Financial System Review—2022

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

Overview

The Canadian financial system has proved resilient throughout the COVID‑19 pandemic, and the balance sheets of businesses and households are generally in good shape. However, in an environment of tightening financial conditions, high global inflation and increased geopolitical tensions, financial system vulnerabilities have become more complex, and risks have become more elevated.

The Bank is paying particular attention to the fact that a greater number of Canadian households are carrying high levels of mortgage debt. These households are more vulnerable to declines in income and rising interest rates. While the sharp increase in house prices over the past year has resulted in significant equity gains for many households, those who entered the housing market in the last year or so would be more exposed in the event of a significant price correction.

The vulnerabilities highlighted in this report suggest the effects for the real economy could be significant if a trigger event occurs, even as systemically important financial institutions remain resilient.

What you need to know about the Bank of Canada’s latest assessment of vulnerabilities and risks to Canada’s financial system – in brief.

Key messages

• Central banks around the world have shifted their focus from providing pandemic-related stimulus to responding to the significant increase in inflation. The lasting effects of the pandemic on supply chains in the context of strong demand for goods and the ongoing Russian invasion of Ukraine are complicating these efforts. The tightening of monetary policy globally will test the resilience of the financial system and could worsen existing financial vulnerabilities.
• In Canada, elevated levels of household debt and high house prices remain two key interconnected vulnerabilities. Many households have seen an improvement of their net worth and liquid asset holdings over the course of the pandemic. At the same time, the share of highly indebted households has risen. Those with high debt are more vulnerable to a decline in income and will face more financial strain when they renew their mortgages at higher rates.
• House prices rose more than 50%, on average, during the pandemic. Expectations of future price increases and increased investor demand likely contributed to this rise. A moderation of housing markets could reverse these forces and amplify the decline in prices. Significant drops in prices would reduce household wealth and access to credit.
• Publicly traded non-financial businesses are generally in good financial shape and appear well-positioned to handle higher interest rates. Previously, concerns were that the pandemic would cause unsustainably high levels of debt across the non-financial sector. But this has not occurred. The vulnerability associated with the reliance of some businesses on high-yield debt markets has also diminished.
• Fragile liquidity in fixed-income markets is an ongoing structural vulnerability. A sudden spike in demand for liquidity from asset managers could exceed the willingness of banks to supply such liquidity, causing large price movements and a potential freeze in some markets. The recent tightening in financial conditions and increased market volatility have reduced liquidity.
• Cyber threats represent a continued vulnerability given the interconnected nature of the financial system. With the ongoing war in Ukraine, state-sponsored cyber attacks are occurring with greater frequency and sophistication, increasing the risk of a successful attack on a Canadian financial institution or financial market infrastructure. Such an attack could have far-reaching effects on the broader financial system.
• The war in Europe has further complicated the transition to a low-carbon economy. In the short term, concerns around global energy security are likely to delay the transition, while the long-term impact is highly uncertain. Overall, the risk of a quick repricing of assets exposed to climate change has increased.
• Cryptoasset markets continue to evolve and grow rapidly, and price volatility remains high. While they do not yet pose a systemic risk to the Canadian financial system, the lack of a regulatory framework means they operate without many of the safeguards that exist in the traditional financial system. This exposes investors to risks such as large and sudden financial losses due to fraud, price declines or a run on stablecoins.

Global macrofinancial conditions

• As the global economy emerges from the COVID‑19 pandemic, several factors have combined to increase volatility in financial markets and reduce investors’ appetites for risky assets. Amid rising global inflationary pressures, major central banks have entered a phase of monetary policy tightening. At the same time, Russia’s invasion of Ukraine has increased volatility in commodity markets and uncertainty more generally, causing significant repricing in some financial markets as investors seek safer assets. The tightening of global financial conditions could more clearly expose existing financial vulnerabilities and will test the resilience of the global financial system. New outbreaks of COVID‑19 in China and associated lockdowns are another source of concern for the global economy and inflation.

Over the past year, inflation has risen worldwide. Many economies have lifted pandemic-related restrictions, leading to robust demand, which has met with global supply constraints. In addition to causing untold human suffering, Russia’s invasion of Ukraine is also adding to inflationary pressures, both by boosting commodity prices and creating additional supply chain issues.

As a result of rising inflation, investors expect major central banks to withdraw a significant amount of monetary policy stimulus. Central banks may substantially increase their policy rates and reduce their balance sheets through quantitative tightening.1 Expectations of both tighter monetary policy and higher inflation have led to a sharp rise in nominal sovereign bond yields around the world (Chart 1). This abrupt repricing in sovereign bonds has happened alongside higher volatility in other asset classes (Chart 2).

Global financial conditions are tighter than they were last year. Excluding the period of market turmoil in March and April 2020, yields on corporate bonds are at multi-year highs. Borrowing rates for households have increased substantially. Five-year fixed mortgage rates have reached levels last seen in 2010. Corporate credit spreads have widened, and most global equity indexes are down significantly in 2022. Investors’ appetites for risky assets have weakened, particularly for technology stocks and cryptoassets, leading to sharp declines in prices and valuations.

The tightening of global financial conditions could expose existing financial vulnerabilities. It could reignite concerns about market liquidity in the event of an episode of severe financial stress (see “Fixed-income market liquidity”). Tightening could also interact with vulnerabilities in emerging-market economies (EMEs)—such as high public and private debt, foreign exchange exposures and large current account deficits—and trigger capital outflows. Concerns about corporate leverage in the property sector in China could intensify further. Finally, tighter financial conditions will put pressure on government finances given higher levels of debt taken on during the pandemic. Fiscal sustainability is a particularly acute concern for some EMEs.

Russia’s invasion of Ukraine is compounding the risks to global financial stability. The war is affecting the global economy through many channels.2 It has increased global uncertainty. As mentioned, the sharp rise in commodity prices and the additional disruptions to supply are adding to already elevated inflationary pressures. In this context, 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. Failure to balance these competing objectives could lead to a further global repricing of risk and a sharp tightening of global financial conditions, potentially triggering risks associated with high leverage.3 The conflict in Europe has also introduced a short-term trade-off between energy security and transition plans in response to climate-related risks and has increased cyber risks (see “Climate change considerations” and “Cyber security”).

These global risks represent important potential threats to financial stability in Canada, and their implications are examined later in this report. The next section focuses on vulnerabilities within the Canadian economy and financial system.

Vulnerabilities in the Canadian financial system

The Bank is committed to promoting the economic and financial welfare of Canada. As part of this commitment, the Bank identifies and monitors areas of vulnerability in the economy and the financial system. Vulnerabilities are pre-existing conditions that can lead to episodes of financial stress or even a financial crisis. They can amplify and further spread shocks throughout the financial system. The interaction between vulnerabilities and shocks can bring about risks that can impair the financial system and harm the economy. Reducing and managing vulnerabilities increases the resilience of the financial system and supports financial stability.

