whatever regime is approved, the central banks said.

“Given its unprecedented scope, pace, and complexity, there is a risk that regulatory reform could have unintended consequences,’’ the bank said. Nonetheless, policy makers said, “at least equally important is the risk that key elements of the reform agenda will be diluted, either because of complacency as economic and financial conditions improve or because of fears that reforms could harm a still-fragile recovery.”