Canada faces a “major shock” to its financial system and economy if Europe’s crisis worsens, the country’s central bank said.
While Canada’s financial system has fared well and conditions in the country remain “very stimulative,” deepening turmoil in Europe may boost funding costs for the nation’s banks and generate losses from assets linked to the euro zone, the Bank of Canada said today in its semi-annual Financial System Review. Non-performing loans at Canadian banks would also increase if growth slows.
“The combined effect of these events could constitute a major shock for both the Canadian financial system and the economy as a whole,” the Ottawa-based bank said, adding sovereign debt strains in the euro region are the “principal” threat to the country’s financial stability. “Should the crisis worsen and spread further across Europe, the impact on the Canadian financial system could be significant.”
The Canadian central bank, which is headed by Financial Stability Board Chairman Mark Carney, said that banks in the 17- nation euro zone need to be recapitalized with European assets, and that “firewalls” need to be strengthened and brought into force.
Recent steps by European governments and central banks “can only create time” and need to be matched by efforts to create a more “robust foundation” for the region’s financial market, such as a banking union, the bank said in the report.
To be sure, Canadian credit markets have remained “robust,” the bank said, citing near historic low corporate bond yields and data that suggest banks have been easing lending conditions.
“In contrast to the volatility in European credit markets, markets in Canada have been relatively stable, and Canadian banks continue to have good access to wholesale funding markets,” according to the report.
Canada’s biggest domestic risk remains high household debt, the bank said in the report, and the ratio of debt to household income is likely to keep rising. The Bank of Canada said that while it welcomed a recent slowdown in the pace of debt accumulation, households remain vulnerable to shocks.
Stretched valuations and continued building in some segments of the country’s housing market are “of increasing concern,” the bank said. Construction and home sales have been stronger than it had anticipated in December, and the proportion of debt held by highly indebted households remains above the average of the past decade, it said.
The Bank of Canada “judges that the risks associated with high levels of household debt and a potential correction in the housing market are elevated and have not diminished since December,” the report said. “A reduction in this domestic risk requires a combination of deleveraging by vulnerable households and a reduction in housing market imbalances.”
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