Bank of Canada Deputy Governor Toni Gravelle, pictured at an event in Toronto last year, says the bank's main concern is a shock that leads to a 'deep recession and a sharp rise in unemployment.'Sammy Kogan/The Globe and Mail
Canada’s financial system has weathered a period of economic uncertainty well, but it could be tested by a combination of geopolitical conflict, changing U.S. trade policy and the spread of artificial intelligence, the Bank of Canada said Thursday.
In its annual Financial Stability Report, the central bank said that the Canadian financial system remains resilient.
Canadian households have largely made it through a period of pricey mortgage renewals without a significant rise in insolvencies, and the country’s banks are well capitalized to absorb potential losses, even in a severe economic downturn, the bank said.
However, some financial-sector vulnerabilities are becoming more acute. Stock market valuations look stretched, creating the risk of a bubble popping. Governments are issuing more debt, which is increasingly being purchased by highly leveraged hedge funds. And AI tools are creating new cybersecurity risks for the financial sector.
“Individually, these and other vulnerabilities look manageable. However, the economic and geopolitical environment has become more volatile,” senior deputy governor Carolyn Rogers said in a news conference, pointing to the war in the Middle East and uncertainty around the upcoming review of the North American trade pact.
“This has made it more likely that a new shock or a combination of shocks could cause several vulnerabilities to crystalize at once... A cascading series of events could cause a sharp loss of investor confidence and lead to a spike in demand for liquidity or rapid asset sales. Funding markets could come under pressure, and stress could spread more broadly,” she said.
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The Financial Stability Report is not a forecast, and the bank does not put probabilities on various scenarios. The FSR also says nothing about monetary policy and the direction of interest rates. Rather, it’s an attempt to outline key risks to the Canadian financial system.
On the crucial issue of household finances and mortgage renewals, the risk level remains largely unchanged from a year ago and looks considerably less concerning than it did several years back, the bank said.
Following the sharp rise in interest rates in 2022 and 2023, there were worries that Canadian homeowners would have trouble renewing their mortgages, leading to significant loan losses for lenders.
So far, however, the situation has proven manageable. Mortgage stress tests worked, pinched homeowners extended their amortization lengths, incomes grew and interest rates retreated.
“To date, most borrowers have managed this risk well. With the final wave of these renewals set to happen over the next 12 months, we expect this risk to have fully passed by the second half of 2027,” deputy governor Toni Gravelle said in the news conference opening statement.
For homeowners with fixed-rate mortgages renewing over the next year, the bank expects them to see a roughly 15-per-cent increase in their monthly payments, on average. This represents about 12 per cent of all outstanding mortgages.
Mortgage arrears remain low overall, and only slightly above the 2018-19 average, the bank said. Although arrears have risen among households with large mortgage balances relative to income. Here, the stress is most acute among Toronto borrowers who took out loans in 2022-23.
While the risks stemming from Canadian household balance sheets remain largely unchanged, other vulnerabilities are increasing, the bank said.
Stock markets have continued to march higher despite various macroeconomic and geopolitical shocks, and are increasingly being driven by a handful of technology companies involved in AI.
That raises the risk that we’re in a stock market bubble, which could deflate if the commercial promise of AI is called into question.
“An abrupt repricing or deterioration in economic fundamentals could cause asset managers to face significant losses, a sudden increase in liquidity needs and forced asset sales to reduce leverage,” the FSR said.
The bank outlined one severe scenario in which an economic shock caused by sustained high global oil prices tied to the war in the Middle East combines with a sharp sell-off in equity markets.
In that situation, gross domestic product could fall 1 per cent, unemployment could hit 10 per cent and home prices could fall by 25 per cent, according to bank modelling.
Another vulnerability is growing in the bond market. Governments, including in Canada, are issuing larger amounts of debt to fund large deficits. Much of this is being bought by hedge funds that fund their purchases using large amounts of money borrowed in short-term funding markets, known as repo markets.
In Canada, between 40 per cent and 50 per cent of new bonds issued by the federal government are now routinely purchased by hedge funds, according to recent bank research.
Increased hedge fund involvement in bond markets can have positive effects, such as lowering borrowing costs and increasing liquidity for trading. However, it can also amplify volatility in moments of market stress.
If hedge funds lose access to repo markets, they can be forced to offload their bonds in a fire sale. That can destabilize a bedrock financial market and drive up borrowing costs across the economy.
The bank has highlighted this risk multiple times in recent years.
Looking beyond the mechanics of the financial system, the biggest risks ultimately stem from things that could happen in the real economy.
If the talks to renew the United States-Mexico-Canada trade agreement break down and the U.S. slaps more tariffs on Canada, that could have major impacts on Canadian businesses and their workers.
Likewise, the continuing war in the Middle East could push oil prices up further, forcing the bank to raise interest rates and increasing the likelihood of a recession.
“The main concern for both households and businesses is a geopolitical or economic shock that leads to a deep recession and a sharp rise in unemployment,” Mr. Gravelle said.
The silver lining is that Canada’s banks are well-placed to handle these shocks, he said.
“Our overall view is that the Canadian financial system remains well positioned to weather shocks. Over the past year, it has faced repeated tests. While there have been some strains, those episodes did not lead to broad-based financial stress. Still, we must remain vigilant.”