Today the Bank of Canada released its annual Financial System Review. Unsurprisingly, it is all about the impact of the coronavirus pandemic on the Canadian financial system, and the system's ability to cope with that impact. Equally unsurprisingly, the Bank's conclusion is that, thanks to the pre-pandemic strength of the economy, the soundness of the banking system and the raft of measures taken over the past two months, the system is in good shape to cope with what may be coming.
Some of the key points, with apologies for a much longer post than usual:
"Strong policies have put a floor under the economy and laid a strong foundation for its recovery. Concerted policy actions by the Bank and other authorities have helped restore market functioning, and liquidity conditions have improved significantly. Government support for households and firms is directly mitigating income losses. Lower policy interest rates are underpinning demand and helping to achieve the inflation target."
Whether this eventually turns out to be true remains to be seen. The scale, scope and speed of the actions taken by the Federal government, shutting down portions of the economy and providing income support to those most affected, have been impressive. However, while this may have "put a floor under the economy", the strength of the "foundation for its recovery" depends on the length of the shutdown. The longer it takes for the economy to reopen, the more likely it becomes that much of what existed pre-pandemic is effectively gone forever, as the Bank acknowledges later in the Review.
"The Bank of Canada has intervened to support liquidity in key funding markets. Starting in mid-March, the Bank established and expanded a range of facilities and large-scale asset purchase programs to address problems with market functioning......The size of the Bank’s balance sheet has roughly tripled, growing from $119 billion on March 4 to $392 billion on May 6. This increase is much larger and occurred much faster than the growth that occurred during the 2007–09 global financial crisis, when the Bank’s balance sheet increased by 50 percent from September 2008 to the peak of the crisis in March 2009."
What is remarkable here is the sheer scale and rapidity of the growth in the Bank's balance sheet. The Review goes on to note early evidence that these measures are having some success, including a surge in corporate bond issuance in the month of April.
"Canadian banks have allowed more than 700,000 households to delay mortgage payments and have also provided increased flexibility on payments for credit cards and lines of credit. This is keeping debt payments down for many households. However, after the six-month deferral period ends, debt-service payments will rebound. The proportion of households with debt-service payments of more than 40 percent of their income, an indicator of household vulnerability, is likely to rise. This will be particularly the case for households whose incomes do not fully recover."
The elevated level of household debt has been a long-standing theme for the Bank of Canada (and, for that matter, for this blog), with debt standing at close to 180 percent of household income. This situation will need to be watched closely as the deferral period nears an end, not least because the banks are rolling the deferred interest into the outstanding principal. The length of the shutdown in the economy will be the key to how this plays out.
"Policy actions are helping businesses manage their cash flow needs and prepare for the recovery. Government policies such as the Canada Emergency Wage Subsidy and the Canada Emergency Commercial Rent Assistance Program help firms continue to pay their workers and make rent payments despite significant declines in revenues.....What started as a cash flow problem could develop into a solvency issue for some businesses. This becomes more likely if the loss in revenues extends over a long period. Lingering concerns about COVID‑19 could lower demand in some industries, damaging their earning capacity. For example, demand for travel services may recover very slowly. The potential for solvency problems also depends on the ability of businesses to access credit from financial markets and banks and therefore becomes more likely if stress in the financial system returns."
Again we see the Bank pointing out that despite the aggressive measures taken to date, problems could become much more severe for the business sector if the slowdown is prolonged beyond a few months. The Bank is clearly correct in identifying the travel sector as being particularly vulnerable here; the restaurant sector, with a heavy predominance of smaller enterprises, seems equally at risk.
"The six largest banks entered the COVID‑19 period with strong capital and liquidity buffers, a diversified asset base, the capacity to generate income and the protection of a robust mortgage insurance system. The Canadian economy was also in a solid position before the onset of COVID‑19. With these strengths, as well as the aggressive government policy response to the pandemic, the largest banks are in a good position to manage the consequences. Without the aggressive policy responses, banks would be faring much worse, with important negative effects on the availability of credit to households and businesses."
This is reassuring, though one would hardly expect the Bank to say anything different. The Bank and the Federal government trumpeted the success of their policies in keeping the domestic financial system safe after the global financial crisis. The current challenge appears to be much greater and a really prolonged downturn might start to impose further strains on the system.
In his remarks introducing the report, Bank Governor Stephen Poloz concluded by saying "To be clear, the pandemic remains a massive economic and financial challenge, possibly the largest of our lifetimes, and it will leave higher levels of debt in its wake. The right combination of fiscal, monetary and macroprudential policies can ensure a return to economic growth and debt sustainability. Further, policy-makers have taken the lessons of past crises to heart and acted to strengthen the financial system. Canada’s adherence to reforms after the 2007–09 global financial crisis, which strengthened the banking sector, is paying off. I am confident that a strong financial system will help Canada emerge from this episode in relatively good shape."
Poloz's successor Tiff Macklem, who steps into the hot seat in three weeks' time, will be hoping Poloz is correct.
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