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Bank of Canada's June Financial System Review Highlights (Text)

Following is the overview section of the Bank of Canada’s Financial System Review. The statement was released today in Ottawa.

Conditions in the international financial system are fragile. Over the past six months, financial conditions have gone through two distinct phases: a significant but short-lived improvement resulting from the European Central Bank’s (ECB) liquidity provisions in December and February, followed by a period of mounting market turbulence as sovereign debt concerns in Europe re-escalated. These concerns reflect widespread doubts about the capacity and resolve of policy-makers to address unsustainable fiscal situations, the capital adequacy of some euro-area banks and the underlying balance-of-payments problems within the euro area. If these issues are not dealt with in an orderly way, the contagion effects on global financial conditions could be significant.

Canada’s financial system continues to be robust despite the challenging global environment. 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. Nevertheless, a further significant deterioration in global financial conditions could have a considerable impact here in Canada through trade, financial and confidence channels.

The Governing Council judges that the risks to the stability of Canada’s financial system remain high, as in December. The sources of the key risks are broadly the same as those highlighted at that time and emanate primarily from the external environment:

- a further escalation of the euro-area sovereign debt crisis; - an economic slowdown in other advanced economies; - financial stress in the Canadian household sector; - a disorderly resolution of global current account imbalances; and - excessive risk-taking associated with a prolonged period of low interest rates.

The key risks to financial stability are highly interdependent and mutually reinforcing. If the sovereign debt crisis in Europe continues to intensify, it would further weaken global economic growth and prompt a general retrenchment from risk. In turn, the weaker global outlook would fuel sovereign fiscal strains and impair the credit quality of bank loan portfolios. The rise in risk aversion would exacerbate pressures on bank balance sheets and could prompt a tightening in lending conditions to households and businesses, adding to the drag on global economic growth. Together, these factors would increase the probability of an adverse shock to the income or wealth of Canadian households. Diminished prospects for growth would also foster expectations of continued low interest rates, potentially further eroding the financial positions of life insurance companies and defined-benefit pension plans, and boosting household borrowing in Canada.

Mitigating the risks to the stability of the international financial system requires a number of policy actions. The most pressing near-term priority is to contain the resurgent crisis in the euro area. Euro-area banks need to be adequately and transparently capitalized. In addition, the financial firewalls (the European Financial Stability Facility (EFSF) and the European Stability Mechanism (ESM)) need to be reinforced and made fully operational to alleviate contagion. Beyond these immediate steps, actions need to be taken by both deficit and surplus countries to address the underlying balance-of-payments imbalances in the euro area. In particular, structural and product market reforms to reduce rigidities and facilitate adjustments in relative wages within the euro area and boost long-term growth must be fully implemented. There also needs to be a clearer path for risk mutualization and enhanced fiscal governance arrangements within the European monetary union. Ongoing discussions about deepening the union, if fully developed, would help address Europe’s problems.

At a global level--and consistent with the G-20 commitments--current account imbalances have to be addressed to help foster sustainable and balanced global economic growth. Among other things, this will require a more decisive move toward market-determined exchange rates by economies with current account surpluses, notably China.

In Canada, the high indebtedness of the household sector and elevated valuations in the housing market require continued vigilance. These conditions make households especially vulnerable to adverse shocks. Building on the Financial Stability Board’s (FSB) “FSB Principles for Sound Residential Mortgage Underwriting Practices,” in March, the Office of the Superintendent of Financial Institutions (OSFI) released a draft guideline for mortgage underwriting by federally regulated financial institutions in Canada. These institutions need to actively monitor risks in their loan and asset portfolios, and adhere to the new mortgage-lending standards. Households need to be cognizant of the fact that borrowing rates will eventually normalize and ensure that they will be able to service new and existing debt over the duration of their loans.

The current environment should not be an excuse to delay or dilute the broader financial reform agenda to make the global financial system more resilient. Timely, comprehensive and consistent implementation of the Basel III capital rules is a key priority. Canadian banks plan to implement these rules at the beginning of the agreed-upon phase-in period, which starts in 2013. Establishing a resilient market infrastructure is also important to reduce the likelihood and consequences of future periods of financial system turmoil. The development of a central counterparty for repos in Canada, launched on 21 February, is a significant step in this direction. Progress has also been made in mitigating systemic risk and improving transparency in over-the-counter derivatives markets. International standards and policy work to support reform in this market are largely complete, and efforts are well advanced in implementing safeguards to strengthen the safety of global clearing infrastructure. Financial stability also requires that credible frameworks for resolution are in place so that all banks, even those that are large and complex, can be resolved in a timely and orderly manner. The FSB’s “Key Attributes of Effective Resolution Regimes for Financial Institutions,” endorsed by the G-20 leaders in November 2011, is an important step forward on this issue.

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