Financial System Review—2019

A stable and efficient financial system is essential for sustaining economic growth and raising living standards. In our Financial System Review, we identify the main vulnerabilities and risks to financial stability in Canada and explain how they have evolved over the past year.

Browse previous versions of the Financial System Review.

Summary

Progress on two key vulnerabilities

The vulnerabilities associated with high household debt and imbalances in the housing market have declined modestly but remain significant.

1. The combined effect of mortgage stress tests and past increases in interest rates has slowed household borrowing and improved the quality of new mortgage lending. The share of Canadians falling behind on their debt payments remains relatively low and steady.
2. Housing resales and price growth have slowed significantly in Toronto and Vancouver over the past two years. Provincial housing measures, mortgage stress tests and past increases in interest rates have helped reduce excesses in these markets. Difficulties in the oil sector continue to weigh on housing markets in oil-producing provinces.

Despite this progress, we need to remain vigilant as the overall level of indebtedness continues to be high, with a large portion of that debt held by highly indebted households.

Fragile corporate debt funding emerging as a vulnerability

Across many countries, including Canada, companies have become more indebted. This increase has been concentrated in lower-rated firms. Investor appetite for high-yield bonds and leveraged loans has driven this increase in borrowing, thus making future activity susceptible to shifts in investor sentiment. We will be monitoring this closely.

Other vulnerabilities highlighted in the 2019 Financial System Review include the following:

• cyber incidents that could spread across the financial system
• the rapidly changing crypto-asset and fintech sectors
• climate change

Assessing climate-related risks

We want to better understand the risks that climate change poses to the economy and financial system. To do this, we are beginning a multi-year research effort and plan to

• collaborate with domestic and international partners to build our analytical capacity, and
• integrate climate-related risks into financial stability analysis.

The Bank of Canada will publish this work on the Financial System Hub and as part of the Financial System Review.

Risk slightly higher, but the system remains resilient

The overall risk to the Canadian financial system has increased slightly since our last assessment in June 2018. This increase is due to a slowdown in economic growth, caused in part by global trade policy uncertainty, last year’s oil price decline, ongoing difficulties in the energy sector and expanded risk taking in global financial markets.

The most important risks to Canada’s financial system remain a severe nationwide recession, a large house price correction and a sharp repricing of risk in financial markets. A recent stress test conducted by our staff considers these risks and finds that if they materialized, large Canadian banks would be well positioned to manage them, which in turn would mitigate the effects on the wider financial system. At the same time, a second stress shows a scenario in which a material rise in interest rates would result in large redemptions in corporate bond mutual funds, causing a material widening in corporate spreads, which may exacerbate liquidity conditions.

Overall, the financial system remains resilient, and confidence among market participants continues to be high.

Accommodative global financial conditions support near-term growth but may also allow vulnerabilities to build:

• Aggregate debt relative to gross domestic product (GDP) for non-financial corporations is near historic highs in advanced economies.
• Government borrowing is still elevated following past rounds of fiscal stimulus.
• In many countries, the household sector is heavily indebted.
• Financial risk taking has broadly increased, and the creditworthiness of some borrowers has worsened.

In these conditions, a sudden and sharp repricing of credit risk could put pressure on borrowers. This leaves the global financial system vulnerable to large economic and financial shocks.1

Vulnerabilities in the Canadian financial system

Vulnerability 1: Elevated level of household indebtedness

• Highly indebted households are those that have a lot of debt relative to their income. They have less flexibility to deal with sudden changes, such as a decline in income or in the price of their home. When many households are highly indebted, the effects of negative shocks on the financial system and the economy are greater.
• Overall, the vulnerability associated with high household indebtedness remains significant, although it has declined modestly. As households adjust to changes in mortgage policies and past increases in interest rates, the pace of borrowing has slowed and the quality of new mortgages has improved. Nonetheless, a large amount of debt in Canada is held by highly indebted households.

Credit growth has slowed notably since 2017, bottoming out recently at about 3.3 per cent. The slowdown is evident in both real-estate and consumer lending (Chart 3). Real-estate lending includes home equity lines of credit, which contracted in 2018, according to new data from banks.2

Household indebtedness, as measured by the ratio of debt to disposable income, remains high. It has been relatively stable because income growth has slowed along with credit growth (Chart 4). In contrast, after having declined for nearly a decade, household debt as a percentage of net worth has recently increased due to slower growth in house prices. Box 1 further discusses long-term trends in household net worth, indebtedness and vulnerabilities.

The quality of new mortgage borrowing has improved, but a large amount of debt in Canada is held by highly indebted households. The share of new mortgage lending to households with a loan-to-income ratio greater than 450 per cent fell to a new, lower level (Chart 5). This decline is due in part to tighter mortgage regulations, including a stricter stress test for mortgage interest rates.3 Some households responded by

• buying a less expensive home,
• delaying their purchases to save more for a down payment, or
• obtaining a loan from a lender that does not apply the stress test.

These regulatory changes increase the resilience of the financial system by making it more likely that new borrowers could handle their mortgage payments even if interest rates rise or their incomes decline. The amount of debt held by highly indebted households, however, remains high and is expected to decline slowly as debt gets paid down and incomes grow.