At this time, the Bank sees six key vulnerabilities in the financial system:

• Vulnerability 1: Elevated level of household indebtedness
• Vulnerability 2: Elevated house prices
• Vulnerability 3: Reliance of some businesses on high-yield debt markets
• Vulnerability 4: High potential demand for market liquidity relative to supply
• Vulnerability 5: Cyber threats in an interconnected financial system
• Vulnerability 6: Mispricing of assets exposed to climate-related risks

The Bank also monitors the rapid evolution of cryptoasset markets.

This section discusses these vulnerabilities, grouped by the area they are mainly associated with:

• households and the housing market (Vulnerability 1 and Vulnerability 2)
• non-financial businesses (Vulnerability 3)
• the financial system (Vulnerability 4, Vulnerability 5 and Vulnerability 6)

Households and the housing market

Households

• Assessing the ongoing vulnerability associated with the elevated level of household indebtedness (Vulnerability 1) has become more complex over the past two years. Overall, however, the vulnerability has increased. This vulnerability relates to households’ ability to continue servicing their debt if incomes decline or interest rates rise, without having to significantly reduce their consumption. Rising asset prices, including those for real estate, along with higher liquid assets have pushed up the net worth of most homeowners, strengthening their resilience to a negative income shock. But Bank staff estimate that the most highly indebted households have generally seen the smallest increases in liquid assets. At the same time, alongside higher house prices, a growing number of households have taken out sizable mortgages to purchase a house, adding to the already large share of highly indebted households.
• These developments are taking place in the context of rising interest rates, high inflation and elevated house prices (Vulnerability 2), which pose their own set of risks for households and the economy. Higher interest rates at the time of mortgage renewal will significantly reduce the financial flexibility of some households, particularly the most indebted (Box 1). Elevated inflation will erode the purchasing power of households if wages do not rise in tandem. Finally, homeowners—particularly the most indebted—may not be able tap into home equity if house prices were to experience a correction (see “A large decline in household income and house prices”).

The financial health of households has generally improved since the start of the pandemic, particularly over 2021. Net worth increased on average by $230,000 per household between the fourth quarter of 2019 and the fourth quarter of 2021, reflecting three key factors:

• Increased residential assets (Chart 3, blue bars)—House prices rose strongly across the country (Vulnerability 2), boosting homeowners’ wealth. Real estate assets account for two-thirds of the growth in net worth since the fourth quarter of 2019.
• Increased financial assets (Chart 3, green bars)—With stock markets reaching new highs during the pandemic, households that have financial assets tied to the stock market (either directly or through mutual or pension funds) generally saw the value of their equity portfolios grow. The recent decline in stock markets still leaves equity valuations about 15% higher than their pre-pandemic levels.
• Higher bank deposits (Chart 3, yellow bars)—In addition to paying down debt and increasing investments in residential and financial assets, households have expanded their holdings of liquid assets.

Overall, households have also increased their liabilities (Chart 3, red bars), with higher mortgage debt more than offsetting lower consumer debt. Many households have taken on large mortgages relative to their income in the context of elevated house prices. At the same time, households have reduced their use of other forms of credit. For instance, in March 2022, total outstanding balances on credit cards were 9% lower than they were in February 2020. Balances on home equity lines of credit were 6% lower. The share of Canadians falling behind on consumer debt payments, at about 2%, remains close to its historical low.4

Looking beyond average balance sheet statistics to evaluate household vulnerabilities is important. The increase in overall net worth seen in 2020 and 2021 hides important changes to its distribution and composition across households. Also unclear is the capacity for some households to service their debt in the event of a loss in income. Typically, when households allocate a larger share of their income to debt payments and have fewer liquid assets or limited access to credit, they must cut back on consumption by more if their disposable income declines (see “A large decline in household income and house prices”).

Many aspects of the ongoing vulnerability related to elevated household indebtedness (Vulnerability 1) have evolved in opposing directions since the start of the pandemic.

• The Bank’s analysis suggests that households across different levels of indebtedness have generally increased their holdings of liquid assets relative to 2019, adding to their financial resilience.5 However, the Bank estimates that the increase in liquidity buffers during the pandemic is smallest for highly indebted households (Chart 4). This group of borrowers includes many first-time homebuyers who have put their extra pandemic savings toward their down payment.

• Most homeowners have more home equity to borrow against if they experience an income shock, but the gains are lowest for those who purchased a house most recently. Households that have enough equity in their house can use home equity lines of credit or mortgage refinancing to access some of this capital in times of financial stress.6 Given the large increase in house prices since 2020, most highly indebted households have improved their equity positions. However, households that bought a property in recent quarters have generally seen the smallest gains and have increasingly made small down payments relative to the purchase price. The number of new mortgages with a loan-to-value ratio of 75% or more increased 40% over this period.7 Combined, these developments suggest that many recent homebuyers would have limited access to secured forms of credit in the event of a decline in income.
• A rising number of households have financially stretched to purchase a house amid elevated house prices. Increasingly over the past year, households have taken on mortgages that are large relative to their income and have opted for variable mortgage rates and longer amortization periods (Chart 5).8 The growing share of new mortgages taken out by borrowers with elevated loan-to-income ratios implies that the overall proportion of highly indebted households likely surpassed its pre-pandemic peak in 2021 (Chart 6), increasing the risk to macrofinancial stability (see “A large decline in household income and house prices”).9^, 10

• Higher interest rates will increase the vulnerability of highly indebted households. Even with a high debt load, households have generally been able to manage their debt servicing costs due to low interest rates since the start of the pandemic. But as mortgages are renewed at higher rates, some households—particularly those that took on a sizable mortgage since the start of the pandemic—will face significantly larger mortgage payments (Box 1). All else being equal, higher interest costs would greatly reduce their financial flexibility in the event of an income shock.

The housing market

• The vulnerability associated with elevated house prices (Vulnerability 2) increased further over the past year. Key developments in the housing market—strong demand relative to supply, driven partly by an increasing share of investors; prices reaching all-time highs in most regions; and expectations that these price increases will continue in most major cities—point to further imbalances in prices compared with a year ago.
• A large misalignment of house prices relative to longer-term fundamentals could lead to an abrupt price correction in the future. Such a correction can, in turn, bring on financial stress for households because housing often represents their largest asset (see “A large decline in household income and house prices”).
• It is too early to tell whether the recently observed decrease in resale activity and prices will be temporary or is the start of a deeper, lasting decline. A sudden reversal of the influx of housing investors seen during the pandemic could amplify downward pressure on prices (Box 2).

After months of exceptionally strong activity in the housing market, resales slowed considerably in March and April 2022 (Chart 7). Until the early months of 2022, demand—including from investors—was remarkably robust, supported by a desire for more housing space, record-low mortgage rates and the accumulation of extra savings. Resales are expected to soften as borrowing rates rise and the pandemic-induced demand for more housing space wanes. Recent monthly data reveal a large decline in resale activity. This could reflect a temporary echo effect from some homebuyers making their purchases earlier to avoid the latest mortgage rate increases, or it could signal the beginning of the end of the pandemic upswing.

