Canada shows early signs of financial crisis

Banking body flags property price gap, high credit disparity among concerns

Canada has been flagged by a global banking body for “vulnerabilities” tied to credit, property prices, and the prospect of rising interest rates.

In a quarterly review published Monday, the Bank for International Settlements, or BIS, said Canada is among the jurisdictions showing early warning indicators for financial crises and domestic banking risks.

The report measures credit and housing prices relative to gross domestic product as well as the ability to service debt in the event of rising interest rates. “Canada, as well as a group of Asian countries, saw increases in the credit gap since September 2016,” the report said.

In its fall report, the BIS indicated that Canada had one of the highest credit-to-GDP ratios among developed nations. That report said the country’s “unusually” elevated level posed a threat to the country’s banking system.

China’s credit to GDP gap remains higher, at 26.3 per cent, according to Monday’s report, but Canada’s 17.4 per cent figure is up from last fall and well above the closely watched BIS threshold of 10 per cent.

The report notes that two-thirds of banking crises were preceded by credit-to- GDP gaps that breached the 10 per cent threshold during the three years before the event.

Canada’s relatively large “property price gap” was also noted in Monday’s BIS review.

Other countries including Germany, some in central and eastern Europe, Greece, Japan, and Portugal were put in the same category, but the BIS said high property price gaps in the latter three countries doesn’t necessarily indicate vulnerabilities because it is being driven by price growth returning to “normal” levels after long periods of decline.

The report said debt service ratios are at manageable levels for most countries provided there are no changes to interest rates. But Canada is flagged alongside China and Turkey as countries that face “potential risks” under more stressed conditions that assume a 250 basis point increase in rates.

The debt service ratio for Canada would jump to 7.9 from 3.6 in such a scenario, according to the BIS report. That’s the second highest among 22 countries measured, lagging only China.

The banking body cautioned that its interest rate sensitivity figures are not the result of a “proper stress test,” and noted that a rise in rates would take time to translate into higher debt service demands.

It is also possible that higher rates would not be fully passed through to consumers, with the degree of pass-through dependent on factors including the share of debt at floating rates, debt maturities, and possible changes in borrowing behaviour, the report said.

Much of the debate around Canada’s buoyant housing market has centred on the growing amount of Canadian household debt, and questions about the ability of consumers to handle their overall debt burdens if and when interest rates rise from prolonged lows.

In a year-end review in December, the Bank of Canada highlighted key vulnerabilities to the Canadian financial system, which included elevated household debt, imbalances in the housing market across the country, and fragile fixed-income market liquidity. But the report from Canada’s central bank also said the “household vulnerabilities” would be mitigated over time by new housing finance rules introduced last year.

The BIS is essentially a bank for central banks around the world.