Households are adjusting to past increases in interest rates. The sensitivity of the economy to higher interest rates has grown because of the rise in household indebtedness and the stricter mortgage interest rate stress tests. As rates rose in 2018, more households were bound by the limits to the debt-service ratio than would have been if the stress tests had not been strengthened.

Until recently, the average debt-service ratio had been relatively stable due to offsetting effects from a steady decline in interest rates and rising indebtedness (Chart 6). Interest rates started to rise in the middle of 2017. The average interest rate for existing debt (the effective interest rate) reached 4.4 per cent by the end of 2018, according to the most recently available data. This led to a rise in the average debt-service ratio, which is at its historic high. Rising interest rates have a more significant impact on highly indebted households, which are already dedicating a greater share of their income to debt payments.

However, since the fourth quarter of 2018, market interest rates on new and renewed loans have declined, leaving Canadians facing less of an adjustment. For example, most borrowers who recently renewed a five-year, fixed-rate mortgage did not see an increase in their mortgage payments.

There are ongoing data challenges in assessing vulnerabilities associated with mortgages. For banks and mortgage insurers, the Bank uses extensive loan-level data to assess vulnerabilities. For other mortgage lending, however, it is more challenging to have a complete perspective. Recent improvements, including new data from the Canada Mortgage and Housing Corporation (CMHC) and Statistics Canada, have helped the Bank better understand loans made by credit unions and by mortgage investment corporations (MICs) (Table 1).4 Despite these improvements, significant gaps remain. For example, the Bank has data on private lending for the Toronto area but not the Vancouver area.

Federal regulators have tightened underwriting conditions over recent years, including more stringent mortgage interest rate stress tests. This has increased the potential for borrowers to move riskier uninsured mortgages to credit unions and private lenders, including MICs.

CMHC’s initial analysis of its new data does not find significant migration of uninsured mortgages with a high loan-to-income ratio from banks to credit unions.5 Uninsured mortgages from credit unions represent around 9 per cent of outstanding mortgages in Canada. Roughly half are from caisses populaires in Quebec, which are required to apply a mortgage interest rate stress test that is equivalent to the one applied by banks. Elsewhere, around 60 per cent of five-year, fixed-rate loans from credit unions were subject to a similar mortgage interest rate stress test. For these credit unions, lending to borrowers with a high loan-to-income ratio decreased, as it did for banks.

MICs are a small part of the Canadian residential mortgage market, with a market share of less than 1 per cent of outstanding mortgages.6 They have, however, grown by about 12 per cent annually over the 10 years ending in 2017, with total assets reaching $13.5 billion. MICs fund their activities primarily through equity offerings. Leverage at MICs is growing but still low, with the equity multiplier (1/equity share) at 1.7, well below their legal limit of between 3 and 6 and much lower than that of the Big Six Canadian banks, at 15 or 16. Furthermore, much of the borrowing is for operating requirements rather than for funding their mortgage portfolios.

MICs are only one type of private lender. Other types of corporations and private individuals make many mortgage loans. Private lending has increased strongly in the Greater Toronto Area, with the volume of new lending doubling between 2015 and 2017. Over the past year, however, it has been relatively stable in contrast to originations by other mortgage lenders, which have declined notably. As a result, the market share of private lenders has continued to rise (Chart 7). This share overstates the importance of private lenders, however, because their loans have shorter terms compared with those of other lenders. As long as their access to capital and leverage remains limited, it will be difficult for private lenders to replace a large portion of the traditional mortgage market.

The share of Canadians falling behind on debt payments is low and relatively steady. Outside of the oil-producing provinces, the percentage of households that have fallen behind by 60 days or more on at least one of their credit payments remains stable at about 3 per cent.7 Alberta and Saskatchewan, however, show a small but steady increase beginning in 2015 after the oil price shock (Chart 8). The impact on the Alberta economy of ongoing adjustment in the oil sector is compounding an already difficult situation for some households.

Vulnerability 2: Imbalances in the housing market

• When house prices grow at a faster pace than can be explained by economic fundamentals, a price correction that leads to financial stress becomes more likely. This can be serious when buyers are highly indebted.
• Overall, imbalances in housing have diminished but remain an important vulnerability. Froth from rising expectations of house price growth has declined in housing markets in the Toronto and Vancouver areas over the past two years. While the Toronto market appears to be stabilizing, prices and resale activity continue to decline in Vancouver. Ongoing difficulties in the oil sector are weighing on housing markets in oil-producing provinces.

Housing resale activity in Canada is down about 20 per cent from its peak in 2016. House price growth has also slowed markedly. For the first time since 2013, it is running below income growth. However, the national data mask diverging regional trends.

Starting in 2015, house prices and resale activity began accelerating in the Toronto and Vancouver areas (Chart 9). This was fuelled, in part, by strong employment and immigration growth, low interest rates and a limited supply of new housing. In turn, expectations of price growth also increased, leading to even stronger demand, including from speculators. At the same time, foreign buyers became increasingly interested in these markets. All this helped reinforce expectations that prices would keep rising rapidly, a situation that was not sustainable.10

In both markets, expectations have since shifted toward slower price increases and resale activity is lower (Box 2). This coincided with measures introduced by provincial governments to curb the impact of non-resident homebuyers and speculation. Subsequent increases in interest rates and the tightening of mortgage underwriting standards also helped dampen price growth expectations, prices and activity.