Growth in house prices has been vigorous and regionally broad-based. In April 2022, house prices were up 24% nationally compared with April 2021, and up 53% relative to April 2020. Despite house prices increasing in nearly all areas, suburbs have experienced the strongest growth—as seen in the Toronto and Montréal regions (Figure 1).15 This dynamic is consistent with the pandemic-induced shift in preferences for more housing space, which is more affordable and widely available in suburban and rural areas than it is in city centres.

Figure 1: House price growth in the Toronto and Montréal regions has been stronger in the suburbs than in city centres

Year-over-year percentage change in the House Price Index for all property types, by forward sortation area, 2022Q1

Part of the exceptional increase in house prices observed since the start of the pandemic may have reflected extrapolative price expectations. This happens when people come to expect that house prices will rise in the future simply because they have risen in the past. In such a situation, homebuyers may rush into the market out of fear of missing out or may hope to realize a sizable capital gain. Under these conditions, housing demand and prices can then become disconnected from underlying fundamentals, putting prices at risk of a correction in the future. Extrapolative expectations, particularly among investors, could amplify and accelerate price declines if a house price correction were to occur. Such a correction could dampen economic activity not only through confidence effects but also because it reduces household wealth and restricts access to credit (see “A large decline in household income and house prices”). Although house prices declined in April 2022, it is too early to tell whether this is the beginning of a substantial correction in prices.

Before the tightening of monetary policy in March, extrapolative expectations appeared to have broadened. The Canadian Survey of Consumer Expectations conducted in February revealed that many Canadians were expecting house prices to increase substantially over the next year. In fact, this is the highest rate for this response since the Bank introduced this survey question in 2016. These elevated expectations also appeared to be broadening. For the first time, the Bank’s House Price Exuberance Indicator characterized house prices in most major Canadian cities as exuberant in the first quarter of 2022 (Chart 8).16 However, these indicators were collected before the slowdown in housing activity and price growth in April. It remains to be seen whether data for the second quarter will support the same conclusion.

The share of Canadians buying homes as investment properties grew in 2021. The increased presence of investors in the real estate market can amplify the vulnerability associated with elevated house prices (Box 2).

Implications for downside risks to future growth in gross domestic product

The vulnerabilities associated with elevated household indebtedness and high house prices increase the downside risks to future growth in gross domestic product (GDP). The robust growth in household credit and house prices observed since the beginning of the pandemic supports short-term economic growth. But over the medium term, it also contributes to increasing the likelihood of a negative outcome on growth (Chart 9).21

The buildup of vulnerabilities changes the distribution of future GDP growth. To illustrate this point, Chart 10 shows the projected distribution of growth for the first quarter of 2024. Compared with a scenario in which household debt and house prices remained constant between the first quarter of 2020 and the first quarter of 2022 (Chart 10, purple dotted line), projected growth (Chart 10, orange line) is both lower and has a greater probability of being negative. The probability of negative growth in the first quarter of 2024 is nearly two times greater given the current level of vulnerabilities. This is because the presence of these two financial vulnerabilities would likely amplify the impact on consumption and GDP if an economic disruption were to lower household income or considerably weaken activity in the housing market (see “A large decline in household income and house prices”).

Non-financial businesses

• The health of non-financial businesses has generally improved over the past year alongside the easing of public health restrictions. Previously, concerns were that these businesses could emerge from the pandemic with high debt levels. But this has not occurred to date. Publicly listed businesses are the only group for which timely firm-level data are available. The share of these businesses with inadequate revenues and cash buffers has returned to near pre-pandemic levels. 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. Publicly listed businesses are also well positioned overall to deal with rising interest rates.
• The reliance of some businesses on high-yield debt markets (Vulnerability 3) is judged to be less problematic than previously estimated. New firm-level data confirm that businesses that issue high-yield bonds have other sources of funding available to them, notably bank loans and lines of credit (Box 3). These firms do not appear to pose a systemic risk to macrofinancial stability.

Corporate balance sheets have generally improved over the past year. The pandemic has been challenging for many businesses. Lockdowns and public health restrictions significantly reduced revenues for some, and supply chain disruptions continue to test business models. However, the easing of containment measures has helped the economic recovery, improving the financial health of many businesses. According to the national balance sheet accounts, the economy-wide leverage of non-financial businesses, measured by the ratio of total debt to assets, has declined continuously since its peak in the second quarter of 2020.22 Liquidity, measured by the ratio of total cash to debt, has also reached all-time highs among firms.

Although microdata are not available for small and medium-sized businesses, data from the financial statements of publicly listed firms offer a similar conclusion. Firms at risk are defined as those not generating enough income to cover interest payments on their debt and having limited liquid assets to meet near-term debt obligations. The share of these firms has returned to pre-pandemic levels (Chart 11).23 This is in part because firms operating in the resource sector benefited from an increase in global commodity prices in 2021. Although 17% of firms were at risk, these firms are typically smaller and accounted for much less of a share of overall corporate debt in the fourth quarter of 2021 (1.6%). This share of corporate debt accounted for by firms at risk is also noticeably smaller than it was earlier in the pandemic (3% in the fourth quarter of 2020).

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.24 Bonds accounted for the largest share of the outstanding debt of listed businesses as of the third quarter of 2021. Firms issued most of these bonds at fixed rates, and the bonds are not set to mature for at least five years (Chart 12). This means that only a small share of the bonds will be affected by changes in interest rates over the next few years.

Some of the bonds set to roll over in coming years were issued at a higher rate than the refinancing rate. This suggests that increases to interest rates from their historic lows could have a limited impact on the refinancing costs of existing corporate debt. The issuance of new debt, however, would become more costly than it was in previous years.

Over the past year, some businesses have relied less on high-yield debt markets (Vulnerability 3). The Bank previously raised a concern that some businesses in need of financing would issue high-yield corporate bonds or secure leveraged loans.25 Firms that rely on these riskier debt markets may be vulnerable to a sudden change in investor sentiment. A shift in the risk appetite of investors could lead to a sharp repricing of existing assets (see “A further global repricing of risk”). It would then become both more expensive and more difficult to roll over existing debt and issue new high-yield bonds.

So far in 2022, Canadian businesses have issued high-yield bonds at a slower pace than that of the previous two years, when many firms increased their issuance to take advantage of favourable financing conditions (Chart 13). This may be due to increased funding costs as high-yield spreads have widened, reflecting a decreasing risk appetite for investors. These investors may also be shifting to safer fixed-income assets following broad increases in bond yields. Additionally, heightened uncertainty since Russia’s invasion of Ukraine may cause firms to hesitate to issue high-yield debt. Higher volatility could be particularly important in the oil and gas sector, which typically accounts for a sizable share of this debt.

Recent analysis suggests businesses that issue high-yield bonds have more diversified sources of financing than previously thought. New firm-level data provide a better understanding of how much firms rely on high-yield debt markets relative to other funding sources (Box 3). This evidence suggests that disruptions to high-yield debt markets would have less impact on the Canadian economy than previously assumed because most businesses that use such debt can draw on other funding sources if needed.

