BoC warns of risks to financial stability

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BoC warns of risks to financial stability

By Vieira , Financial Post June 21, 2010 9:14 AM

OTTAWA -- The risks to financial stability have shot upward in the past six

months, the Bank of Canada said Monday, as mounting worries over Europe's

sovereign debt threaten to freeze funding markets, derail the global recovery

and trigger a " disorderly " resolution of global trade imbalances.

In its semi-annual financial system review, the central bank's governing council

warned financial stability would be on shaky ground until policy makers in key

economies -- like those in the Group of 20 -- agree to banking reforms designed

to curb risk taking, and outline credible plans to return to more sustainable

debt levels.

" While many aspects of the Canadian macrofinancial environment have improved …

the governing council considers that, overall, the near-term risks to the

financial system have increased, " the central bank said.

" Despite forceful policy actions to stabilize the global financial system since

2007, several of the vulnerabilities that contributed to the crisis remain, and,

in some cases, may have been exacerbated. "

The report provides further colour that might help explain the central bank's

cautiousness in terms of the future path for monetary policy. While Canadian

economic growth has to date exceeded expectations, governor Mark Carney said

last week in a speech that more rate hikes are no sure thing as aggressive

budget-cutting in Europe and concern about bank exposure to sovereign debt could

drag down global growth.

The central bank suggested world leaders, who are set to meet at the G20 summit

in Toronto this coming weekend, might want to focus on reducing the risks in the

financial system.

" Safeguarding financial stability will require strong and appropriately targeted

policy actions to reform global financial systems and to establish sustainable

fiscal positions, " the central bank said in its review. " Until this is achieved,

the financial system is likely to remain fragile. "

The bank's risk assessment highlights how strong Canadian financial markets

participants have held up through the recession and into the early stages of the

recovery -- but warned domestic markets are not immune to developments across

the Atlantic and elsewhere.

Over the past six months, the risks to funding and liquidity markets, global

imbalances and the overall outlook have increased, the central bank said. The

threat posed by household debt, which stands at record levels based on a

debt-to-disposable income ratio, remained unchanged from December.

The increase to the risks can be traced back to Europe, which emerged as a focal

point after Greece asked for international aid to help refinance its debt. In an

effort to calm market fears, European policy makers designed a nearly

US$1-trillion rescue package to help support the euro currency and backstop some

of its more indebted members, such as Spain, Portugal, Italy and, of course,

Greece.

" While these measures have been helpful in tempering the recent stress in

financial markets, they fall short of providing a lasting solution to fiscal

challenges, " the bank's review said.

To date, the central bank said, Canadian bank funding has been largely

unaffected by Europe-led pressures in short-term money markets. Yet, the Bank of

Canada said lending could be upended as Europe's public finances " reawaken "

tensions in some international bank funding markets.

The concern from the Bank of Canada's view is that the " intensification " of

sovereign risk could lead to tighter lending conditions, as banks hoard cash in

a time of uncertainty, and governments go too far in trying to bring discipline

to their balance sheets.

Plus, record-low interest rates in developed economies are pushing capital

toward emerging markets. The central bank said this " may be causing excessive

credit growth and the creation of asset bubbles, " which heightens the risk that

key developing economies, led by China, could cool down " abruptly " .

Also, pending banking reforms -- which will ultimately require banks to keep

more and better quality capital on their balance sheets -- would pose " some

challenges " in the lead up to their implementation, the Bank of Canada said.

Plus, it added the reforms, which the G20 wants to get an agreement on by end of

year, could be " diluted " over concerns they may stifle lending just as the

recovery gains steam.

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