Preparing for the worst

Bank of Canada Senior Deputy Governor Carolyn Wilkins gave an important speech to the International Finance Club of Montreal this morning, titled "Financial Stability in an Uncertain World".  She covered three inter-related topics: Canada's progress in taming vulnerabilities in its financial system;  the  worsening global economic outlook; and the Canadian financial system's ability to handle an economic crisis, if and when one arises. 

As usual,  the key financial vulnerability in the Bank's mind lies in the state of household finances and imbalances in the housing market.  Ms Wilkins noted that the situation has improved in the past couple of years:

"Credit growth has moderated, and income growth has picked up. So the debt-to-income ratio has been stable over the past couple of years. Also, the share of new mortgages going to highly indebted borrowers fell to a low of 13 percent."

Part of the credit for this goes to the Bank itself and other regulators:

"Federal authorities made changes to mortgage-financing rules to ensure that borrowers could handle higher interest rates or lower incomes. British Columbia and Ontario introduced tax measures to reduce demand for housing from non-residents and speculative buyers. And the Bank increased its policy interest rate from 0.5 percent in mid-2017 to 1.75 percent last autumn, where it remains today. We did this to achieve our inflation target, and when borrowing costs rise, credit growth slows."  

Although there are signs of reviving activity in the housing and mortgage markets, the Bank believes that "the regulatory and other measures in place will support the quality of new credit and mitigate the buildup of imbalances in the housing market."

Turning to the international situation, Ms Wilkins focused on the interplay between trade conflicts and financial markets. She noted that the high household debt levels seen in Canada are also seen elsewhere (Australia, Sweden).  She also pointed out that the quality of corporate debt has been declining, with an increasing proportion of that debt being bundled into increasingly complex collateralized debt instruments, an ominous echo of the financial crisis a decade ago. 

The risk the Bank sees is that a perfect storm could be in the offing:

"An increase in uncertainty or bad trade news could be the trigger. This, in turn, could spark a sharp reversal in risk premiums and lead to a drop in prices for assets, including for houses. Creditors would see more defaults, especially from corporations with lower credit ratings. Moreover, if enough investors rushed to adjust their portfolios at the same time, liquidity would dry up, amplifying the effects. All of this would find its way to the banking system, making it harder for business owners and families to borrow and intensifying the downturn."

Turning finally to the resilience of the Canadian financial system, Ms Wilkins presented a generally positive picture:

"Canadian banks are part of a global banking system that is more solid than it was a decade ago. Globally active banks are holding over US$2 trillion more capital than they were at the beginning of 2011, when the phase-in of the post-crisis reforms began. This translates to a 7-percentage point increase in their Tier 1 capital ratio.  The leverage limits and new liquidity regulations also make these banks more resilient."

She noted that a recent IMF-designed stress test showed that the Canadian banking system could even withstand an extreme scenario in which unemployment jumped by six percentage points (effectively doubling the current rate) and house prices fell by 40 percent. 

This was a timely speech, in view of growing fears that the global economy may be set for a downturn, taking the Canadian economy along with it.  It is interesting that Ms Wilkins was the person chosen to deliver this reassurance.  With Governor Stephen Poloz's term ending in the New Year, she appears to have the inside track to take on the top job.