Financial system

Fixed-income market liquidity

• Fragile liquidity in fixed-income markets (Vulnerability 4) is a structural vulnerability that stems largely from considerable growth in the asset management sector over the past two decades. This growth has increased the likelihood that a sudden spike in the demand for liquidity could exceed the supply. When many asset managers and other financial market participants try to sell assets at the same time, bank-owned dealers may be unwilling to fully absorb these assets on their balance sheets. As a result, some fixed-income markets could freeze, and financial market participants could be forced to sell assets at significantly reduced prices.
• This vulnerability has not changed significantly over the past year. While the asset management sector grew robustly, growth was more modest in the subsectors that are most likely to suddenly demand liquidity, such as fixed-income investment funds. As well, investment funds are holding a greater share of their portfolios in cash. At the same time, the willingness of bank-owned dealers to supply liquidity may be somewhat more constrained by quantitative tightening (Box 4) and by uncertainty around inflation and Russia’s invasion of Ukraine.

Fixed-income markets remain vulnerable to a sudden spike in demand for liquidity (Vulnerability 4). This structural vulnerability has developed in part because the asset management sector—which includes investment funds, pension funds and insurance companies—has grown from $2.3 trillion in assets under management in 2008 to $7.1 trillion in 2021. Over this period, some asset managers have shifted their portfolios to riskier, less-liquid assets. For instance, mutual funds have increased their allocations to corporate bonds from more-liquid government bonds, including those with a lower quality of credit.27 To meet the claims of their investors or counterparties, asset managers may have to sell fixed-income assets to generate cash. While bank-owned dealers act as the primary intermediaries of fixed-income markets, this role is reinforced under normal conditions by the willingness of asset managers and other financial market participants to both buy and sell fixed-income assets. In a crisis, if many asset managers try to generate cash by selling fixed-income assets, and other financial market participants are unwilling to buy these assets, it may fall upon bank-owned dealers to buy these assets and hold them on their balance sheets. Market functioning could be severely impaired if these dealers are unwilling to buy these assets if, for example, the riskiness of these assets increases or dealers approach internal risk limits. This happened in March 2020, causing some fixed-income markets to freeze and making it harder for firms to generate cash.28

Developments in the asset management sector over the past year have not substantially affected potential demand for liquidity. While the asset management sector grew by 12.6% in 2021, a smaller group of entities that may engage in a significant amount of maturity transformation, credit transformation and liquidity transformation grew by only 4.1%.29 Moreover, the increase in the growth in fixed-income investment funds was mitigated because the share of cash held by investment funds grew over the past year. A subset of fixed-income funds that hold lower-rated, relatively illiquid bonds—making them most likely to rely on cash buffers in a crisis—was the main factor behind this growth.

The willingness of banks to supply liquidity to fixed-income markets may have further decreased. In recent months, volatility in fixed-income markets has increased and market liquidity has declined. As well, ongoing quantitative tightening may reduce excess liquidity in the banking system and place downward pressure on banks’ liquidity coverage ratios (Box 4). As banks approach their internal limits for their liquidity coverage ratios and seek to rebuild their liquidity, their dealers’ capacity to support fixed-income market making may be negatively affected.30

Cyber security

• Russia’s invasion of Ukraine has increased the level of concern around cyber security. Cyber threats (Vulnerability 5) represent a structural vulnerability that stems from the interconnectedness of the financial system—a cyber attack on one part of the system can quickly spread to other parts and threaten financial stability. The greater frequency and sophistication of state-sponsored attacks in the context of the ongoing war in Ukraine have increased the risk that a successful cyber attack could have consequences across the financial system. Against this backdrop, financial institutions and authorities continue to invest in improvements to their cyber resilience.

Cyber threats (Vulnerability 5) are a significant structural vulnerability, given the highly interconnected nature of the financial system. A successful cyber attack on a major financial institution, financial market infrastructure or other critical infrastructure (such as power grids or telecommunications systems) could cause system-wide disruptions. It could also have high financial and reputational costs as well as significant consequences for the smooth and continuous delivery of financial services. For instance, households and firms could temporarily lose:

• access to their funds
• the ability to make electronic payments

Ultimately, public trust in the financial system rests on the ability of participants to protect the day-to-day functioning of the system. This means ensuring resilient operations, which includes preserving the integrity of personal and financial data.

Russia’s invasion of Ukraine has increased the risk of a cyber attack with effects across the entire financial system. While ransomware—the most common cyber threat—could have consequences for the entire system, it has been used mainly to extort money. In contrast, cyber attacks performed in the context of a geopolitical military conflict, which could include targeting a country’s financial system, are purposely designed to inflict the most damage. In recent months, Russia has carried out many cyber attacks on Ukraine in addition to its military offensive. The greater frequency and sophistication of state-sponsored cyber attacks raise the risk that a successful attack in Canada could significantly disrupt the Canadian financial system (see “A cyber attack that has systemic consequences”).33

Financial system participants remain concerned about potential cyber incidents. As in previous years, many of the respondents to the Bank of Canada’s spring 2022 Financial System Survey identified cyber incidents as one of the top three risks for their organizations (Chart 14).34

Financial institutions and authorities continue to invest in improvements to their cyber resilience. The financial industry remains at the leading edge of cyber risk management practices.35 Financial institutions have invested in further improving their security controls and contingency plans, including third-party risk management practices, in light of the most recent state-sponsored and other cyber attacks observed around the world. These and other investments by individual businesses are crucial, but sector-wide action is also needed to address broader implications of a successful cyber incident. The Bank has therefore been actively involved in enhancing collaboration and information sharing across the financial sector. See “Cyber threats” for information on what the Bank is doing to improve the financial system’s resilience to cyber threats.

Climate change considerations

• The risk associated with climate change primarily reflects the high level of uncertainty associated with the transition to a low-carbon global economy. The wide range of possible paths for this transition creates the potential for the quick repricing of assets exposed to climate-related risks, which could lead to stranded assets. Russia’s invasion of Ukraine has increased this uncertainty.
• This risk is amplified by the fact that pricing may not properly reflect hard-to-assess economic and financial risk factors associated with the impacts of climate change (Vulnerability 6). Better disclosure of climate exposures by businesses and financial institutions—along with a clear, detailed and credible transition path by global policy-makers—can facilitate the assessment of risks and the adequate pricing of assets. Both internationally and domestically, initiatives are underway to establish a more standardized and systematic approach to the disclosure of exposures to climate-related risks.
• In the short term, ongoing geopolitical conflicts are threatening global energy security, increasing the dependence on more-polluting fossil fuels (such as coal in Europe) and raising the risk of a delay in necessary transition plans. Over the medium term, the situation is more uncertain. The current high level of energy prices could boost investments in carbon-intensive sectors in the short term, resulting in additional assets being stranded in the future. Conversely, Russia’s invasion of Ukraine could help strengthen momentum toward achieving energy independence by speeding up investments in renewable sources of energy.

The vulnerability associated with climate change stems from the likelihood that the pricing of assets exposed to either physical or transition climate risks does not fully reflect the hard-to-measure future economic risk factors due to climate change (Vulnerability 6). For financial instruments to be appropriately priced, market participants need access to reliable information on firms’ and financial institutions’ exposure to climate-related risks and on their transition plans. The current level of disclosure is not enough to properly assess these risks.

