What ails Canada?

The Bank of Canada today released its semi-annual financial system review, finding that the Canadian financial system’s vulnerability to adverse shocks decreased modestly since its last report in June.

But the country – whose banks weathered the financial crisis without any infusion of government money – has not radically changed its conservative outlook. “Over the medium term, vulnerabilities associated with global financial and economic imbalances and household indebtedness will emerge as the most prominent risks to the Canadian financial system,” the report said.

While indebtedness in the US and UK has been falling, debt-to-income ratios in Canada have reached historic highs. The Bank reported an increasing risk of credit losses on Canadian household loans over the past six months.

The other major risk to Canada’s financial system, according to the report, comes from its southern neighbour. “Disorderly adjustment of exchange rates is a key area of vulnerability… could occur if the international policy response to the crisis did not help to address these disequilibria by fostering a timely and sustained rotation of demand away from excess consumption in the United States and towards internally generated sources of demand in the developing countries of Asia.”

The Bank found that over the past six months, the depreciation of the dollar and moves by the G20 have lessened the risk of global imbalances, but have been counterbalanced by growing fiscal deficits in major industrialised countries.

Notably, the Bank sees the capital positions of its banks as less of a threat to its financial stability than any of the other four risk factors. In fact, Canadian banks are so well capitalised, that the Bank notes that over capitalisation might slow the improvement in credit conditions. A recent FT article noted that the largest six banks had tier one capital ratios well in excess of required levels and were “hoarding funds in preparation for growth opportunities.”

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