By Daniel Seleanu, Compliance Complete

TORONTO, July 1, 2014 (Thomson Reuters Accelus) – Canada’s overheated housing market represents a significant risk to the stability of its financial system, the country’s central bank has warned.

In its recently released Financial System Review (FSR) (PDF), the Bank of Canada (BOC) warned that while the system was stable overall, it remained vulnerable to several risks that could trigger a disorderly market correction. The economic and financial consequences of such a correction would be severe, the BOC predicted.

The FSR describes four key risks to Canada’s financial system, all of which ultimately relate to housing:

A sharp correction in housing prices resulting from a large macro-economic shock. The BOC believes this scenario carries elevated risk, low probability, and severe potential impact.

A sharp increase in long-term interest rates globally, including in Canada, likely resulting from an overshoot in US rates. The BOC believes this scenario carries moderate risk, low probability, and moderately severe potential impact.

Stress emanating from China and other emerging market economies that could be triggered by a severe financial disruption in China, associated reversal of Chinese economic growth, and the subsequent, widespread impact on global economic and financial systems. The BOC believes this scenario carries elevated risk, moderate probability, and moderately severe potential impact.

Financial stress from Europe with global consequences, possibly caused by market concern over banking sector health or a sudden economic shock related to geopolitical tensions in Ukraine and Russia. The BOC believes this scenario carries elevated risk, moderate probability, and moderately severe potential impact.

Risk 1: Housing market correction

The risk of precipitously declining home prices was the primary focus of the BOC’s financial stability report. “A serious, widespread correction in house prices resulting from a sharp increase in unemployment is the most important domestic financial system risk,” it said. Despite judging the probability of such an outcome to be “low,” the BOC stressed that the severe economic and financial impact justified an “elevated” risk rating.

Underscoring the centrality of this risk, the BOC explained that the other three could each act as triggers for a housing correction. Macroeconomic shocks from rapidly-rising US interest rates, Chinese economic stress, or a European financial crisis would cause a sharp increase in Canadian unemployment and thus sharply reduce the ability of Canadians to service their debts, the BOC explained. It added that stretched valuations in certain housing segments, namely Toronto condominiums, combined with worrying levels of household indebtedness, make Canada vulnerable to shocks of this nature.

“Given the importance of housing to the Canadian economy and financial system, the impact of such a situation would be widespread, and there could be significant adverse feedback between economic and financial conditions that would amplify its impact,” the FSR said.

The possibility, albeit relatively low, for a persistent and substantial decline in housing prices would impact the financial system through several channels, including financial sector links to the housing market, broader financial market impacts, and negative feedback from the economy. The BOC noted that Canadian financial institutions would face simultaneous declining revenues and increased loan losses. Without singling out any particular institutions, the BOC warned that mortgage and consumer debt defaults could cause especially severe losses for “certain institutions and mortgage insurers”.

Risk 2: Interest rate spike

The second key financial system risk outlined by the BOC was that from significantly higher interest rates resulting from “an overshoot in US long-term interest rates triggered by a reassessment by markets of US monetary policy”. While observing a “relatively smooth” reaction to the Federal Reserve’s tapering of asset purchases, and predicting a lower probability of future US monetary policy adjustments, the BOC warned that a jump in US long-term interest rates would cause a “moderately severe” impact on Canada. That impact, it said, would travel through multiple channels and be driven by wider global financial and economic consequences.

“Unexpected changes to the market perceptions of the path of US monetary policy could trigger a sudden rise in global term premiums, surges in market volatility, and sell-offs across asset classes, all of which could be exacerbated by the rapid unwinding of positions and structural changes in liquidity in some market segments. Close correlations of global term premiums would immediately transmit the interest rate shock to Canada, and Canadian investors could incur significant losses,” the BOC explained.

Due to strong integration across global financial markets, movements in the United States would likely be replicated in Canada, characterised by increased volatility and widespread asset devaluation. “Aside from sustaining losses, it could also negatively affect investor confidence and lead to a significant increase in market funding costs for Canadian financial and non-financial corporations,” the BOC said. It added that if US economic growth were to weaken significantly as a result of tighter financial conditions, then Canadian banks active in the United States could experience related losses.

Reiterating the threat of a housing correction, the report also stressed that a sudden, conservative shift in US monetary policy would put upward pressure on Canadian long-term interest rates, which would increase debt-service costs for Canadian households, potentially leading to a rise in mortgage defaults and downward pressure on residential real estate prices.

Risk 3: Stress from China and other emerging markets

Financial and economic stress emanating from serious financial disruptions in China, leading to a significant slowdown in Chinese economic growth, represents another key systemic risk for Canada. The BOC stressed that the probability of this risk materializing had increased over the last six months, due to growing vulnerabilities in China’s financial system. Major stress in China would have widespread repercussions on global economies and financial systems, the report said, adding that it would cause a moderately severe impact on Canada.

“The trigger for this risk could be a series of defaults that begin in the shadow banking sector and rapidly spread across the Chinese financial system, leading to a deep credit squeeze that, in turn, could sharply reduce economic growth in China. The resulting decline in global commodity demand and prices would be transmitted back to Canada through its extensive exposures to the commodity sector,” the FSR said.

As with the other risks, the BOC warned that Chinese economic decline could trigger a Canadian housing market correction, due to plunging global aggregate demand and subsequent high unemployment. Additionally, it noted that Canada’s significant exposure to global commodity demand and prices would be a key channel for transmitting the contagion to the Canadian financial system.

“Weaker demand for Canadian exports from other countries, in addition to lower commodity prices, could also induce extensive commercial loan losses at Canadian banks and other financial sector entities,” the report said.

“Canadian regional economies that depend on the commodity or export sectors would experience a serious downturn that could lead to a correction in regional housing and real estate markets. Smaller financial sector entities with assets highly concentrated in these regions, could experience a significant level of default that could trigger failures.”

The BOC also emphasised that Canadian equity markets would likely experience related declines that were disproportionate to global peers, due especially to the significant weight of the commodity sector on the Toronto Stock Exchange (TSX). “Feedback between adverse financial system and economic events would then overlap,” the report predicted.

Risk 4: Eurozone stress

Finally, the BOC highlighted the key risk posed by financial stress from a renewed Eurozone crisis. However, while noting that significant vulnerabilities remained in the European financial system, the BOC observed positive developments since the end of 2013, which it said reduced this risk from “high” to “elevated”.

Shifting market views regarding the adequacy of European bank-balance sheet repairs, or a political shock from Russia and Ukraine, would be transferred to Canada through its exposure to financial markets, the report said. Additionally, it stressed that Canada’s economy could be further affected through trade channels, “and if the impact was sufficiently severe, it could trigger a correction in house prices”.

According to the BOC, there is a moderate probability that financial stress in Europe could be triggered by, for example, sudden investor insecurity regarding the health of the banking sector or a reversal of economic recovery that would negatively impact banks and sovereigns. This could cause a dangerous debt spiral that would spread across the financial system, which would then have broad repercussions for Canada, the report explained.

The FSR predicted that a European financial crisis would induce a “flight to safety,” a widespread retrenchment from risk, and a broad repricing of assets. In keeping with the theme of real estate vulnerability, the report warned: “Such widespread effects on Canada’s financial system and economy could also trigger a sharp correction in the Canadian housing market.

(This article was produced by the Compliance Complete service of Thomson Reuters Accelus. Compliance Complete provides a single source for regulatory news, analysis, rules and developments, with global coverage of more than 400 regulators and exchanges. Follow Accelus compliance news on Twitter: @GRC_Accelus)