Bank of Canada says high household debt levels, elevated home prices pose top risks for economy - The Globe and Mail

The Bank of Canada warned that household vulnerabilites have worsened over the past year and could lead to stress in the financial system as borrowing costs soar and highly indebted borrowers struggle to service their debts.

In its latest Financial System Review, the central bank said high levels of household indebtedness and elevated home prices are the top two vulnerabilities that could lead to problems or even a crisis in the financial system.

The cost of borrowing has spiked over the past few months and is expected to become more expensive as the Bank of Canada aggressively raises interest rates to combat high inflation.

“Central banks face a delicate balancing act. They must reduce inflation while seeking to safeguard both the recovery from the pandemic and overall financial stability,” said the report.

Higher interest rates have already slowed real estate activity, with property sales declining nationwide and home prices falling in some of the country’s hottest markets such as the Toronto suburbs. Several private sector economists have forecast double digit percentage declines in home prices this year, but the central bank said it was too soon to say whether this was the start of a substantial correction.

The bank listed several worrisome trends that have taken place over the course of the pandemic’s real estate boom: Households have increasingly stretched financially to purchase property; homebuyers that bought properties in recent quarters have made smaller down payments relative to the purchase price; and investors have increasingly leveraged their existing homes to buy new properties.

The high amounts of household indebtedness could eventually become problematic for the financial system, as central banks around the world raise interest rates. The global economy could soon start to slow or slip into a recession. That could lead to job losses and make it hard for mortgage holders to make their loan payments.

If home prices drop, that could further restrain homeowners’ ability to use the equity in their homes. Homeowners may be forced to reduce their spending and or sell their property.

“If the shock is large enough to cause many households to be in this situation, the size of the impact could create a negative feedback loop between the real economy and the financial system,” said the report. “The likelihood of this risk materializing and its impact on the economy are greater today than in the past.”

The central bank is primarily concerned about the highly indebted borrowers who took out mortgages over the past two years. Over one-quarter of mortgage holders have a loan to income ratio above 450 per cent. That is the highest level on record.

Central bank economists calculated that those borrowers would see a significant jump in mortgage payments at renewal time. If a highly indebted borrower took out a variable-rate mortgage in 2020 or 2021, they would see a median increase of $1,000 in their monthly payments in 2025 or 2026, said the report.

Despite growing risks, the central bank said that commercial banks remain well-positioned to weather an economic downturn or shock coming from the housing market.

In the event of a “severe and prolonged recession” Canadian banks would experience a significant hit to their capital buffers, but they would likely be able to continue lending to businesses and households, the bank said. This is supported by sound mortgage underwriting practices, solid capital ratios and a “robust capacity to generate revenues even in times of stress.”

The Bank of Canada offered a relatively upbeat assessment of corporate balance sheets. The ratio of debt-to-assets for non-financial companies has declined continuously since its peak in the second quarter or 2020. Meanwhile, the ratio of cash-to-debt has reached an all-time high.

“This improvement is due in part to the favourable impact that rising commodity prices are having on corporate balance sheets in the resource sector – a sector where firms have historically been more financially vulnerable,” the bank noted.

Companies that use bond markets to raise money will face higher borrowing costs as interest rates rise. But the central bank noted that most outstanding bonds are not set to mature in the next five years.

Still, companies could face challenges servicing their debt if the economy moves into recession, the bank said: “The direct impact of higher interest rates on the financing costs of most publicly listed firms will likely be small but could be problematic if higher rates are accompanied by a shock to firms’ revenues.”

The Financial System Review noted a range of other risks that appear to be growing. Russia’s invasion of Ukraine has increased the chance of a state-sponsored cyber attack against Canadian banks, the central bank said.

Meanwhile, financial stability concerns related to climate change remain a pressing issue. The worry is that asset prices and company valuations do not properly account for risks related to a transition to a lower-carbon economy.

The bank also expanded its analysis of cryptocurrencies. It reiterated its view that cryptocurrencies are “not yet of systemic importance” to the Canadian financial system. Although it did note that interest in the asset class is growing rapidly and expanding from retail investors to institutional investors.

In 2021, around 13 per cent of Canadians owned Bitcoin, which is up from 5 per cent in 2020. The median holding was about $500.

The bank’s principal concern is the lack of regulation in the crypto-sector. Many crypto companies function like traditional financial institutions, but with far less oversight.

“Until this regulatory gap is addressed, investors in and end users of unbacked crypto assets are subject to heightened risk of financial losses from events such as fraud, cyber attacks or the failure of key custodian or service providers,” the bank said.

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2022-06-09 14:25:43Z
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