Canada’s financial systems at low risk

Financial life in Canada is looking pretty good, says the Bank of Canada in its biannual Financial Systems Review, but a slowdown in the U.S. economy could change this sunny outlook.

According to the report, “the financial positions of the Canadian household and corporate sectors remain strong, reflecting years of solid economic expansion,” but three potential risks could derail Canada’s good financial standing.

The Bank lists the risks as an abrupt slowdown of the U.S. economy, a deterioration in the prices of risky assets and a disorderly resolution to global imbalances. Still, the report says, the “financial system appears to be well positioned to withstand the … risks.”

Reasons for the Bank’s positive assessment include strong domestic demand, supported by increased employment growth and gains in real income and net wealth, as well as moderate growth in the U.S. economy. Healthy numbers in Europe, Asia and Japan have also helped the Canadian economy by balancing out the U.S.’s economic growth rate. “This suggests that the projected rotation of domestic-demand need for an orderly resolution of global imbalances is underway,” says the report.

Things weren’t always looking so great, especially during the late-February market dip, but today, says the report, the financial markets are positive. “This volatility has subsided, and risk premiums have since contracted towards the historically low levels observed prior to that period,” says the report.

Still, if a major American economic slowdown occurs due to weakening housing and business investments and a drop in consumption because of tightening credit conditions, the Great White North could be seriously affected.

Banks, while not directly affected, would face indirect consequences. “A sharp deceleration of the U.S. economy would affect many export-related sectors in Canada, some of which have been experiencing financial stress for several years,” says the report.

It adds that banks would see the quality of loans to households drop, as employment and incomes in export sectors would suffer.

The Bank counts the chances of a sharp decline as “remote” and says the major banks are “relatively well placed to withstand this shock, although some smaller institutions may be more exposed.”

An economic slowdown could also affect Canadians’ risky assets. “A sudden adjustment in the prices of risky assets in Canada … could have repercussions for the net worth of individuals, institutional investor and firms, for the availability of credit … and for the near term growth of the global and Canadian economies.”

If the markets re-price risk, investors might sell off their U.S. holdings, increasing volatility. If that happens, the chance of a “disorderly resolution of global imbalances” could increase. “A disorderly adjustment could entail lower global economic growth and rising protectionism,” thereby adversely impacting the Canadian export sector, says the report.

When it comes to the financial stability of Canada’s banks, the report says all the major institutions recorded strong profits in 2006 and the first half of 2007, and maintained a high capital ratio and a good credit quality. It also applauds the banks for improving their risk-management practices. “The market’s assessment is that banks remain in a strong financial position,” says the report. “All this suggests that banks would be well positioned to withstand adverse shocks.”

The non-financial corporate sector also received an encouraging assessment. The report says profitability was high in 2007, “with the leverage ratio of the sector at a low level.”

Another bright spot in Canada’s financial fortunes is our lack of sub-prime problems. The report cites sub-prime mortgages as a factor in declining credit quality in some U.S. mortgages and related credit market instruments.

Because Canada hasn’t adopted the dubious mortgage strategy, the household debt-service ratio has increased, and mortgage loan arrears and personal bankruptcies are at low levels.

Filed by Bryan Borzykowski, Advisor.ca, bryan.borzykowski@advisor.rogers.com

(06/21/07)

Bryan Borzykowski