Household balance sheets present key risk to financial system: BoC

Date: Tuesday, June 22, 2010
Author: Investment Executive

Overall risks to financial stability have risen over the past six months, according to the Bank of Canada.

In the latest version of its Financial System Review, the Bank examines five key risk areas, and finds that risk has only diminished in one of them – capital adequacy – over the past six months. It judges that household balance sheet related risk is unchanged over that period, but that three other risks have increased, including funding & liquidity, global imbalances & currency volatility, and the global economic outlook, which, on balance, increase overall risk.

Risks to the stability of the financial system seemed to be diminishing, it notes, until concerns about sovereign credits emerged, raising counterparty and funding & liquidity concerns.

“Although bold policy actions taken by European governments and central banks, with international support, succeeded in heading off a full-blown crisis of confidence, these events illustrate the continuing risk to financial stability posed by unsustainable public finances,” it says, adding that the drying up of liquidity highlights the system’s continued fragility.

That said, the Canadian financial system has strengthened over the past six months, it says, due to a stronger-than-expected economic recovery, and the already comparatively strong capital and liquidity positions of Canada’s financial institutions. However, household balance sheets are still a significant source of risk, and the system is vulnerable to renewed stress in global markets.

Ultimately, the Bank says that its Governing Council judges that, “while financial conditions have broadly improved in Canada since the December 2009 FSR, the overall level of risks to Canadian financial stability has increased.”

The biggest homegrown risk remains household balance sheets. The Bank notes that the proportion of Canadian households that are vulnerable to adverse wealth and income shocks has increased in recent years with the steady rise in aggregate household debt in relation to income.

“Overall, the Governing Council considers that the risk of systemwide stress arising from material losses on loans to Canadian households remains elevated, and is roughly unchanged since the last FSR,” it says, adding that it continues to monitor the evolution of household borrowing to assess the vulnerability of the household sector to adverse
macroeconomic shocks.