Over the past year, momentum toward a more standardized and systematic approach to the disclosure of exposures to climate-related risks has been building. Investors are increasingly demanding consistent, comparable and useful climate-related information. As a result, several initiatives have emerged to standardize the way firms report their exposures to climate risks. More importantly, standards for disclosure appear to be converging globally.

• Standardization of disclosures to climate risks: The following organizations have recently proposed requirements related to firms’ disclosure of exposures to climate risks:
  • the International Sustainability Standards Board (ISSB)36
  • the US Securities and Exchange Commission (SEC)37
  • the Canadian Securities Administrators (CSA)38
  The rules proposed by the CSA are less prescriptive than the ISSB and SEC standards but, like those standards, are based on the four pillars of recommended disclosures created by the Task Force on Climate-Related Financial Disclosures but are less prescriptive.39 If the finalized Canadian standards for disclosure of climate risks are not largely consistent and comparable with emerging global standards, Canadian businesses may not be able to attract enough capital to facilitate the transition to a low-carbon economy. It is therefore important for disclosure standards in Canada to be aligned with those adopted internationally.
• Systematic disclosure: Before the COP26 climate conference held in November 2021, Canada’s Big Six banks joined the Net-Zero Banking Alliance.40^, 41 This alliance requires members to, among other things:
  • annually publish information on their greenhouse gas emissions
  • regularly disclose progress against a board-reviewed strategy for decarbonizing their activities and assets by 2050
  Moreover, the Canadian government announced in its 2022 budget that the Office of the Superintendent of Financial Institutions will require federally regulated financial institutions to disclose their climate exposures starting in 2024.42 The Bank will begin to report its climate-related financial risks starting in fiscal year 2022.

Despite these developments, the financial sector remains in the early stages of building its capacity to assess risks related to climate change. See “Climate-related risks” for information on what the Bank is doing to help this sector improve its understanding, measurement and disclosure of climate-related risks.

The difficulty in assessing the value of assets exposed to climate change may also reflect jurisdictions’ lack of a clear, detailed and credible economic policy path to achieve net-zero emissions by 2050. In addition to long-term objectives for greenhouse gas emissions, a timely and clear roadmap by global policy-makers for achieving those objectives has the most potential to lower the likelihood of a sharp correction in asset prices. Delayed action would need to be more aggressive in the future to achieve the same goal, making a sudden repricing of carbon-intensive assets more likely and leaving investors exposed to sudden financial losses. Mispricing can defer investments needed to achieve such a transition.

In the near term, current geopolitical conflicts are likely increasing the risk of a disorderly repricing of assets. Russia’s invasion of Ukraine has placed the importance of energy security at the forefront of global policy-making and has served as a reminder that the global economy remains highly dependent on fossil fuels. An embargo against Russian exports of energy commodities would stimulate the exploitation of alternative—and possibly more-polluting—sources of fossil fuels (such as coal) in the short term. And with global prices of energy commodities now substantially higher than they were before the invasion of Ukraine, valuations of carbon-intensive assets appear farther away from where they will need to be in a future low-carbon economy. This short-term increase in prices could promote investments in carbon-intensive sectors in some jurisdictions, which could lead to a larger economic impact, including stranded assets, as the world shifts to cleaner forms of energy.

The long-term impact of current geopolitical conflicts is more uncertain. In response to current conflicts, some countries may seek to accelerate their energy transition plans through greater investments in renewable sources of energy. The desire for energy security could also boost the credibility of existing transition plans, helping reduce market mispricing. Moreover, elevated prices for fossil fuels will encourage consumers and businesses to transition away from this form of energy more quickly.

The Bank will continue to monitor these developments and analyze their implications for climate-related risks and the future of the Canadian economy and financial system.

Cryptoassets

• Cryptoasset markets are growing rapidly, and their expansion has outpaced global efforts to regulate them. Risk is therefore rising, although the Bank assesses that it has not yet become systemic. Investors in cryptoassets do not benefit from the same levels of protection offered for other classes of assets. Considerable swings in prices make these assets inadequate as a method of payment; consequently, they remain primarily a speculative investment. Cryptoassets are, however, becoming more integrated into the traditional financial system, increasing the risk that shocks to these markets could affect the broader financial system. The number of holders of cryptoassets is also growing rapidly in Canada. However, holders of cryptoassets generally underappreciate the risks associated with them.
• Stablecoins have emerged as a potential solution to price volatility in the cryptoasset market (Box 5). They should be less volatile than other cryptoassets because their value is pegged to a national currency in most cases and partially or fully backed by liquid assets in many cases. But the lack of transparency and leverage associated with some of them can lead to disorderly runs when investors start doubting their ability to redeem their funds. This was recently demonstrated by the sudden collapse of some stablecoins. A run on a stablecoin can quickly spread through cryptoasset markets more broadly given the central role this type of backed cryptoasset plays as a method of payment in both crypto trading platforms and decentralized finance. Federal and provincial authorities are moving to develop an integrated regulatory framework for stablecoins, but this remains work in progress.

Cryptoasset markets remain small on a global scale but have grown rapidly in recent years. The market capitalization of cryptoassets (including stablecoins) rose from about US$200 billion at the start of 2020 to a peak of close to US$3 trillion in November 2021 (Chart 15). With the sharp drop in cryptoasset prices in recent months, market capitalization declined to near US$1.2 trillion in early June 2022.43 Expressed on a global scale, these numbers remain relatively small. For instance, according to the Financial Stability Board (FSB), the market capitalization of cryptoassets equalled only 1% of global financial assets at its peak in November 2021.44

Ownership of cryptoassets is also broadening, primarily as a speculative investment rather than a method of payment. In 2021, about 13% of Canadians owned Bitcoin, up from 5% in 2020.45 The median holding of Bitcoin was about $500, mostly for investment purposes. To date, the significant volatility in the prices of these unbacked cryptoassets as well as high transaction costs have been key obstacles to their wide acceptance by merchants as a method of payment. For example, prices of cryptoassets such as Bitcoin and Ether were generally four to five times more volatile throughout 2021 than the S&P 500 stock market index was. Sudden price corrections mean that investors who hold these types of cryptoassets can be exposed to significant financial losses.

Interconnections between unbacked cryptoasset markets and the financial system appear limited but are expanding rapidly. Institutional participation in these markets has grown in recent years. However, estimating the growth of institutional investments in these assets and related infrastructure is difficult due to the lack of readily available and consistent data on the exposures of financial system participants to these markets. Discussions with industry participants suggest that portfolio exposures remain small. Cryptoassets have generally become more accessible to investors in recent years through the emergence of closed-end funds, crypto exchange-traded funds and listed companies dealing in or mining cryptoassets. Moreover, hedge funds and some large pension funds are reportedly investing more in cryptoasset platforms. Cryptoassets are also becoming more integrated into the traditional financial system (often referred to as the financialization of cryptoassets), including through the development of crypto derivatives markets and as investment assets or collateral for loans.

