Household debt, housing market top risks to economy: Bank of Canada

The Bank of Canada building is pictured in Ottawa on September 6, 2011. (THE CANADIAN PRESS/Sean Kilpatrick)

The Bank of Canada is flagging the steady climb of household debt and still-hot housing markets as the financial system's top vulnerabilities -- but it's also seeing some early signs of improvement.

In a report Tuesday, the bank said there's some evidence Canada's exposure to these persistent trouble spots has begun to ease, thanks to healthy job creation, tightening housing policies and higher mortgages rates.

The assessment is part of the bank's semi-annual review, which explores key vulnerabilities and risks surrounding the stability of the financial system. It describes vulnerabilities as pre-existing conditions that could amplify or propagate economic shocks.

"Overall risks to the Canadian financial system remain elevated. Some preliminary signs of improvement, however, are emerging," the bank said in its latest financial system review.

"Better economic conditions and several new policy measures support prospects for additional progress."

The report said indebtedness, especially the number of highly indebted households, remains high. Household debt relative to income has reached historically lofty levels and continues to grow, the bank said.

But it noted there's already some green shoots that suggest stricter lending rules have started to reduce the country's exposure to hefty debtloads.

When asked about the Bank of Canada's slightly more-optimistic tone compared to its last review in June, governor Stephen Poloz told reporters the most important thing to remember is that the vulnerabilities remain elevated.

"These are not measured in decimal points -- they're just elevated," Poloz said in Ottawa.

"That means that any shock that comes our way is going to be magnified by those vulnerabilities and that's a concern for us."

The report pointed to mortgage insurance policy changes, which included a stress test, introduced by the federal government a year ago.

The bank predicted further easing is likely on the way due to higher interest rates and another new stress test to be introduced in the new year, this time aimed at low-ratio mortgages that don't require insurance.

In January, the Office of the Superintendent of Financial Institutions will implement new lending guidelines that will require borrowers who do not require mortgage insurance to show they would still be able to make their payments if interest rates were to rise.

The Bank of Canada has raised its benchmark rate twice since July and experts predict it's likely to continue along a gradual hiking path.

The combination of these factors is also expected to reduce household imbalances by applying downward pressure on prices in major real-estate markets like Vancouver and Toronto.

Still, the bank's report carefully noted that it's uncertain exactly how borrowers and lenders will react to the incoming OSFI measures.

But it did offer estimates about the impact of the upcoming OSFI changes.

The bank said if the new stress tests had been in place for the 12 months leading up to June, then 10 per cent of low-ratio mortgages nationwide would've failed to qualify. For Toronto, Vancouver and their surrounding areas, the bank estimated that 12 per cent of mortgages would not have qualified.

"The policy changes affecting housing finance are clearly a step in the right direction," Poloz said.

"Still, it will take time for these, as well as the effects of recent interest rate increases, to significantly reduce these vulnerabilities."

In the report, the bank once again listed cyber threats as another key vulnerability for Canada.

Poloz has said a cyberattack against the financial system is a scenario that likely troubles him the most. In a recent interview, he said he was unsure how severe the fallout from such an event could be and he struggled to picture what it might look like.

"Cyberattacks do not respect borders: they can originate from outside Canada and be transmitted across the global network that financial institutions rely on to operate their businesses," the report said.

The bank said it has been working with industry, international organizations and federal and provincial authorities to improve collaboration and policy-making to ensure rapid response and recovery from a cyber event. An example could include a loss of connectivity or corruption of data within the payments system.

The report also assessed how the biggest risks facing Canada have evolved since its last update in June.

It said the chances of a severe nationwide recession or a drop in global growth triggered by a significant financial disruption in an emerging market, like China, remained elevated. However, the bank added that the chances of these scenarios playing out were decreasing.