The two markets appear to be at different points in their adjustment. After slowing sharply beginning in 2017, the Toronto area appears to be stabilizing, while resales and prices continue to fall in the Vancouver area. Prices in these areas remain 40 to 60 per cent higher than they were four years ago, when prices began to accelerate. This suggests that housing imbalances remain an important macrofinancial vulnerability. But strong fundamentals, including employment growth and supply constraints, support prices.

Previous trends are continuing in other regions. Resales and prices in urban Alberta and Saskatchewan have continued to trend downward. House prices are now about 10 per cent lower than they were at their peak about four years ago, reflecting the regional economic impact of low oil prices.

In contrast, strong employment growth and, according to some reports, increased interest from foreign buyers have contributed to the rise in house prices in the Montréal area. Montréal and several other markets, such as Ottawa and Halifax, remain on solid footing.

The 2019 federal budget introduced new housing affordability measures.11 The key initiative is the First-Time Home Buyer Incentive. Many of the details have not yet been announced. However, under the three-year, $1.25 billion plan, households with an annual income of less than $120,000 will be eligible for a shared-equity mortgage from CMHC worth 5 per cent of their home price on a resale and 10 per cent for a new build. Mortgage costs are reduced since no interest or principal payments are required on the shared-equity mortgage. When the home is sold, the first-time homebuyer will share their capital gains or losses with CMHC.

Other measures include the following:

• an increase in the maximum amount a first-time homebuyer can withdraw from a registered retirement savings plan to $35,000, up from $25,000;
• an additional $10 billion for the Rental Construction Financing initiative, a program to fund the construction of affordable rental units;
• a Housing Supply Challenge with funding of $300 million; and
• the Expert Panel on the Future of Housing Supply Affordability, jointly established with British Columbia.

The new measures help address housing affordability and are not expected to significantly affect vulnerabilities. The size and targeted nature of the measures will limit pressures on housing demand, and other elements are designed to boost housing supply. As a result, any increase in prices should be small.12 The creation of new highly indebted households will be limited by a 400 per cent cap on the allowable loan-to-income ratio. In addition, shared-equity mortgages could act as a modest shock absorber for the economy and the financial system by contributing to the resilience of household balances sheets to a decline in house prices.

Vulnerability 3: Cyber threats and financial interconnections

• A successful cyber attack or other major cyber incident at a financial institution could spread across the interconnected financial system, interrupting the delivery of crucial financial services and damaging investor confidence.
• Cyber threats remain a key structural vulnerability. Federal authorities and financial institutions are making significant investments to strengthen the cyber resilience of the financial system, including through enhanced coordination, collaboration and information sharing. Continued vigilance is needed to maintain security.

Cyber incidents continue to be identified by market participants as the greatest risk to the Canadian financial system, according to the Bank’s Financial System Survey. The number of incidents that have or could have resulted in substantial financial losses has increased steadily over the past decade, according to international data on cyber events collected by Advisen from publicly verifiable sources (Chart 10). The finance and insurance sector is the most affected, with more than one-fifth of incidents.

Financial system participants are particularly concerned about cyber incidents at third-party service providers (Chart 11). A key factor driving the concern about cyber threats is the high degree of interconnectedness between financial institutions. This interconnectedness extends to crucial services offered by third parties, including cloud services and utilities. When many financial institutions rely on the same third-party service provider, a disabling cyber incident could have systemic effects. The Bank, the Department of Finance Canada and the Office of the Superintendent of Financial Institutions (OSFI) are members of the G7 Cyber Expert Group, whose work includes managing cyber risk from third parties.16 Separately, the Bank oversees financial market infrastructures, including their risk management practices. This involves, for example, strengthening expectations for third-party risk management and ensuring that risk management standards limit the propagation of risk across the system.

Financial institutions, governments and authorities have been making significant investments to address cyber vulnerabilities. The Bank recently updated its cyber security strategy for 2019–21. In addition to measures that strengthen the Bank’s own cyber resilience, the strategy includes several initiatives for the broader financial system. For example, the Bank plans to set out more detailed expectations for how financial market infrastructures would meet the Bank’s cyber risk management standards. In addition, the Bank continues its partnership with Payments Canada and the Big Six Canadian banks to enhance the resilience of Canada’s wholesale payments system to cyber incidents. The federal government has also been taking action. It established the Canadian Centre for Cyber Security, the RCMP National Cybercrime Coordination Unit and two new federal cyber investigation teams. The government will also introduce legislation to strengthen the cyber resilience of Canada’s critical infrastructure.

Coordination and information sharing among private and public sector entities are crucial for improving cyber resilience. As Chart 10 shows, it can take several years for a cyber incident to be visible in public sources. This is because firms can be slow to detect incidents, and it can take a long time to assess their effects. Firms are also reluctant to report incidents. Statistics Canada’s 2017 Survey of Cyber Security and Cyber Crime revealed that, of finance and insurance businesses suffering a cyber incident, only 29 per cent reported it to police, 21 per cent reported it to the Canadian Cyber Incident Response Centre,17 and 3 per cent reported the incident to their regulator.

