Canada’s financial system is more vulnerable than six months ago because of potential fallout from Europe, “severe tensions” in global markets and fears that global trade imbalances won’t be narrowed soon enough for private demand in emerging markets to replace spending by consumers and governments in countries that need to get their balance sheets in order, according to the conclusions the central bank has reached during its semi-annual review.

Policy makers said Canada’s system continues to function well and has actually strengthened since their last assessment in late 2009. However, they reiterated concerns about household debt Canadians have built up amid historically low borrowing costs, and outlined how Canada’s economy could fall victim to fiscal troubles in advanced nations or asset bubbles in emerging markets, if responses to either led to a sharp drop in bank lending or demand.

“Many aspects of the Canadian macro-financial environment have improved since last December, with the economic recovery proceeding as expected and conditions in Canada’s financial system generally strengthening,” the central bank’s governing council said in its report.

Still, members warned near-term risks to Canada have increased because of “heightened concerns that worldwide fiscal strains have the potential to cause tensions in interbank funding markets, to derail the global economic recovery, or to trigger a disorderly resolution of global imbalances.’’

The level of risk has increased in three of five categories that policy makers look at for their review: funding and liquidity; the so-called imbalances in the global economy that exacerbated the financial crisis of 2008; and the current economic outlook.

Canadian banks’ capital levels – and the quality of what they possess – have improved since December, the central bank said, while risks posed by household balance sheets remain roughly unchanged even as households’ financial vulnerability to economic shocks is growing. The rising debt-to-income ratio among Canadians, which Bank of Canada Governor Mark Carney has warned about for several months, could pose a risk to banks and the economy as a whole, should borrowers default on their loans and force banks to hold back on extending credit.

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Much of the alarm about the indebtedness of Canadian households focuses on the sector’s debt being 146 per cent of personal disposable income. This is up from 90 per cent just 20 years ago. And two decades before that, indebtedness was less than 80 per cent of after-tax income. This rise in household indebtedness is a sociological as well as economic and financial phenomenon.
- Don Drummond, Chief economist, TD Bank Financial Group, Defusing Canada’s debt bomb, April 17, 2010

Canadian borrowers are fast approaching a day of reckoning. Lured by cheap money to buy up, buy in, expand and make over, families have pushed credit levels to a record high. Now, mortgage rates are beginning to creep up and the Bank of Canada is poised to retreat from the record-low interest rates it adopted to fight the recession and spur recovery. The end of the free-money era has left consumers more vulnerable than ever, and those who threw caution to the wind could soon face costs they can’t handle.
Household debt has surged three time faster than income in recent years and now stands at a record high of more than $1-trillion. Put another way, Canadians owe about $1.47 for every dollar of disposable income. Even more remarkably, they took on more debt during the slump – a first for a recession – because borrowing was so cheap. With debt levels this high, even a small hike in interest rates will be ugly for those whose incomes aren’t rising fast enough to meet their day-to-day expenses. Their woes could have a snowball effect: As debt-strapped consumers pull back, their credit woes spill over into the broader economy and risk putting a damper on the recovery.

Canada’s brewing debt storm
- Paul Waldie and Steve Ladurantaye Globe and Mail Canada April 17, 2010

Average Canadian household debt reaches $96,000
- CTV News Canada February 16 2010

Surging household debt is emerging as the greatest risk to Canada’s financial system.
- Household debt emerges as greatest risk to Canada’s financial system, June 15, 2009

The current level of indebtedness of Canadian households is a highly disturbing matter…
- Certified General Accountants Association of Canada, March 2009
Where Has the Money Gone: The State of Canadian Household Debt in a Stumbling Economy