A stable and efficient financial system is essential for sustaining economic growth and raising standards of living. In the Financial System Review, the Bank of Canada identifies the key sources of concern for the financial system in Canada and explains how they have evolved over the past year.
The structure of the Financial System Review is undergoing a series of changes to more clearly communicate the risks to financial stability. For 2023, the Bank is no longer discussing financial system vulnerabilities and risks separately; these are now combined under several key areas of concern. This approach reduces repetition, improves readability and allows for a more concise and direct analysis of the nature and level of risk. In short, it allows the Bank to take a more deliberate look at what could go wrong and what the implications would be for financial stability. Another key change is removing from the publication the discussion of issues related to the efficiency of the financial system. These issues will be covered through regular postings to the Financial System Hub.
The Financial System Review is a product of the Governing Council of the Bank of Canada: Tiff Macklem, Carolyn Rogers, Paul Beaudry, Toni Gravelle, Sharon Kozicki and Nicolas Vincent.
Over the past year, financial conditions have tightened globally in response to monetary policy actions aimed at reducing inflation. Recent stresses in the banking sector in the United States and Switzerland further tightened financial conditions. Authorities in these countries reacted swiftly, limiting the spillover effects to the broader financial system.
These events have exposed vulnerabilities—notably, business models that rely excessively on an environment of low interest rates and low volatility—and serve as a reminder that risks can emerge and spread quickly. As the financial sector adjusts to higher interest rates, participants, regulators and central banks must be more vigilant about vulnerabilities and risks.
Canadian regulators have taken important steps to help safeguard the financial system. Canadian banks remain robust, but they are not immune to international developments. The reliance of Canada’s large banks on wholesale funding makes them vulnerable to deteriorating conditions in global financial markets. If the cost of wholesale funding were to rise significantly due to a persistent period of global financial stress, it could lead to Canadian banks tightening lending conditions, making it more difficult and expensive for Canadian households and businesses to access credit.
In light of higher borrowing costs, the Bank of Canada is more concerned than it was last year about the ability of households to service their debt. More households are expected to face financial pressure in the coming years as their mortgages are renewed. The decline in house prices has also reduced homeowner equity, and some signs of financial stress—particularly among recent homebuyers—are beginning to appear.
A large negative shock, such as a severe global recession with significant unemployment that further depresses house prices, could increase loan defaults among households. If defaults on uninsured mortgages with negative equity were to occur on a large scale, they could result in sizable credit losses for Canadian lenders.
Elevated funding costs and persistent periods of stress can reduce the capacity of the banking sector to provide market liquidity. This liquidity is crucial to financial stability given the growing importance of non-bank financial intermediaries, such as asset managers, and their reliance on fixed-income liquidity. If a significant spike in demand for liquidity were to occur, it could lead to a potentially destabilizing decline in asset prices.
The Bank remains concerned about threats to financial stability from a major cyber incident, particularly in the context of rising geopolitical tensions and Russia’s ongoing war in Ukraine. A successful cyber attack that damages activities in one part of the financial system could spread quickly, undermining the public’s confidence.
Climate change also poses significant risks. These risks include disruptions from more frequent and extreme weather events and uncertainty about the transition to a low-carbon economy. The measurement of these risks remains inconsistent globally, and their disclosure, insufficient. For these reasons, assets exposed to these risks may be mispriced. An abrupt repricing of these assets could lead to losses for financial system participants.
Cryptoasset markets do not currently represent a significant concern for the stability of the Canadian financial system. They remain small and mostly separate from the financial system. If they do become more interconnected, shocks in these markets could spread to the broader financial system and affect financial stability.
The Bank will continue to closely monitor the financial system for early signs of strain and has the tools to provide emergency liquidity to the financial system if severe stress were to develop.
Deposit runs at Silicon Valley Bank and Signature Bank led the US Federal Deposit Insurance Corporation to take control of both institutions and offer extraordinary support to their depositors.1 Soon after, Credit Suisse came under severe stress, and Swiss authorities responded by facilitating a takeover by UBS. These events increased volatility in US government bond markets from already-elevated levels (Chart 1).