Bank of Canada Says Financial Risks Have Eased on Europe

Canada’s central bank said risks to the country’s financial system have eased as Europe has made progress repairing balance sheets, while the chief domestic threat remains imbalances in the housing market, including an oversupply of multiple-unit dwellings.

The total risk level was reduced to “elevated” from a June assessment of “high” as the danger posed by Europe’s financial crisis receded to “high” from “very high,” the Ottawa-based central bank said today in its semi-annual Financial System Review. Housing-market risks remained “elevated” in the latest report.

“Five years after the start of the global financial crisis, economic growth remains modest, dampened by the repair of balance sheets by households, financial institutions and governments,” the bank said in its report. “Nonetheless, there have been positive developments in the global financial system” since June, particularly stabilization in the euro zone.

The other financial-system vulnerabilities include low interest rates that may cause some investors to take risky positions to generate better returns, and potential financial weaknesses in some emerging markets, according to the report.

Canada’s housing market has retained its strength after Finance Minister Jim Flaherty introduced tighter mortgage-lending rules last year on concern about overbuilding of condominiums in Toronto and Vancouver. Low mortgage rates are supporting demand, and Bank of Canada policy makers said last week that housing has been stronger than they forecast.

Temporary Strength

“The housing market has shown renewed vigor over much of 2013,” including gains in housing starts and resales, the central bank said today.

That strength is probably temporary, the bank said. While the ratio of Canadian household debt to disposable income rose to a record 163.4 percent in the second quarter on increased mortgage borrowing, the bank said the risk associated with high debt levels will probably ease. “The overall moderating trend is expected to resume in due course,” the bank said in its report.

The Canadian dollar was little changed after the report, gaining 0.1 percent to C$1.0619 per U.S. dollar at 12:40 p.m. in Toronto. One Canadian dollar buys 94.17 cents. Government bonds rose, with the yield on the five-year benchmark note falling 2 basis points to 1.79 percent.

Governor Stephen Poloz on Dec. 4 kept his benchmark interest rate at 1 percent where it’s been for more than three years citing sluggish inflation. He will speak on “Monetary Policy as Risk Management” in a Dec. 12 speech in Montreal.

Inflation Focus

“The relative comfort the bank has with financial stability reflected in the FSR —- and specifically with the view that household imbalances will once again begin to resolve themselves —- will help keep the focus on the inflation side of the equation,” said David Tulk, chief Canada macro strategist at Toronto-Dominion Bank’s TD Securities unit.

Today’s assessment also said there are signs of “an oversupply of multiple-unit dwellings” in big cities, the bank said in the report, singling out the condominium market in Toronto, Canada’s largest city.

“If the upcoming supply of units isn’t absorbed by demand as units are completed over the next few years, there is a risk of a correction in prices and construction activity,” the bank said. The housing market is also more vulnerable if demand has been inflated by investors who are more likely to get out of the market if it weakens, the report said.

Mortgage Lending

Smaller lenders who are accounting for more of the recent growth in the mortgage market may pose a risk if there is a correction, because they may have less underwriting experience and greater exposure to financial-market turmoil that could impair how they raise money, the bank said.

Domestic banks have little direct exposure to the euro zone, with the risks coming from either indirect ties to lenders in the U.S. and U.K. or a global deterioration in confidence that would be tied to any fresh crisis in Europe, according to the report.

“Weak banks and stretched governments in the peripheral countries remain a significant source of vulnerability” from Europe, the bank said. “Lower political resolve, due to reduced market pressures or reform fatigue, could delay much-needed progress on reforms, leaving the euro area vulnerable to a renewed period of financial turmoil.”

Emerging-market countries pose a greater risk to the global financial system because of rapid credit growth and “uneven progress on financial and macroeconomic reforms” in some of those countries, the bank said today.

One risk to the financial system coming from outside of capital markets and housing is the increase in coordinated computer attacks, the report said. The central bank is leading a group of companies and government organizations focused on building better protections against attacks on the computer networks that control important payment systems, it said.

To contact the reporter on this story: Greg Quinn in Ottawa at gquinn1@bloomberg.net.

To contact the editors responsible for this story: David Scanlan at dscanlan@bloomberg.net; Chris Wellisz at cwellisz@bloomberg.net

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