Without a good understanding of current cyber incidents, it is more difficult to establish good strategies to protect and recover from them. Canadian financial sector authorities are clarifying existing reporting requirements and introducing new ones, including for federally regulated financial institutions, marketplaces, clearing agencies and dealers. The Bank is also reviewing its own requirements for cyber reporting for systemically important financial market infrastructures. These changes will allow better monitoring by authorities, including helping protect other financial system participants who might experience similar incidents.

Canadian financial institutions and their authorities are also strengthening relationships with security partners and improving domestic and international communication protocols. One key initiative is the formation of a new public-private partnership in Canada to prepare for and respond to systemic-level operational events, including cyber events. This partnership aims to improve coordination among financial institutions, financial market infrastructures and public authorities. It also provides a forum for collaborating on financial sector-wide resiliency initiatives.

Vulnerability 4: Fragile corporate debt funding from certain markets

• Highly indebted firms with poor debt-service capacity and low holdings of liquid assets have less flexibility to deal with a sudden decline in income or a sharp increase in interest rates. If the providers of this debt are highly leveraged or vulnerable to changing investor sentiment, adverse shocks can lead to important spillovers to the financial system.
• Indebtedness of the Canadian non-financial corporate sector is high, primarily driven by commodity-related sectors. Strong investor demand and deterioration in the creditworthiness of Canadian firms in certain sectors have led to increased reliance on US high-yield bonds and leveraged loans. Borrowers in these markets are increasingly vulnerable to sudden changes in investor sentiment. This emerging vulnerability warrants monitoring.

Corporate indebtedness in Canada is elevated. Non-financial corporate debt relative to income, at 315 per cent in 2018, is well above its historical average.18 Furthermore, the proportion of outstanding debt owed by firms that have poor debt-service capacity and low liquid asset holdings (debt at risk) is also historically high (Chart 12).19 A sectoral analysis indicates that the rise in indebtedness and debt at risk has been driven largely by firms in commodity-related sectors, reflecting both higher debt and a sharp decline in income due to lower commodity prices since 2014. At the same time, the average Canadian firm has enough liquid assets and cash to manage a quick rise in interest rates or a sharp decline in income over the near term, suggesting that it has adequate financial flexibility.

Corporate debt is also rising in many other advanced economies.20 This trend is taking place in the context of stricter regulatory requirements for banks, which now fund a smaller share of corporate debt. Non-bank credit providers have stepped in, partly motivated by a search for higher returns in the low interest rate environment.21 In particular, the global market for high-yield debt, which includes high-yield bonds and leveraged loans, has grown significantly and is now larger than it was before the global financial crisis (Box 3). Lending standards have also loosened in recent years, and the quality of corporate debt has deteriorated across many countries.22 Consequently, investors are more exposed to credit risk and firms are more vulnerable, on average, to a rapid repricing of risk. At the same time, non-bank credit providers have created a more diverse funding pool for firms, which benefits financial stability and efficiency.

Like that in many other countries, the non-financial corporate sector in Canada relies heavily on non-bank credit providers. For example, the amount of bonds outstanding issued by the Canadian non-financial firms increased from $270 billion in 2008 to $580 billion in 2018,24 with the increase evident across all sectors (Chart 13).

Canadian corporations, particularly firms with a lower credit rating, are increasingly funded in the United States. Over the past four years, the increase in corporate bonds issued by Canadian non-financial corporations has been driven primarily by issuers of lower-quality credit (Chart 14). Because the market for Canadian high-yield bonds is very small, these firms, including many in commodity-related sectors, have issued mainly in the United States. This has helped boost the share of bonds issued in US dollars by Canadian firms from 40 per cent in 2007 to around 60 per cent in 2018.

An increasing number of Canadian firms in various industries are also relying on the US leveraged loan market. The outstanding amount of leveraged loans to Canadian non-financial firms has increased over the past four years from Can$80 billion to Can$175 billion. About one-third of these leveraged loans are covenant-lite, compared with one-fifth only four years ago. Globally, the increase in covenant-lite loans is even more pronounced.

Together, the funding from leveraged loan and high-yield bond markets accounts for at least 12 per cent of total non-financial corporate debt (Chart 15).25 This is 6 percentage points higher than a decade ago. Borrowing in US dollars provides a natural hedge to some Canadian firms due to their business activities. For example, oil and gas firms price their products in US dollars.

Borrowers in leveraged loan and high-yield bond markets are vulnerable to changes in investor sentiment. Large shocks that heighten uncertainty or aversion to risk have the potential to destabilize funding. This is especially true when investors are seeking more risk for higher returns, as may be the case in a low interest rate environment. The December 2018 episode of large and rapid redemptions from loan investment and bond funds provides some evidence that these markets are fragile (see the section “Analysis of financial system resilience” for an examination of this effect in corporate bond funds). This episode resulted in an increase in credit spreads and fewer bonds and loans issued. Moreover, persistent problems in these markets could have broader implications for financial stability in Canada through the macroeconomic effects of a decline in corporate funding availability in the United States. Developments in these markets will be especially important as a greater number of leveraged loans and high-yield bonds mature in 2019 and beyond.