The Bank’s assessment that these markets are not yet of systemic importance is reinforced by the fact that the major sell-off in cryptoasset markets in May 2022 was broadly inconsequential for the traditional financial system in Canada and abroad.

Stablecoins aim to meet the demand for a more liquid and less volatile cryptoasset. Stablecoins play a key role in decentralized finance, a suite of alternative financial products offered in cryptoasset markets that mimic traditional financial services (e.g., loans, insurance, asset management and custody). Like other cryptoassets, stablecoins can also pose risks to financial stability if adopted on a significant scale without appropriate regulatory safeguards, particularly regarding the ability of issuers to respect redemptions (Box 5).

The lack of adequate regulatory frameworks for cryptoassets is a key factor behind this vulnerability. Firms operating in cryptoasset markets often perform functions similar to those of traditional financial institutions. They share many risks but are not subject to the same regulatory standards. Until this regulatory gap is addressed, investors in and end users of unbacked cryptoassets are subject to heightened risk of financial losses from events such as fraud, cyber attacks or the failure of a key custodian or service provider. Moreover, a significant challenge to the regulation of cryptoassets is that they are easily used for transactions across borders. This can be positive for economic activities such as remittances, but it creates opportunities for illegal transactions such as money laundering and terrorist financing.46 For the regulation of these markets to be effective, countries will have to coordinate closely to ensure consistency and prevent criminals from exploiting regulatory gaps.

The regulatory response is taking form but needs to gather momentum. Regulators globally have recognized the risks posed by deficient regulatory frameworks and are working to address them. For instance, in March 2022 the US administration released an expansive executive order:

• launching a strategy on digital assets
• requesting many federal government agencies to jointly examine the regulation of digital assets47

In Canada, provincial securities administrators have issued guidance for the regulation of cryptoassets and cryptoasset trading platforms that meet the definition of securities or securities market infrastructure, respectively. The federal government announced in its 2022 budget that it would conduct a legislative review of the financial sector. The first phase of this review will focus on digital currencies, including cryptoassets and stablecoins.48 As part of that work, the government will examine:

• regulatory approaches to maintaining the security and stability of the financial system as digital currencies become more common
• the potential need for a central bank digital currency in Canada

In addition, a Bank of Canada official currently chairs the FSB Regulatory Issues of Stablecoins working group that is collaborating to promote globally coordinated regulatory responses to stablecoins.

More generally, federal and provincial authorities should move quickly to develop an integrated regulatory regime for cryptoassets, otherwise this vulnerability could continue to worsen.

Risks and resilience

Analysis of banking system resilience

• The resilience of Canadian banks is key to preserving the stability of the financial system. Stress testing of major banks in Canada confirms that even if they faced a large and persistent economic shock, they would likely continue lending to the economy. Therefore, vulnerabilities highlighted in this report are primarily macrofinancial in nature. This means that the repercussions of a shock would adversely affect the real economy through financial linkages, even if the banking system remained solvent.

Bank staff conducted a stress-testing exercise to evaluate the resilience of the banking sector to a large and persistent economic shock.51 They employed a hypothetical risk scenario that entailed a severe and prolonged recession (a 5.8% decline in GDP lasting six quarters) to test the capital positions of domestic systemically important banks in Canada. They assumed no remedial fiscal and monetary policy measures, so the recession had a long-lasting negative impact on the Canadian economy.

In the risk scenario, banks incur significant financial losses but nevertheless remain resilient. The impacts on bank capital are sizable, with banks breaching the capital conservation buffer requirement of 8% during the first two years (Chart 16). The total common equity Tier 1 capital ratio declines rapidly from 12.3% to 7.4% in the first year before recovering to 8.3% by the end of the scenario.52 Although the decline in their capital ratios is sizable, banks are viewed as remaining broadly resilient because the capital ratios remain above the regulatory minimum of 4.5%. They therefore continue lending throughout this scenario and thus contribute to economic activity. Their resilience is supported by solid capital positions, a robust capacity to generate revenues even in times of stress and sound underwriting practices.

Market participants’ confidence in the resilience of the Canadian financial system has reached the highest level reported (Chart 17).53 The Bank’s most recent Financial System Survey revealed that all respondents are confident the Canadian financial system could withstand a large shock. Reasons cited for this high confidence were:

• the well-capitalized banking sector
• the well-regulated financial system
• the pandemic response from fiscal and monetary policy authorities

Risks and financial stability

A large decline in household income and house prices

• This risk has increased over the past year but continues to be macrofinancial in nature, meaning there would be negative spillovers to both the macroeconomy and the financial system. House prices have risen further, and the health of the balance sheets of households is more tied to the value of their home. An increasing share of households have taken out mortgages that are large relative to their incomes, making them more vulnerable to rising interest rates. The likelihood of a shock that reduces real income has also increased.

A shock leading to lower household income—such as a global recession—would significantly reduce the ability of households to service their debts. A sizable decline in house prices could reinforce this effect. As explained in the 2021 Financial System Review, such an event would have an amplified effect on the macroeconomy given the two vulnerabilities identified in this report—the elevated level of household indebtedness and elevated house prices.

For instance, if debt payments take up a large portion of its income, a household facing a job loss could have difficulty servicing its debt without significantly reducing consumption. In addition, if the shock were to cause house prices to drop considerably, reduced equity would further restrain the ability of some households to use secured sources of borrowing, such as home equity lines of credit or mortgage refinancing. Households with limited liquid assets may be forced to liquidate assets or reduce their spending, or both. 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.

The likelihood of this risk materializing and its impact on the economy are greater today than in the past for a few reasons:

• Housing represents a greater share of a household’s assets than in previous decades. This means that household net worth is now more sensitive to movements in house prices.
• With more highly indebted households, an increase in unemployment would lead to more occurrences of financial stress among households.
• High debt levels have made debt service ratios much more sensitive to rising mortgage rates, making indebted households possibly more vulnerable at renewal time.

A further global repricing of risk

• This risk has also increased over the past year. Global financial markets have already experienced a correction. Nevertheless, the risk of a further, disorderly repricing of risk remains. Geopolitical tensions are running high, and the associated economic uncertainty is affecting risk appetite. In addition, major central banks are entering a phase of monetary policy tightening that could interact with existing vulnerabilities.

A global repricing of risk could lead to much tighter financial conditions around the world and in Canada, which would reduce private domestic demand. This risk was discussed at length in the 2021 Financial System Review. A shock causing a significant change in market sentiment could lead to a large drop in the value of financial assets, implying lower net worth for households and firms and lower residential and business investment. If the change in market sentiment were to lead to a sudden increase in demand for safe assets, market functioning could be impaired, given the noted vulnerability of market liquidity to spikes in demand.

