Canada's Housing Bubble

JEREMY TOROBIN Globe and Mail

Risks to the economy and financial system have edged higher over the past six months, the Bank of Canada warned Wednesday, citing the European debt crisis, the uneven global recovery, and vulnerable consumers who are not doing enough to cut their debts.

In their latest semi-annual assessment of the financial system, central bank policy makers said Canada’s banking sector remains relatively sound.

Still, they reiterated that Canadian banks could be affected significantly should the European debt crisis spread to the continent’s bigger countries or beyond, or if Canadian households are unable to manage their debt loads when interest rates rise or if there’s another downturn in the jobs market.

``The Canadian financial system is not immune to the tensions that are currently affecting European markets,’’ Governor Mark Carney and his rate-setting panel said in the report.

``Even though the direct exposure of the Canadian banking sector to credit claims on entities from the most vulnerable countries is low, domestic banks could face losses on loans to other countries whose banks are more exposed.’’

On Canadian household debt, Mr. Carney and his deputies said the risks posed to the wider financial system and the economy remain ``elevated,’’ and once again urged borrowers and banks to be careful about taking on or dishing out loans. While policy makers view the probability of a ``labour market shock’’ as lower than six months ago, they said further slowing in the growth of credit is essential.

This is especially so because the central bank has issued several stern warnings, including last week in Vancouver - the country’s hottest real-estate market by far - but has been reluctant to raise interest rates because of the extremely uncertain global picture, leaving the policy response to the Finance Department. The government has tightened mortgage rules through measures that are helping to slow the pace of debt accumulation, but ``it will take some time for their full effect to be felt.”

``The growing vulnerability of this sector increases the risk that a shock to economic conditions would be transmitted to the broader financial system via a deterioration in the credit quality of household loans,’’ the central bank said. ``The resulting increase in loan-loss provisions and the reduced quality of the remaining loans could lead to tighter credit conditions and, in turn, to mutually reinforcing declines in real activity and in the overall health of the financial sector.’’

Ever mindful of how Canada’s export-heavy economy could suffer disproportionately if other countries fail to do their part in fostering a smoother global recovery, Mr. Carney warned that in addition to the ``acute fiscal strains’’ in Europe that threaten to lead to a Greek default, which could have severe ramifications throughout the global banking system, countries like the United States and Japan must come up with credible debt-reduction plans. Furthermore, efforts to beef up international banking standards must continue apace, he said.

``The most pressing issue internationally is to take up additional steps to consolidate public finances and to shore up the balance sheets of banks that are undercapitalized and burdened with underperforming assets,’’policy makers said. ``If the significant fragilities that still burden the financial system are not addressed in a timely manner, the progress achieved to date could be derailed.’’