The Canadian financial system remains sound, although there are risks on the horizon, concludes the Bank of Canada in its latest Financial System Review.

“Since the release of the last Financial System Review in June 2005, the global and domestic financial systems have remained sound. Globally, benign macroeconomic conditions have supported financial stability,” the Bank says. It notes that healthy economic growth and low interest rates have helped financial institutions, non-financial corporations, emerging economies and households to stay financially strong.

However, as the European Central Bank also noted today, the Bank says that the Canadian financial system remains exposed to the risk of a disorderly resolution of global imbalances. “While this risk is low over the near term, it remains a key consideration over the medium term,” it suggests.

Growing imbalances could pose challenges to global financial stability in the future. “Since June, global economic growth and favourable interest rate differentials have led to ample capital flows that have allowed smooth financing of global imbalances. This has, however, also increased the imbalances themselves and, thus, the possibility of a disorderly resolution remains a key risk over the medium term. As well, the prices of riskier assets appear to reflect investor expectations of an extended continuation of favourable financial developments.”

While global financial markets and asset prices have proven to be resilient in the face of several negative shocks, including the sharp rise in energy prices, “the potential for a significant price reversal in riskier assets remains,” the Bank cautions. Overall, the Bank of Canada concludes that the risk of a shock having a significant negative impact on the Canadian financial system is small.

“The implications of persistently low yields on long-term bonds are also a key risk consideration to monitor. Should the current factors driving the high current levels of desired global savings relative to business investment remain in place over the medium term, long-term bond yields could remain below those previously deemed appropriate in light of the economic fundamentals. Such an outcome would have implications for many financial system participants,” it notes.

That said, the Bank suggests that, despite the past appreciation of the Canadian dollar and substantial increases in energy costs, the overall financial situation of the Canadian non-financial corporate sector remains robust, based on an analysis of indicators available through the third quarter of 2005. “Similarly, the household sector appears to pose a low risk to the financial system, despite a continued rise in indebtedness and sharply higher energy-related expenditures,” it says.

As for the fact that the Bank is raising rates, it notes that updated simulations continue to indicate that a return of policy rates to more normal levels should not materially impair the credit quality of household debt. And, it adds that the likelihood of a marked reversal in house prices in major Canadian markets also appears limited.

“Overall, the credit quality of the assets of the Canadian banking sector has remained strong and close to recent cyclical highs. The quality of assets continued to contribute to the very strong financial results reported by major Canadian banks in the first half of 2005,” it says. “The strong capital position of the banking sector continues to provide institutions with a buffer should adverse economic or financial developments occur.”

“Other financial institutions in Canada, such as securities dealers, life, health, and property and casualty insurance companies, also continued to report robust profitability,” it observes.