OTTAWA - The Bank of Canada is warning of a global epidemic of contagion spreading from Europe, saying Canada's economy and financial systems are already being impacted and risks of further damage are elevated.

The central bank's semi-annual financial stability review released Thursday states bluntly that Canadians need to start worrying about the worsening debt mess in Europe and its ability to hit home hard.

"The (bank's) governing council judges that the risks to the stability of Canada's financial system are high and have increased markedly over the past six months," it stated.

"Since June, the global retrenchment of risk associated with the European crisis has indeed resulted in a significant correction in the prices of equities and other risky assets, as well as a widening of credit spreads in Canada. Should the crisis deepen and spread further to the larger European economies, transmission to Canada could become more severe.... An adverse outcome for Europe would also raise the risk of a significant impairment of funding conditions for Canadian institutions."

Frankly, it says, measures currently undertaken to bring the European debt crisis under control "have repeatedly fallen short of what is needed."

European leaders were meeting later in the day for yet another attempt to come up with a solution that would satisfy markets, which have put the eurozone, including Germany, on watch for a debt rating downgrade.

Wednesday night, Finance Minister Jim Flaherty poured cold water on an unconfirmed report that G20 nations would funnel US$600 billion to Europe through the International Monetary Fund.

The TD Bank said in an analysis that the central bank's gloomy report "reinforces" their pessimism about Europe, and that global growth will worsen as risks continue to rise.

"Canada will largely be impacted by falling commodity prices, a hit to confidence and weaker export growth. Nonetheless, these events are likely to push the Canadian unemployment rate higher and asset values lower-- hitting the household sector at a time when they have become more vulnerable to such shocks," said TD economist Diana Petramala.

As it has in the past, but this time with more urgency, the bank report flagged record high consumer debt, warning that a shock such as falling house prices or a sharp rise in unemployment could push many Canadians to the point they can no longer make debt payments.

The bank conceded that the growth of mortgage debt has slowed, particularly after March's clamp-down by Ottawa reducing top amortization periods from 35 to 30 years.

But it noted that credit accumulation is still rising faster than incomes, which have slowed, and that October saw a rebound in mortgage growth.

"The rising indebtedness of Canadian households in recent years has increased the possibility that a significant proportion of households would be unable to make debt payments in the event of an adverse economic shock," it warns.

Recently, the International Monetary Fund warned Ottawa it may have to lean again on mortgage rules to slow down Canadians eager to buy while interest rates are at floor levels. The Bank of Canada doesn't go as far, but possibly as far as it can in saying that "continued vigilance is warranted."

Still, the expectation is for the housing market to cool and fresh data released Thursday morning appeared to back the bank's bet. Canada Mortgage and Housing Corporation reported seasonally adjusted annual rate of housing starts plunged to 181,100 units in November from 208,800 the prior month. The new level was more in line with what analysts would consider sustainable.

Still, with rates at historical lows, CIBC economist Benjamin Tal said he wouldn't be surprised if mortgage credit growth resumes again, and bank governor Mark Carney is obviously frustrated. He would like to raise rates, but the economy is far too weak for that, Tal said.

"Their hands are tied. This means you have a much longer duration of extremely low interest rates and people can be blinded by those and continue to take out mortgages and create a housing market bubble," he said.

Tal said Flaherty may be forced to clamp down further on eligibility rules for mortgages to make house purchases less affordable.

Most of the concern in the report stems from the European situation worsening. But the potential for an "adverse shock" is increasing, the bank said, and risks are not all restricted to Europe.

The bank said financial markets are also keeping a wary eye on Japan and U.S. sovereign debt, particularly after August's debt-ceiling fiasco in Washington that underlined the political dysfunction in the capital. There is a "small but significant risk," the bank says, that investors will demanding higher rates for underfunding the two governments.

The bank made it clear that Canada's problems to date are of a factor lower than those faced by European nations and the U.S.

While financial conditions have tightened, Canadian banks still have access to funding at wholesale markets have not significantly diminished.

Canadian banks also have an advantage in that they are well capitalized and have little direct exposure to European debt. Exposure ranges from virtually zero in the case of Greek and Portuguese debt, to a high of 3.4 per cent of capital with respect to Italy. That compares to exposure rates as high as 154 per cent and 193 per cent that German and French banks have to Italian debt.

But the report warned that Canadian banks are not out of wreckage range should Europe's financial system crash.

"Should the crisis deepen and spread further to the larger European economies, transmission to Canada could become more severe through the credit and funding channels. Indirect credit exposures could also become more important -- for example, via the significant exposure of German and French banks ... or in a more extreme case, if U.S. banks become affected."

The review gave no hint about the bank's interest rate outlook in Canada, but made it clear it is uncomfortable with rates being so low for such an extended period.

The bank said low interest rates and the weak performance of markets are putting the squeeze on insurance companies and pension plans, which are at a higher risk of being unable to meet their financial obligations.