Bank of Canada Says Financial System Strong Despite Shock

(Bloomberg) -- Canada’s financial system remains resilient even in the face of the Covid-19 pandemic and moves to keep credit markets functioning have been largely effective, though risks remain, according to the Bank of Canada.

The country’s largest banks remain well capitalized even in the most pessimistic scenario, though some smaller lenders may struggle, and many businesses, especially in the energy sector, face higher funding costs and potential downgrades, the central bank said Thursday in its annual Financial System Review.

Canada entered the crisis with strong banks, the protection of a robust mortgage insurance system and an economy in a solid position, the central bank said. “With these strengths, as well as the aggressive government policy response to the pandemic, the largest banks are in a good position to manage the consequences,” policy makers led by Governor Stephen Poloz said in the 39-page report that nevertheless outlines significant, across-the-board risks to the financial system.

Small energy firms, lower-rated companies and some alternative lenders were singled out as potential flash points.

It’s the central bank’s first comprehensive statement about the risks to Canada’s financial stability since the economy went into lockdown in mid-March. Since then, policy makers have expanded the bank’s balance sheet by about C$270 billion ($192 billion) in efforts to prevent credit markets from seizing up. Purchases of assets including government bonds, bankers acceptances and commercial paper have been successful and in many cases uptake has declined, the central bank said.

Policy Response

The bottom line from the central bank is things would have been much worse without the massive monetary and fiscal response. Yet even with that response, the fallout from the economic shutdown will be worse than the 2008-2009 crisis, policy makers said, and the longer the crisis lasts, the worse things could become for households and businesses.

“Overall, the Bank of Canada still sees the financial system as resilient. But the longer the economy remains tamped down, or if there are second waves of the virus once restrictions are eased, there could be further strains that require policy makers to take even more aggressive action,” wrote CIBC economist Royce Mendes in a note.

Running the more pessimistic scenario from the April 15 Monetary Policy Report, which assumes a second-quarter economic contraction of 30%, the bank finds policy actions combined with payment deferrals limit the rise in mortgage arrears, with the rate of around 0.8% in the second half of 2021. That’s still almost double the peak rate in 2009.

Since the Covid-19 shock, higher-risk Canadian firms are finding it difficult to tap U.S. leveraged loan markets, and some alternative lenders have suspended redemptions to cope with liquidity pressures. In addition, other small independent lenders which normally finance small firms “have reported challenging market conditions that, if persistent, could jeopardize the future of their business.”

Alternative lenders, such as mortgage investment corporations, have become increasingly important for the provision of credit to households and small businesses, and now account for 1.5% of residential mortgage lending nationally.

Households Vulnerable

The bank acknowledges that many Canadian households face financial difficulty as jobs have been lost due to Covid-19. A significant share of the labor force is unemployed or underutilized and that will “continue for an unknown period.”

The weakness in the labor market, along with physical distancing, have led to a decrease in housing activity. Both housing sales and listings are down sharply. Households may feel even more financially burdened if they are having difficult selling their homes. Most Canadian households see prices declining over the next six to 12 months.

Highly indebted households will have a hard time managing income losses from lost employment. About 20% of all mortgage borrowers do not have enough liquid assets to cover two months of mortgage payments.

Poloz downplayed concerns the central bank’s role in financing government spending could lead to a loss of its independence. “This government has been unwavering in its commitment to central bank independence throughout this,” Poloz said during a press teleconference in Ottawa. “We’ve behaved in ways which have been completely consistent with our inflation target. The key anchor to all that is the inflation target.”

The governor, who steps down next month, cited the adage that central banks have the power to lend, while governments have the power to spend. “That distinction is crucial, and for us, the business of lending really only really has its power when people have confidence in the inflation target and therefore the independence of the central bank,” he said.

“The objective is, in the first instance, market functioning. That’s crucial, because the monetary policy actions we’ve taken won’t go anywhere if financial markets were to stay gummed up as they were in early March.”

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