Vulnerability 5: Climate change

• Climate change continues to pose risks to both the economy and the financial system. These include physical risks from disruptive weather events and transition risks from adapting to a lower-carbon global economy.
• The Bank is undertaking a multi-year research plan to better assess the risks from climate change that are relevant to its mandate. This work includes collaborating with domestic and international partners, such as with the Central Banks and Supervisors Network for Greening the Financial System (NGFS).

The Bank of Canada is incorporating climate change risk into its analysis of the Canadian economy and financial system. Economic activity and the environment are intertwined. Most experts agree that the global climate is changing and that this has growing implications for the economy. But the range of possible outcomes is large.

Climate change creates important physical risks both in Canada and globally. According to the Intergovernmental Panel on Climate Change, the average world temperature in 2017 was around 1°C higher than pre-industrial levels and is projected to rise by 0.2°C per decade. One consequence is an increase in extreme weather events such as flooding, hurricanes and severe droughts. Insured damage to property and infrastructure in Canada averaged about $1.7 billion per year from 2008 to 2017, up from $200 million per year from 1983 to 1992.26 Canada is particularly affected—it is estimated to be warming significantly faster than the rest of the world.27

The move to a low-carbon economy involves complex structural adjustments, creating new opportunities as well as transition risk. Investor and consumer preferences are shifting toward lower-carbon sources and production processes, suggesting that the move to a low-carbon economy is underway. Transition costs will be felt most in carbon-intensive sectors, such as the oil and gas sector. If some fossil fuel reserves remain unexploited, assets in this sector may become stranded, losing much of their value. At the same time, other sectors such as green technology and alternative energy will likely benefit.

Both physical and transition risks are likely to have broad impacts on the economy. Moving labour and capital toward less carbon-intensive sectors is costly and takes time. Global trade patterns may also shift as production costs and the value of resources change. The necessary adjustments are complex and pervasive and might lead to increased risk for the financial system. In addition to insurance companies, many other parts of the financial system are exposed to risks from climate change. Banks have loans to carbon-intensive sectors as well as to connected sectors—for example, those upstream or downstream in supply chains. Asset managers hold carbon-intensive assets in and outside Canada. The Government of Canada’s Expert Panel on Sustainable Finance is studying these issues.

Limited understanding and mispricing of climate-related risks could potentially increase the costs of transitioning to a low-carbon economy. The risks faced by the financial system from climate change can be managed most effectively when investors and authorities know what exposures firms face and how they are being managed. The Financial Stability Board’s (FSB) Task Force on Climate-related Financial Disclosures recommends that firms publish climate-related financial information. However, this practice is not universal. Few firms disclose the financial impact of climate change on their assets and operations. Moreover, there are also inconsistencies in how firms report climate-related risks across industries and regions.

In addition, asset prices may not fully reflect carbon-related risk, which could also raise the cost of transitioning to a low-carbon economy. Mispricing might occur for a variety of reasons. These include a lack of information on carbon exposures or incentives that are not properly aligned. Mispricing can also occur because decision makers find it difficult to account for uncertain and complex events in the distant future. If assets are mispriced, correct incentives will not be in place to manage and mitigate risks. Rapid repricing might cause fire sales and interact with other vulnerabilities—like excessive leverage—destabilizing the financial system. Better transparency could help alleviate this risk.

Through research and collaboration with partners, the Bank is improving its understanding of climate risks as they relate to the Bank’s mandate. The Bank is working with members of the NGFS. The NGFS’s first comprehensive report, released in April 2019, has four non-binding recommendations related to central banks, including the Bank of Canada:

1. Integrating climate-related risks into financial stability monitoring and micro-supervision. The Bank will develop the tools needed to monitor and analyze climate-related risks, leading to a meaningful assessment of these risks. One approach is to use scenario analysis.
2. Integrating sustainability factors into own-portfolio management. The Bank is considering how to integrate environmental, social and governance factors into its investment framework for the Bank of Canada pension fund.
3. Bridging the data gaps. By participating in the NGFS working groups and other groups, the Bank will help identify data gaps. This will help relevant domestic and international stakeholders focus their efforts to improve the availability of data.
4. Building awareness and intellectual capacity and encouraging technical assistance and knowledge sharing. The Bank is building its analytical capacity as part of a multi-year research plan. To accelerate the plan’s development, the Bank is collaborating with the NGFS and other groups. The Bank plans to publish its work on the Financial System Hub and as part of the Financial System Review.

Two other NGFS recommendations do not fall directly within the mandate of central banks but are important to facilitate their work:

5. Achieving robust and internationally consistent climate and environment-related disclosure, and
6. Supporting the development of a taxonomy of economic activities.

