The Bank of Canada released its latest Financial System Review (FSR) this morning – its biannual assessment of the risks facing Canada’s financial system. The core message is that vulnerabilities remain, but have begun to ease as policy measures have improved the resilience of the financial system. The key vulnerabilities identified are high household indebtedness and housing market imbalances. Cyber risks also remain a concern.
On household indebtedness, healthy income gains, a marked slowing of credit growth, and improvements in credit quality have helped reduce this vulnerability. Also helping are higher interest rates and policy measures (notably the B-20 underwriting change). On the latter point, it remains too early to fully assess the extent of impacts, notably potential shifts to credit unions and private lenders. At the same time, credit growth may have slowed, but debt levels remain high. These high levels make existing debtholders more sensitive to rate increases.
There are also pockets of undiminished risk. In auto lending, the Bank notes that loans terms have become increasingly longer, and that one in three new car buyers owe more on their existing vehicle than it is worth at the time of trade-in, thus ballooning the size of the new loan. Similarly, although the mortgage underwriting standards seem to have reduced the growth of loans to highly-indebted borrowers, it remains too early to draw any firm conclusions. Moreover, although private lenders haven’t meaningfully increased the pace of originations so far this year, the slowing in overall credit growth has pushed these lenders up to a roughly 8% market share in the GTA.
Related to high debt levels are imbalances in the Canadian housing market. Here, the Bank sees somewhat less positive developments, noting evidence of speculation in condo markets. Interesting analysis suggests that neighborhoods with a significant investor presence tended to see larger declines in home prices from 2016 to April 2018. This is consistent with the Bank’s concern that price-gain-expectation fueled price increases are more sensitive to adverse shocks. With carrying costs reported to increasingly exceed rental revenue, the risk of a negative adjustment appears elevated.
Cyber threats remain a constant, with the interconnectedness of the financial system allowing such an event to potentially propagate beyond its source. The Bank continues to improve its defensive capabilities, and work with the major banks on recovery plans should a serious incident occur. Other risks discussed include the funding profiles of smaller banks (monolines), which rely on brokered deposits – the experience of Home Capital last year underscored the potential speed with which this funding can be withdrawn. For larger banks, the reliance of foreign funding (about 7% of assets) and risk of its withdrawal is a concern.
Risks need a trigger to metastasize into real economy impacts. Three are on offer: a severe recession, seen as ‘Elevated but decreasing’ in light of a strong labour market and a healthy economy more generally; A house price correction in overheated markets, a ‘Moderate’ risk given slowing home prices; and a sharp increase in long-term rates, seen as ‘Moderate but increasing’, given the global trend of monetary policy normalization.
Key Implications
This is by definition a report meant to raise eyebrows, and raise eyebrows it does. Things may be moving in the right direction, but the legacy of past developments will hang over the economy for some time to come. For instance, underwriting standards have undoubtedly improved in the wake of B-20 changes, but the few months of lending under this new regime have to be stacked up against the stock of debt already outstanding. Similarly, risks around auto loans and condo markets bear careful monitoring.
These risks must be considered against their economic backdrop. As it stands, the economy remains healthy, with the unemployment rate at a more than 40 year low and wage growth trending above the 3% mark. What’s more, while housing continues its adjustment process, it is likely almost over, with underlying demand expected to stabilize activity around mid-year, albeit at diminished levels.
If there is a key trigger, it may somewhat counterintuitively be of too strong an out-turn, particularly in the United States. As noted in the FSR, longer-term Canadian rates are influenced by international factors. With the U.S. economy likely to deliver a robust performance this year and next, yields will rise and will impact borrowing costs here. We expect the Bank of Canada to monitor these developments closely, and this remains a key factor constraining the path of Canadian monetary tightening going forward. In many ways, the Federal Reserve will help do the Bank of Canada’s job for it, and so the challenge for the Bank of Canada may thus be ensuring financial conditions here remain appropriate given the risks discussed – notably the elevated sensitivity of households to interest rates.
