Following is the overview section of the Bank of Canada’s Financial System Review. The statement was released today in Ottawa. Footnotes and tables have been removed.
Conditions in the international financial system remain challenging. A synchronous slowing in economic activity is taking place in both developed and emerging economies, and the outlook for growth remains modest. Although global financial conditions have improved since June, largely reflecting important announcements by major central banks and European authorities, the level of uncertainty is elevated. This reflects concerns about the underlying strength in the major economies, and whether policy-makers have the resolve to put in place a lasting solution to the crisis in the euro area and to address the impending “fiscal cliff” in the United States.
Despite the challenging global environment, Canada’s financial system continues to be robust. The balance sheets of Canadian banks are healthy, and banks have retained access to low-cost funding across the term structure. Financial markets in Canada have been more stable than their global counterparts. Corporate leverage in Canada is at an all-time low and firms have good access to credit from both banks and capital markets. Nevertheless, the Canadian financial system continues to be vulnerable to a number of interrelated and mutually reinforcing risks.
The Governing Council judges that the risks to the stability of Canada’s financial system remain high, as they were at the time of the June FSR. The sources of the key risks are similar to those highlighted in June, and emanate primarily from the external environment.
The most important risk continues to be the reintensification of the crisis in the euro area. This crisis has three interconnected elements: the potentially unsustainable fiscal trajectories of some peripheral countries; the weaknesses of the banking systems in those countries; and the underlying imbalances within the euro area. Modest and uneven global economic growth also represents a risk to the Canadian financial system. The risk is that the deficiency in global demand deepens or becomes more entrenched. This could be triggered in the near term by the fiscal cliff in the United States or, over the medium term, by disorderly fiscal consolidation in advanced economies or a lack of rotation of demand toward consumption in China and other surplus countries. Domestically, the primary financial stability concern relates to the high level of household indebtedness and elevated valuations in some segments of the housing market. These household imbalances could themselves be a trigger for financial system stress or they could amplify adverse economic shocks originating elsewhere. Finally, the low interest rate environment in major advanced economies represents another risk to the financial system, both in Canada and globally. This risk involves increased vulnerability for financial institutions with long-duration liabilities (e.g., life insurance companies and pension funds), and increased incentives for excessive risk taking in a search for yield, which could distort the pricing of both real and financial assets.
A realization of any of the key external risks would affect the Canadian financial system through three broad channels: trade, financial and confidence. The trade channel would have an impact on the financial system through weaker international trade in goods and services. Shocks that weaken global economic growth would reduce the demand for Canadian exports and dampen economic activity, resulting in a deterioration of Canadian business and household balance sheets and impairing the credit quality of bank loan portfolios. The financial channel involves three main effects related to the interconnections between Canadian financial institutions and the global economy. First, these institutions could experience direct and/or indirect losses owing to their exposures in affected regions or sectors. Second, counterparty risks and contagion could drive up the cost of bank funding and create severe disruptions in its availability in some markets. This would weaken the balance sheets of Canadian financial institutions and could lead to tighter lending conditions for businesses and households. Third, financial stresses could trigger a broad-based retrenchment in risk taking, which could exacerbate other adverse impacts through the financial channel. Finally, there is the confidence channel, through which adverse shocks could cause a decline in consumer, business and investor confidence, leading to weaker domestic demand and tighter financial conditions. These three transmission channels, like the key risks, are closely linked and could be mutually reinforcing.
Important steps have been taken since June to mitigate the key risks identified in Table 1. In particular, additional monetary policy stimulus announced by several central banks - including the U.S. Federal Reserve, the European Central Bank (ECB), the Bank of Japan and the Bank of England - will help support global economic growth. The actions taken by European authorities have reduced the near-term risk of a severe adverse event, resulting in a significant easing in financial conditions.
While these steps are important, further measures are needed. In the euro area, plans for establishing a single banking supervisor need to be supplemented with other critical elements of a banking union - namely, a framework for common deposit insurance and cross-border bank resolution. Further structural reforms are also necessary to narrow divergences in competitiveness within the euro area. In addition, work is needed to establish a closer fiscal union, including a fiscal transfer system and some form of mutualization of sovereign debt. In the United States, a clear and credible plan is required to address the fiscal cliff and the medium-term fiscal challenges.
In Canada, changes to the rules for government-backed insured mortgages and the introduction of mortgage underwriting guidelines are expected to support the long-term stability of the Canadian housing market and mitigate the risk of financial excesses. In the past six months, the growth of household credit has continued to moderate, sales of existing homes have declined and the growth in house prices has slowed. Nevertheless, there is a risk that the moderation in the housing market could prove transient, and that imbalances could remain elevated or build up further. To mitigate this risk, households should ensure that their borrowing is in line with their current and prospective ability to service their debt. Financial institutions must ensure that they have rigorous lending practices in place and are actively monitoring their risks, consistent with the mortgage underwriting guidelines from the Office of the Superintendent of Financial Institutions (OSFI). For their part, authorities will continue to carefully monitor the financial situation of the household sector and developments in the housing market.
The current environment should not be taken as an excuse to delay or dilute the global financial reform agenda. In particular, it is imperative that all jurisdictions fully and consistently implement Basel III rules. Canadian banks are expected to meet Basel III capital requirements by the beginning of 2013, which is the start of the phase-in period that extends to 2018. Establishing a resilient financial market infrastructure is also important to reduce the likelihood and consequences of future financial system turmoil. Good progress has been made on this front since June, both in Canada and internationally. In October, Canadian authorities announced that market participants can clear standardized over-the-counter derivatives using any central counterparty recognized by Canadian authorities, including global central counterparties. In addition, the Bank of Canada has adopted new international risk-management standards for its oversight of systemically important financial market infrastructures. At the international level, work has moved forward on ending “too big to fail” and strengthening the oversight and regulation of shadow banking activities.