Vulnerability 6: Rapid change in crypto-asset markets

• Crypto assets are diverse and fast-evolving, posing risk to the financial safety of consumers and investors.
• Crypto assets do not currently represent a significant vulnerability for the Canadian financial system. They lack the size and, most importantly, the connections with the traditional financial system necessary for large shocks to spread or intensify. But because crypto assets have the potential to create changes in the financial system, monitoring by both domestic and international authorities is crucial.

Crypto assets form a diverse landscape, creating a range of risks. Some crypto assets, such as Bitcoin, were originally designed for making purchases. Although they are often referred to as crypto currencies or crypto money, they lack many of the essential characteristics of money because they make poor media of exchange, stores of value and units of account.28 Another kind of crypto asset, called a security token, allows buyers to take an ownership interest in an asset. For example, initial coin offerings are sometimes designed to allow buyers to purchase equity in a firm. In contrast, utility tokens give holders the right to consume some product or service associated with a platform.

Looking at the underlying economic characteristics of the different kinds of crypto assets helps authorities monitor and manage risks across the landscape. Both internationally and in Canada, authorities are focused on issues related to consumer and investor protection, market integrity, tax evasion, money laundering and terrorist financing. The intergovernmental Financial Action Task Force provides guidance on how its requirements for combatting money laundering and terrorist financing apply to crypto assets.29 The Basel Committee on Banking Supervision has published expectations for how banks should manage risks from exposure to crypto assets.30 And the International Organization of Securities Commissions is focusing on trading platforms for crypto assets and investment funds with exposures to crypto assets. In Canada, Canadian Securities Administrators and the Investment Industry Regulatory Organization of Canada are consulting on developing a framework to regulate crypto-asset trading platforms.31

Crypto-asset markets continue to pose little threat to the stability of the financial system. A significant fall in crypto-asset prices has shrunk the overall size of these markets, and the use of initial coin offerings to raise funds has declined sharply in the past year. In addition, exposures of financial institutions to crypto-asset markets remain small.

But crypto-asset markets and other uses of the underlying distributed ledger technology continue to change quickly. Implications for financial stability might arise rapidly. The FSB has developed a framework to monitor crypto-asset markets for possible development of financial stability risks.32 In Canada, federal and provincial authorities have set up a working group to monitor the crypto-asset markets. The group is chaired by the Bank of Canada and includes representatives from the Heads of Regulatory Agencies, the Financial Consumer Agency of Canada, the Financial Transactions and Reports Analysis Centre and the Canada Revenue Agency.33

Recent investor losses at crypto companies—in Canada and other countries—reinforce the need for investor awareness and caution. The failure of QuadrigaCX—a crypto exchange—and a fraud investigation targeting an initial coin offering by consulting firm Vanbex are evidence of weak governance. This creates substantial risks for investors in crypto assets. Investors and consumers must take primary responsibility for understanding the full range of risks before participating in these markets.

Risks and resilience

• Vulnerabilities can amplify and transmit adverse events. This can harm the economy and threaten financial stability. Systemic risk is analyzed along four dimensions:

1. Growth at risk: aggregate downside risk to the real economy associated with financial system vulnerabilities
2. Key risks to financial stability: the most important downside risk scenarios
3. Analysis of resilience: the financial system’s ability to absorb and manage specific risk scenarios
4. Market views: participants’ perceptions of financial system risks and resilience

• Overall risk to the financial system remains significant and is slightly higher than at the time of the June 2018 FSR.
• A stress test shows the resilience of large Canadian banks. At the same time, bond mutual funds are taking on more risk in a low interest rate environment. Respondents to the Bank’s Financial System Survey continue to see the Canadian financial system as highly resilient.

Growth at risk

• The growth-at-risk framework quantifies aggregate macrofinancial risks in terms of future economic growth.
• Downside risks to the economy associated with financial vulnerabilities remain significant.

Growth at risk quantifies downside risks to the economy by estimating the rate of future GDP growth that should be exceeded in all but the worst 5 per cent of outcomes.36^, 37 It does not depend on any specific risk scenario but accounts for the effects of financial vulnerabilities and financial market stress on GDP growth outcomes. Because it relies on statistical analysis of aggregate cross-country indicators, growth at risk does not fully capture the evolution of vulnerabilities as analyzed in the sections above. For example, due to limitations in the data, it does not include measures of the quality of debt.

Growth at risk has increased since the June 2018 FSR, mostly because the pace of economic growth has slowed (Chart 16).38 Financial vulnerabilities and financial market stress magnify the downside risk.

Key risks to financial stability

• Beyond the broad assessment of risks measured in growth at risk, Governing Council evaluates the most important downside risk scenarios for the Canadian financial system (Table 2).
• The key risks remain the same as in the June 2018 FSR. Risks have risen slightly over the past year because economic activity in Canada and abroad has slowed and because risk taking has expanded in global financial markets. This expanded risk taking involves some Canadian firms that are relying more on potentially fragile funding sources. The most important risk remains a severe nationwide recession leading to a rise in financial stress.

