Bank of Canada: household indebtedness "most prominent risk"

The Bank of Canada released its bi-annual Financial System Review today, detailing what it feels are the greatest risks to the Canadian economy and tabling proposed policy to mitigate those risks. 

The 62 page report suggested that risks to the financial system remain, yet have "declined modestly" since June.  They credit this decline with their own policy reactions and the actions of other central banks to inject liquidity into struggling credit markets. 

"Canada’s major banks have also increased their stock of highly liquid assets and their reliance on more stable sources of funding, thus reducing their exposure to further liquidity shocks and bolstering their ability to provide credit during periods of stress. However, much of this buildup in liquid assets is the result of liquidity support from the Bank of Canada and the Government of Canada to restore the ?ow of credit."

The fact that this increased market liquidity has been largely exogenously produced is cause for caution to some.  They feel that it may encourage banks to take further risks with the knowledge that assistance will be available if necessary.  It is a phenomenon widely known as "moral hazard." 

The liquidity positions of most banks worldwide has been improving over the past year, in reaction to rising delinquency rates and decreasing loan quality (see charts below). 

Canadian banks are also increasing their capital ratios ahead of a January 2011 change in accounting standards.  They will be moving to incorporate IASB (International Accounting Standards Board) regulations, which disallow off-balance sheet assets, requiring banks to bring the nebulous assets back on to their balance sheets. 

The Bank's report did, however, hedge their optimism about the generally improving health in the financial system.  They noted that household debt was rising to "historically high levels."  They warned that "households need to assess their ability to service these debt obligations over their entire maturity, taking into account likely changes in both income and interest rates and the risks surrounding this outlook."

"The Bank judges that the likelihood of system-wide stress arising from substantial loan losses on Canadian household portfolios remains relatively low at the moment, particularly given the near-term prospects for growth. However, the likelihood of this risk materializing in the medium term is judged to have risen since June as a result of higher levels of household indebtedness."

Other risks that the Bank detailed include the large fiscal deficits of many countries worldwide.  They noted that should this continue, increased risk premiums could jeopardize the global recovery.  They also warned against imprudent risk taking in assets beyond their fundamentals, raising the possibility of higher loan losses than currently projected.  Lastly, the report commented on the apparent deceleration in willingness to pursue regulatory reform as economic conditions improve. 

The entire report can be read here.  Read a summary here.