Overview:

Over the past year, financial conditions have tightened globally in response to monetary policy actions aimed at reducing inflation. Recent stresses in the banking sector in the United States and Switzerland further tightened financial conditions. Authorities in these countries reacted swiftly, limiting the spillover effects to the broader financial system.

These events have exposed vulnerabilities—notably, business models that rely excessively on an environment of low interest rates and low volatility—and serve as a reminder that risks can emerge and spread quickly. As the financial sector adjusts to higher interest rates, participants, regulators and central banks must be more vigilant about vulnerabilities and risks.

Canadian regulators have taken important steps to help safeguard the financial system. Canadian banks remain robust, but they are not immune to international developments. The reliance of Canada’s large banks on wholesale funding makes them vulnerable to deteriorating conditions in global financial markets. If the cost of wholesale funding were to rise significantly due to a persistent period of global financial stress, it could lead to Canadian banks tightening lending conditions, making it more difficult and expensive for Canadian households and businesses to access credit.

In light of higher borrowing costs, the Bank of Canada is more concerned than it was last year about the ability of households to service their debt. More households are expected to face financial pressure in the coming years as their mortgages are renewed. The decline in house prices has also reduced homeowner equity, and some signs of financial stress—particularly among recent homebuyers—are beginning to appear.

A large negative shock, such as a severe global recession with significant unemployment that further depresses house prices, could increase loan defaults among households. If defaults on uninsured mortgages with negative equity were to occur on a large scale, they could result in sizable credit losses for Canadian lenders.

Elevated funding costs and persistent periods of stress can reduce the capacity of the banking sector to provide market liquidity. This liquidity is crucial to financial stability given the growing importance of non-bank financial intermediaries, such as asset managers, and their reliance on fixed-income liquidity. If a significant spike in demand for liquidity were to occur, it could lead to a potentially destabilizing decline in asset prices.

The Bank remains concerned about threats to financial stability from a major cyber incident, particularly in the context of rising geopolitical tensions and Russia’s ongoing war in Ukraine. A successful cyber attack that damages activities in one part of the financial system could spread quickly, undermining the public’s confidence.

Climate change also poses significant risks. These risks include disruptions from more frequent and extreme weather events and uncertainty about the transition to a low-carbon economy. The measurement of these risks remains inconsistent globally, and their disclosure, insufficient. For these reasons, assets exposed to these risks may be mispriced. An abrupt repricing of these assets could lead to losses for financial system participants.

Cryptoasset markets do not currently represent a significant concern for the stability of the Canadian financial system. They remain small and mostly separate from the financial system. If they do become more interconnected, shocks in these markets could spread to the broader financial system and affect financial stability.

The Bank will continue to closely monitor the financial system for early signs of strain and has the tools to provide emergency liquidity to the financial system if severe stress were to develop.

Source: Bank of Canada Publication