Analysis of financial system resilience

• Stress tests can help gauge the possible impact of risk scenarios and the ability of the Canadian financial system to absorb and manage risks.
• A first stress test investigates the impact from an extreme but plausible scenario based on the key risks. In this scenario, the banking system experiences substantial losses, but regulatory capital buffers absorb these losses and help maintain resilience.
• A second stress test looks at how a sharp rise in interest rates affects mutual funds that specialize in corporate bonds. It shows that, with their increasing size and riskier portfolio holdings, these funds would have larger effects on market liquidity than in the past.

Banks would weather this storm in part because initial capital levels include substantial buffers to handle losses. These buffers include

• a capital conservation buffer of 2.5 per cent and a surcharge of 1 per cent applied to domestic systemically important banks;
• the new domestic stability buffer, which was introduced in June 2018 and is currently set at 1.75 per cent; and
• additional capital beyond the regulatory requirements held at the discretion of each bank.

OSFI sets the level of the domestic stability buffer twice per year based on monitoring of a range of systemic vulnerabilities done in consultation with the Bank of Canada and other federal authorities.

These buffers are designed to help banks manage the materialization of risks, while minimizing the effects on the financial system. They allow banks the space to take corrective action before their viability is threatened.

The Canadian mortgage insurance system also limits the impact on banks. This system protects banks against losses on some of their riskiest mortgages—those with a high loan-to-value ratio. The losses on insured mortgages instead fall on mortgage insurers. Mortgage insurance is guaranteed by the federal government—fully for CMHC and subject to a 10 per cent deductible for private mortgage insurers.

Significant uncertainties around the results remain. For example, the assumptions of losses on loan portfolios are conservative and may overestimate actual losses. In contrast, extreme economic uncertainty might cause a rise in risk aversion and a loss of confidence in the banks that is greater than that incorporated in the analysis. If that were to occur, bank creditors would withdraw more funding.

There is also uncertainty about how banks would respond. Banks may aggressively cut costs to protect earnings. They may also decide to deleverage more than the scenario assumes. That could protect bank capital but also result in a further tightening of financial conditions, which would exacerbate the negative effects on the economy. In addition, this analysis does not incorporate the effects of interventions by authorities, who have tools they can deploy to support the functioning of the financial system.

While the core of the financial system has become more resilient, risks may move elsewhere in the system. The Bank monitors these developments, with a specific focus on non-bank entities engaged in financial intermediation activities that involve a significant amount of maturity, liquidity and credit transformation.

A stress test of corporate bond funds

Over the past decade, open-ended fixed-income mutual funds with large holdings of corporate bonds (bond funds) have grown significantly. These bond funds offer daily redemptions to investors, but they hold assets that may be difficult to sell on short notice. If many investors were to withdraw simultaneously, the funds might be forced to quickly sell bonds to honour their commitments, potentially decreasing liquidity in the bond market. A decrease in liquidity could have negative consequences for both bondholders and bond issuers, which could amplify the effect of an adverse shock on the financial system. Asset managers are, however, aware that market liquidity may be less reliable than in the past and have indicated that they are altering their portfolio management strategies to prepare for periods of low liquidity.42 This should mitigate the impacts of a decline in liquidity on the financial system.

Bank staff analyzed a scenario where both short- and long-term interest rates increase sharply, by 100 basis points over one quarter, using data from the end of 2018. This scenario could be caused by sudden changes in economic or financial conditions outside of Canada, such as in Risk 3. Similar interest rate increases in Canada in the 1980s and 1990s led to increases in market stress.

Bond funds would suffer losses on their investments and face large investor redemptions in this risk scenario. When interest rates increase, the value of bond investments decreases. Based on historical relationships between fund performance and investor demand for redemptions at the fund level, bond funds would experience redemptions estimated at around $70 billion out of a total of around $350 billion in assets under management. How individual bond fund managers would react depends on their investment strategy and risk management practices, which are quite varied. For example, passively managed funds would behave differently than actively managed funds.

In this analysis, bond fund managers are assumed to behave identically and sell assets proportionally to their holdings. Bond funds are estimated to collectively sell more than $30 billion in corporate bonds (Chart 18). The impact on bond prices depends on the willingness of bond buyers such as broker-dealers and long-term investors (including pension funds and insurance companies) to buy from the bond funds.

The sale of corporate bonds by funds would have a larger impact on fixed-income market liquidity than in the past. The liquidity risk premium would increase by an estimated 93 basis points compared with around 40 basis points if it had happened in 2007 (Chart 19). This is because of both demand and supply factors. On the demand side, mutual funds have grown; they hold more corporate bonds, including more bonds with lower credit quality, and they have reduced their cash buffers. On the supply side, post-crisis regulations have increased the cost for broker-dealers to intermediate large and relatively sudden investor flows.43

The results depend on several assumptions and are subject to significant uncertainty. For instance, if bond funds were to rely primarily on their holdings of cash and liquid assets to meet redemption demands, the increase in the liquidity risk premium would be lower initially—although the funds would then be less able to deal with future redemptions. In contrast, the increase in the liquidity risk premium would be larger if long-term investors are assumed not to purchase corporate bonds from mutual funds. This illustrates that the countercyclical behaviour of long-term investors can be an important stabilizing force. In addition, as previously mentioned, asset managers are altering their portfolio management strategies to prepare for periods of low liquidity, which should mitigate the impacts on the financial system of a scenario like the one examined here.

