The uptick in inflation reported this week (see previous post) is one of the things the Bank of Canada is worried about at the moment, but it's nowhere near the top of the list. On Thursday the Bank released its Financial System review. Introducing the report to the media, Governor Tiff Macklem listed the Bank's key concerns as investors' rising appetite for risk, high home prices and indebtedness, climate-related vulnerabilities, fixed income market liquidity and the risks of a cyber attack on the financial system.
Regarding risk appetite, Macklem noted that A rapid change in market sentiment—perhaps due to a setback in efforts to end the pandemic or a stalled economic recovery—could cause a sharp repricing of risk and a tightening of global financial conditions....Wider credit spreads could particularly affect Canadian companies that rely on high-yield debt markets.
As for the housing market and debt, the Bank's view can be summarized as follows:
Consumer preference, combined with low interest rates that make borrowing more affordable, has boosted demand for single-family homes, particularly in suburbs and outlying areas of major Canadian cities. Housing supply has not been able to keep up with this surge in demand, and this has pushed prices for single-family homes sharply higher in several markets.
...some households have taken on significantly more mortgage debt. The increased issuance of mortgages with high loan-to-income ratios is of most concern.... It is important to understand that the recent rapid increases in home prices are not normal. Even without a shock, some of the factors that caused prices to rise fast could reverse later, and that could leave some households with less equity in their homes. And interest rates are unusually low. Borrowers and lenders both have roles in ensuring that households can still afford to service their debt at higher rates.
Not long after Macklem's speech, the Office of the Superintendent of Financial Institutions (OSFI) raised the "minimum qualifying rate" for new uninsured mortgages by 50 basis points to 5.25 percent. Borrowers must be able to demonstrate that they could still service their loans if rates rose to this level. Given that five-year fixed rate loans have been available this year for 1.7 percent or even less, this is a reasonably stringent test.
On climate-related vulnerabilities, Macklem stated that The potential impact of climate risks is generally underappreciated, and they are not well priced. That means the transition to a low-carbon economy could leave some investors and financial institutions exposed to large losses in the future....in some parts of the country, particularly British Columbia and Ontario, households that are highly leveraged are also more exposed to severe weather events. The Bank....is also working to assess the financial-system implications of different scenarios for the transition to a low-carbon economy. We’re learning a lot from this work and will publish a report later this year.
On fixed income market liquidity, Macklem commented that While financial markets are currently functioning well, the extreme market stresses that occurred when the pandemic struck highlighted the vulnerability of the financial system to sudden spikes in the demand for liquidity. Over the past decade, the potential demand from the asset-management industry for market liquidity in periods of stress has outpaced the capacity of banks to provide it. We are working at both domestic and international levels to better understand this structural liquidity vulnerability and how best to improve the resilience of core funding markets.
And last but not least on the risk of cyber attacks, the digital transformation of the economy and the interconnected nature of the financial system—globally and in Canada—increase the risks of a cyber attack. The recent ransomware attack on a top US pipeline operator is a timely illustration. This FSR discusses a number of cyber security initiatives the Bank is leading.
It's a long and varied list, so it's perhaps worth concluding with Macklem's customary words of comfort regarding the Canadian financial system:
The Canadian financial system went into this crisis in a solid position and has proved to be resilient. This reflects sound risk management across a range of financial system participants combined with Canada’s strong regulatory and supervisory framework. Unprecedented policy support from governments and the Bank has also played a crucial role. Together, these factors have allowed the financial system not only to weather the huge shock but also to act as a shock absorber for the broader economy—by continuing to provide credit and by deferring loan payments for some households and businesses.
Here's hoping he's right.
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