In the event of a sudden repricing of risk, financial or commodity-trading firms that are highly leveraged may be unable to meet margin calls or interest payments. Through the use of derivatives and prime brokerage arrangements with multiple lenders, these firms may build highly leveraged positions that their counterparties and regulators are unaware of, as was the case with Archegos Capital Management.54 Left unchecked, positions built up through “hidden leverage” may become large enough to harm financial stability, especially if they are paired with lenders’ concentrated credit exposure to highly leveraged firms. The FSB has identified this issue as a growing concern, and the Bank of Canada is currently participating in FSB initiatives to understand hidden leverage in the global financial system.55

A cyber attack that has systemic consequences

• Recent global geopolitical conflicts have heightened this risk. The greater frequency and sophistication of state-sponsored cyber attacks in the context of Russia’s invasion of Ukraine increase the risks that a successful attack could significantly disrupt the Canadian financial system.

A successful cyber attack that harms critical participants in the financial system could threaten Canada’s financial stability (Figure 2). Attacks perpetrated on a systemically important financial institution, such as a major bank, or a systemic financial market infrastructure (FMI), such as a major payment system or clearing and settlement system, can have cascading effects. Alternatively, targeted attacks on critical infrastructure—such as the electricity grid or providers of telecommunications, cloud or critical services—could disrupt operations in multiple sectors, including the financial sector.

The systemic nature of this risk stems from the fact that participants in the financial system are highly interconnected—operationally, technologically and financially—and share important service providers. A successful cyber attack on a key financial institution, FMI or critical service provider could potentially affect financial stability through one or more of these connections. The attack could impair a financial institution’s provision of services to both its own clients and other financial institutions. For instance, a major bank needing to transfer a large amount of funds to other institutions may not be able to do so if a cyber attack causes its computer system to crash. In turn, other institutions relying on these funds for their operations may not be able to conduct critical business.56

A cyber attack could spread malware from a key financial institution to all other connected institutions, resulting in the potential loss of data integrity, system availability or data confidentiality. A cyber attack that leads to a large financial loss at the targeted financial institution could then result in further losses at other financial institutions. Under certain circumstances, a large part of the financial system may be affected. Such a scenario could reduce the confidence households and businesses place in the financial system, and preserving trust in the system is a key factor in maintaining financial stability. In an extreme situation, this scenario could even lead to runs on banks or funds and fire sales of assets.

Participants in the financial system remain vigilant and continue to invest significantly to maintain their overall resilience against cyber attacks. The sources of these attacks evolve, and cyber criminals develop new strategies that are more sophisticated and harder to detect. The greater frequency and sophistication of state-sponsored cyber attacks, especially the recent attacks by Russia on Ukraine, are of concern.57 The ongoing digitalization of the economy and financial services, while bringing benefits, creates more interconnections and entry points into computer systems for cyber criminals to exploit.

Market view of risks

The Bank solicits the views of financial system participants through its Financial System Survey. The survey results are a useful benchmark to compare Bank views and analytical work with outside opinions. The survey also provides information in areas where the Bank has limited data or insight, and it helps identify new topics for analysis.

Market participants believe that the likelihood of a shock with the potential to severely impair the functioning of the Canadian financial system has increased (Chart 18). This increase is greater in the short term, although the reported medium-term likelihood is slightly higher. For both horizons, market participants cited similar reasons, including increased geopolitical risks, the withdrawal of monetary policy support and higher inflation.

Safeguarding the financial system

• The Bank of Canada collaborates closely with domestic and international partners, both private and public, to improve the resilience of the financial system.

Domestically, the Bank is actively involved with federal and provincial authorities on issues pertaining to the financial system. The Bank chairs the Heads of Regulatory Agencies Committee and its Systemic Risk Surveillance Committee (SRSC), two federal-provincial forums for cooperation on financial sector issues (Box 6). The SRSC’s work contributes directly to the Bank’s assessment of the financial system that is published in the annual Financial System Review. To achieve its financial system goals, the Bank also collaborates with federal, provincial and international authorities as well as industry through financial system committees. In particular, the Bank participates actively in the Senior Advisory Committee (SAC) and the Financial Institutions Supervisory Committee.

Internationally, the Bank contributes to discussions on financial system issues. Through many committees and working groups, the Bank regularly collaborates and shares information with other central banks, the International Monetary Fund, the World Bank, the FSB, G7 and G20 members and the Bank for International Settlements.

Household debt and elevated house prices

The Bank contributes to financial stability by helping to increase awareness of ongoing and emerging risks related to household finances and the housing market. Through the Financial System Review, the Financial System Hub and public speeches by members of Governing Council, the Bank shares pertinent research and analysis, drawing insights to help households, lenders and policy-makers better identify and mitigate risks. Through its membership on committees, the Bank also actively engages in dialogue and information sharing with various federal and provincial authorities.

In Budget 2022, the federal government announced measures to help reduce imbalances in the housing market. In particular, it proposed banning foreign investors for two years to increase the supply of homes for sale to domestic residents. As well, investments in affordable housing are designed to boost housing supply. These measures would better align housing supply and demand, which could help to moderate increases in house prices over the medium term.

More generally, federal authorities periodically review the need to adapt regulatory guidance and policies to make sure the risks to financial institutions and the financial system as a whole remain contained. For instance, in June 2021, the Office of the Superintendent of Financial Institutions (OSFI) and the Minister of Finance implemented a new minimum qualifying rate used in stress tests on uninsured and insured mortgages issued by federally regulated financial institutions.60 OSFI committed to reviewing the minimum qualifying rate at least annually, in December. It will also conduct a holistic assessment of Guideline B-20: Residential Mortgage Underwriting Practices and Procedures to ensure it remains clear and appropriate.61

Financial market functioning

Efforts at interest rate benchmark reform

Since 2013, work has been underway globally to address concerns about the reliability and robustness of major interest rate benchmarks—including the London Interbank Offered Rate (LIBOR). At the end of 2021, this work reached a major milestone with the discontinuation of all Japanese-yen, Swiss-franc, euro and British-pound LIBOR rates as well as some of the less used US-dollar LIBOR rates. Work continues to prepare financial markets for the discontinuation of the remaining US-dollar LIBOR rates after the end of June 2023.

In Canada, work on domestic benchmark reform has been led by the Canadian Alternative Reference Rate Working Group (CARR), a committee established by the Canadian Fixed-Income Forum in 2018. CARR brings together the Bank and 22 firms from across the Canadian financial system. In 2021, CARR began examining the efficacy of the Canadian Dollar Offered Rate (CDOR) to ensure Canada’s benchmark regime remains robust, relevant and effective. CDOR is a major interest rate benchmark in Canada; it underpins more than $20 trillion worth of derivatives, securities and loans and plays a key role in the market for bankers’ acceptances.