Market views of risk and resilience

• The views of market participants are helpful in identifying financial system risks and assessing the resilience of the system to those risks.
• In the Bank of Canada’s semi-annual Financial System Survey, respondents view risks as continuing to rise, but their confidence in the system’s resilience remains high. Indicators based on market values of bank equity also show high confidence.

The Bank solicits the views of financial system participants through its Financial System Survey. The survey results are a useful point of comparison for the Bank’s views and analytical work. The survey also provides information in areas where the Bank has limited data or experience and helps identify new topics for analysis.

The overall perception of risk has continued to edge higher, but confidence in the resilience of Canada’s financial system remains high. Once again, respondents from the Canadian financial system identified a cyber incident as the greatest risk. The perceived risk from a deterioration in the global economic outlook or a drop in residential and commercial property prices increased (Chart 20).

Market perceptions of banking system resilience can also be inferred from the information contained in market data, including stock prices. A composite index of market-based indicators suggests the perceived resilience of large banks is close to its highest level since the crisis (Chart 21). Small banks are considered less resilient than they were.44

Safeguarding the financial system

• The Bank of Canada works with other authorities in Canada and internationally to foster a stable and efficient financial system. This includes measures to increase the resilience of financial institutions and financial market infrastructures and measures to keep core funding markets working, even through periods of stress. Policy measures related to the vulnerabilities analyzed above are discussed in those sections. In addition, other notable policy developments contribute to a stable and efficient financial system.

Proposed enhancements should strengthen Canada’s interest rate benchmarks. Interest rate benchmarks are used globally to set payments for trillions of dollars of financial contracts, such as variable-rate loans and derivatives. Questions regarding the integrity of some of these rates, especially the London Interbank Offered Rate (LIBOR), have threatened confidence in some financial benchmarks. The resulting uncertainty represents a potentially serious source of systemic risk. Regulators from many countries are therefore reviewing benchmarks to improve their robustness and reliability.

The Canadian Fixed-Income Forum formed the Canadian Alternative Reference Rate Working Group (CARR) to review and improve existing Canadian benchmark rates and assess whether new rates should be developed. Deputy Governor Lynn Patterson discussed this in her speech “Rebooting Reference Rates.” Since then, the focus has been on two benchmarks:

• The Canadian Overnight Repo Rate Average (CORRA) is a transaction-based benchmark that measures the cost of overnight repurchase agreement (repo) funding. CORRA is primarily used in the derivatives market for setting payments on overnight indexed swaps. It is currently based on the relatively small number of general collateral repo transactions conducted through interdealer brokers. To make CORRA more robust and representative of the entire market, CARR has proposed broadening the range of transactions considered and modifying the calculation methodology.
• The Canadian Dollar Offered Rate (CDOR) is the primary benchmark rate for financial products denominated in Canadian dollars. It is a term rate that represents the cost for borrowers to draw from their bankers’ acceptance facilities.45 Because CDOR is survey-based, there is a risk that it could be discontinued if respondents stopped providing quotes for its calculation. To guard against this risk, CARR is developing more robust fallback language for certain types of financial contracts referring to CDOR. This would set out which alternative rates could be used for determining payments if CDOR was discontinued permanently. CARR is also investigating the need for a new term risk-free rate to complement CDOR and act as a credible fallback.

Resilience and continuity of the Bank of Canada’s market and banking operations will strengthen financial stability. These operations are essential for implementing the Bank’s core functions in monetary policy, funds management and the financial system. In early 2019, the Bank officially opened its first parallel operating site in Calgary for its market and banking operations. The Calgary Operational Site will work with Head Office and share day-to-day operational responsibilities. Once fully functional, this site will maintain the Bank’s critical market and banking operations in the event of any disruptions in the National Capital Region.

The Bank of Canada has reduced mechanistic reliance on ratings from credit rating agencies. Such reliance can cause rating downgrades to have drastic effects on issuers and asset holders, potentially causing systemic disruptions. For this reason, the Bank of Canada has been implementing, in its own policies, the FSB’s principles for reducing reliance on ratings from credit rating agencies. In July 2018, the Bank removed the mechanistic reliance on credit rating agencies from its collateral policy related to the Standing Liquidity Facility.46

Progress on modernizing Canada’s payment systems continues. Payments Canada continues to make progress toward creating three new payment platforms: a new high-value payment system called Lynx, an enhanced retail system for clearing paper-based and electronic batch payments, and a real-time payment system.47 An application provider and a vendor to provide hosting and system integration for Lynx have been selected. Design work continues on the retail batch and real-time payment systems. In addition, the Government of Canada proposed in Budget 2019 to require payment service providers to establish sound operational risk management practices and to protect users’ funds against losses. The Bank of Canada would oversee compliance with these requirements, which were outlined in the government’s consultation paper on the retail payments oversight framework.

Endnotes

The Financial System Review is a product of the Governing Council of the Bank of Canada: Stephen S. Poloz, Carolyn A. Wilkins, Timothy Lane, Lawrence Schembri, Lynn Patterson and Paul Beaudry.

This report includes data received up to May 9, 2019.