Household debt a bigger threat: BoC

The Canadian financial system remains in flux, with risks posed by domestic financial institutions declining while household balance sheets and the global economy are worsening.

All in all, the overall risk assessment for the financial system remains unchanged since the Bank of Canada last issued its Financial System Review in December 2008.

“Policy actions of the Bank of Canada and the Government of Canada have gained considerable traction, helping to reinforce the improvement in domestic funding conditions for financial institutions as the global financial crisis subsided,” the bank said in its review. It also noted that market-making activity had increased.

One of the greatest concerns for the system had been capital adequacy of the banking industry, but these risks have abated over the past six months. Potential corporate and household loan-losses remain a threat to adequacy, but so far there has been no tsunami of defaults.

While the banks remain well capitalized, the Bank of Canada expressed some concern that the market is exerting pressure on the banks to maintain this capital level, which would preclude the proper use of funds: buffering against loan-losses.

“This could force banks to curb balance sheet growth, causing a tightening of credit conditions that would reinforce the negative impact of the economic downturn on the financial system,” the bank noted.

Household balance sheets have deteriorated over the past six months; job losses have accelerated. The central bank used a round number of 10% unemployment in a stress test and found that it would result in “a significant increase in losses for financial institutions.” It should be noted, however, that the bank is not predicting 10% unemployment, but simply used the number in its model.

“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,” the bank said in the review.

What has come to pass, however, is that the global economy has weakened more than the bank had predicted in its December review, resulting in a greater impact than initially expected.

There are signs that a recovery may be underway, but structural trade and currency imbalances remain in place, despite a cyclical easing of trade flows from emerging markets into developed economies.

“The global financial system has started to emerge from its most severe crisis since the 1930s,” the bank said. “The rapid implementation of the principles set out in the G-20 leaders’ summit communiqué will be crucial to making further progress in restoring the normal functioning of the financial system and supporting the economic recovery.”

(06/15/09)