CARR’s work on reviewing CDOR culminated in December 2021 with the publication of a white paper recommending that CDOR’s administrator, Refinitiv Benchmark Solutions (UK) Ltd. (RBSL), cease the publication of CDOR after the end of June 2024.62 The recommendation included a two-stage transition plan to move from CDOR toward the Canadian Overnight Repo Rate Average (CORRA) as the primary interest rate benchmark in Canada. After a public consultation on CARR’s recommendation, RBSL announced on May 16, 2022, that it would cease the publication of CDOR after June 28, 2024.63 OSFI provided support for the implementation of CARR’s two-stage transition path by referencing CARR’s timelines in its supervisory expectations for federally regulated financial institutions and private pension plans.64

CARR will manage the transition until CDOR ends. This work includes:

• developing and maintaining a roadmap that outlines steps and timelines needed for Canadian markets to transition from CDOR in a timely manner, including various “CORRA first” initiatives to support CORRA liquidity
• determining whether a term CORRA rate is feasible and appropriate for Canada for certain loan products—and developing such a rate, if appropriate
• identifying securities that reference CDOR and that would be affected by CDOR’s cessation, and identifying solutions for securities that will be difficult to move to a new reference rate
• identifying any potential legal, accounting or taxation-related roadblocks to the transition away from CDOR

Other initiatives

The Bank has been working with the financial industry through the Government of Canada Market Functioning Steering Group to develop a framework for supporting the market functioning of Government of Canada securities in a low interest rate environment. This framework includes an industry-wide “fail fee” for failing to deliver Government of Canada securities for settlement. It also provides a complementary set of recommended industry best practices relating to those settlements. This steering group will conduct an industry-wide consultation on the fail fee later in 2022 before the Canadian Fixed-Income Forum makes a final decision on its implementation.

Through its role as Chair of the Canadian Foreign Exchange Committee, the Bank has also been working with industry to encourage all firms active in the foreign exchange (FX) market in Canada to adopt the FX Global Code to demonstrate their commitment to a well-functioning FX market.65 The code is a set of 55 principles of good practice to promote a robust, fair, liquid, open and appropriately transparent market. It was developed through a partnership between central banks and market participants from 20 jurisdictions around the world.

Cyber threats

The 2022‒24 Cyber Security Strategy is the foundation for the Bank’s work on cyber threats. The strategy focuses on three pillars:

• integrating cyber resilience in all of the Bank’s own operations
• collaborating with external partners to improve the resilience of the financial sector
• providing clear cyber security guidance to inspire confidence in the financial system

The Bank has also been responding to the competitive market for cyber security staff by developing new strategies to identify and recruit talent as well as to retain and develop existing employees. Further, the Bank is playing a coordinating role within the financial sector to increase public-private partnerships aimed at enhancing cyber security talent management and development. This issue is important to the entire financial sector.

Domestically, many of the cyber security initiatives the Bank leads are taking place through the Canadian Financial Sector Resiliency Group (CFRG) and the Resilience of Wholesale Payments Systems (RWPS) initiative.

• The CFRG is a forum of key private and public participants from the financial sector. It facilitates various initiatives to improve the financial sector’s operational resilience. These initiatives include conducting tabletop exercises and investigating the risks from interconnections with critical infrastructure in other sectors. In the event of an operational incident with potential systemic consequences, the CFRG helps coordinate the response of its participants.
• The RWPS is a collaboration between the Bank, Canada’s six largest banks and Payments Canada to share information and enhance the cyber resilience of Canada’s wholesale payments systems.

Following Russia’s invasion of Ukraine and the corresponding increase in risks to cyber security in the financial sector, the Bank and its partners reinforced their cooperation and information sharing. The CFRG meets regularly, and members have worked diligently to re-examine contingency plans around cyber security. The group’s tabletop simulation exercises provide members with an opportunity to practise how they would communicate with each other to share information and coordinate their decisions if a major cyber incident occurred. The Bank has also participated in similar discussions and simulations with its G7 counterparts.

Over the past year, Canadian federal authorities have published new guidance on best practices around cyber resilience for some key participants in the financial system. In October 2021, the Bank introduced new Expectations for Cyber Resilience of Designated Financial Market Infrastructures. The Bank is using these expectations to assess the cyber resilience of designated FMIs. Similarly, OSFI is reviewing comments it received during public consultations on Draft Guideline B-13: Technology and Cyber Risk Management. The guideline will apply to all federally regulated financial institutions.

Climate-related risks

To help the financial sector assess and disclose its climate exposures, the Bank is developing scenario-based approaches. For consistency and comparability, financial institutions need a common understanding of how the Canadian economy will evolve under various pathways to reduce greenhouse gas emissions. The Bank is using its expertise in macroeconomic modelling to provide reference projection scenarios for the financial sector. Earlier this year, the Bank and OSFI published the results of a pilot project that used climate scenarios to assess transition risks.66 This project was an important first step toward gaining a better understanding of the potential exposure of the financial sector to climate transition risks. It also helped participants improve their ability to perform climate scenario analysis and adapt their risk management practices to climate change.

Building on the success of this initiative, the Bank continues to collaborate closely with OSFI and financial system participants to assess financial risks stemming from climate change. Notably, Bank staff are analyzing the exposure of the real estate sector and mortgage portfolios to flood risks. And they are improving the Bank’s capacity to assess the systemic nature of climate-related risks, including those related to the transition to a low-carbon economy. The Bank is also enhancing its framework for modelling the macroeconomic effects of the transition. This will inform future stress testing and scenario analysis.

The Bank is reviewing its market operations to better integrate climate change considerations.67 To support this review, the Bank will consult with financial market participants and other stakeholders in autumn 2022. This consultation is intended to obtain views on adjustments the Bank may consider introducing to its financial market operations to promote the resilience of the financial system.

Given the global nature of climate change, the Bank continues to be actively involved in the climate work of a variety of international bodies, including the G7, the G20 and the FSB. In particular, the Bank sits on the steering committee of the international Network of Central Banks and Supervisors for Greening the Financial System. Through this forum, the Bank uses its influence and expertise to promote a scenario-based approach to the disclosure of climate-related risks.

Innovations in Canada’s payment systems

Safe and robust payment systems are crucial to overall financial stability.68 They enable consumers, businesses and governments to safely and efficiently purchase goods and services, make financial investments and transfer funds.

The Bank continues to partner with Payments Canada and industry organizations to modernize Canada’s core payment systems, notably around two initiatives:

• Lynx: At the end of August 2021, Payments Canada successfully launched Lynx, Canada’s new large-value payment system. Upon its launch, the Governor of the Bank of Canada designated Lynx as a systemically important payment system, including it under the Bank’s oversight.69 This new payment system is more resilient and cyber secure than its predecessor, the Large Value Transfer System.70 It also incorporates a more robust framework for financial risk management by settling payments in real time on a gross basis. A second release of Lynx is planned for late 2022 to introduce the ISO 20022 message standard, which will enable more data-rich payments.
• Real-Time Rail: The new retail payment infrastructure will support instant payments for individuals and businesses. Its launch is targeted for the second half of 2023.

The Bank continues to prepare for its new role supervising retail payment service providers (PSPs).71 Retail payments is an area of the financial system experiencing rapid growth and innovation, and PSPs are evolving in the electronic payment ecosystem. In 2021, the Bank’s tool kit for promoting the resilience of the financial system expanded. Under the Retail Payment Activities Act, which received Royal Assent in June 2021, the Bank will be responsible for supervising PSPs. In this role, the Bank will build confidence in the safety and reliability of services provided by PSPs while protecting end users from specific risks. The Bank is currently supporting the Department of Finance Canada in developing the regulatory framework for the new retail payments regime.

Endnotes

This report includes data received up to June 7, 2022.