Knowledge, Integrity, Humour

Bank of Canada Financial System Review 2019

May 21, 2019

Financial System Review Summary - 2019

Stephen S. Poloz, Carolyn A. Wilkins, Timothy Lane, Lawrence L. Schembri, Lynn Patterson, Paul Beaudry
May 16, 2019
 

A stable and efficient financial system is essential for sustaining economic growth and raising living standards. In our Financial System Review, we identify the main vulnerabilities and risks to financial stability in Canada and explain how they have evolved over the past year.


Vulnerabilities are pre-existing conditions that can interact with and magnify shocks. Risks are extreme scenarios that threaten the ability of the financial system to perform its core functions were they to occur. These risks are not our base-case forecast, which is presented in our quarterly Monetary Policy Report.

Progress on two key vulnerabilities

The vulnerabilities associated with high household debt and imbalances in the housing market have declined modestly but remain significant.

  1. The combined effect of mortgage stress tests and past increases in interest rates has slowed household borrowing and improved the quality of new mortgage lending. The share of Canadians falling behind on their debt payments remains relatively low and steady.
  2. Housing resales and price growth have slowed significantly in Toronto and Vancouver over the past two years. Provincial housing measures, mortgage stress tests and past increases in interest rates have helped reduce excesses in these markets. Difficulties in the oil sector continue to weigh on housing markets in oil-producing provinces.

Despite this progress, we need to remain vigilant as the overall level of indebtedness continues to be high, with a large portion of that debt held by highly indebted households.

New measures have curbed borrowing, reduced speculative behaviour in housing markets and made the financial system more resilient. While the fundamentals in the housing sector remain solid overall and the sector should return to growth later this year, we continue to monitor these vulnerabilities closely.

Fragile corporate debt funding emerging as a vulnerability

Across many countries, including Canada, companies have become more indebted. This increase has been concentrated in lower-rated firms. Investor appetite for high-yield bonds and leveraged loans has driven this increase in borrowing, thus making future activity susceptible to shifts in investor sentiment. We will be monitoring this closely.

Other vulnerabilities highlighted in the 2019 Financial System Review include the following:

  • cyber incidents that could spread across the financial system
  • the rapidly changing crypto-asset and fintech sectors
  • climate change

Assessing climate-related risks

We want to better understand the risks that climate change poses to the economy and financial system. To do this, we are beginning a multi-year research effort and plan to

  • collaborate with domestic and international partners to build our analytical capacity, and
  • integrate climate-related risks into financial stability analysis.

The Bank will publish this work on the Financial System Hub and as part of the Financial System Review.

 

Risk slightly higher, but the system remains resilient

The overall risk to the Canadian financial system has increased slightly since our last assessment in June 2018. This increase is due to a slowdown in economic growth, caused in part by global trade policy uncertainty, last year’s oil price decline, ongoing difficulties in the energy sector and expanded risk taking in global financial markets.

The most important risks to Canada’s financial system remain a severe nationwide recession, a large house price correction and a sharp repricing of risk in financial markets. A recent stress test conducted by our staff considers these risks and finds if they materialized, large Canadian banks would be well positioned to manage them, which in turn would mitigate the effects on the wider financial system. At the same time, a second stress shows a scenario in which a material rise in interest rates would result in large redemptions in corporate bond mutual funds, causing a material widening in corporate spreads, which may exacerbate liquidity conditions.

Overall, the financial system remains resilient, and confidence among market participants continues to be high.

Global uncertainty is rising, and risks to financial stability have edged up in the past year. Still, confidence in the resilience of Canada’s financial system remains high, and we are seeing improvements in some of the key vulnerabilities we’ve been worried about for many years.

 

Stephen S. Poloz, Governor
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