Serious, but low probability, risks remain from the ongoing credit crunch, according to the Bank of Canada.

In the latest issue of the Financial System Review, the central bank says that the Canadian banks, “appear to be well positioned to absorb the effects of the recent market turbulence, because of their initial sound capital positions and strong profits.”

However, it says that uncertainty remains in financial markets. “The fragility of some markets — especially those for structured products — is continuing to hinder the ability of market participants to value assets normally traded in those markets. The difficulty in valuing assets is creating uncertainty about the accuracy and comparability of the losses reported by participants,” it says.

“Amid this uncertainty, a shock could lead to a marked increase in risk aversion, a further deterioration in liquidity in markets, and a widening in risk premiums. The impact could extend to some markets that, to date, have been little affected,” it warns.

Shocks could include a much greater deterioration in the U.S. housing market than financial markets currently expect. “A further increase in risk premiums, together with the slowing in the U.S. economy, could also lead to a slowing of activity in the world outside the United States. This could reduce or reverse the recent improvement in global imbalances, again raising the prospect of a disorderly resolution of these imbalances. This could entail an abrupt and sizable decline in the value of the U.S. dollar, greater volatility in financial markets, a further rise in risk premiums, and an increase in protectionism,” it cautions.

The Bank judges the probability of this scenario as low. “But if it were to materialize, the greater-than-expected slowing in the U.S., and possibly the global, economy, together with a decline in commodity prices and an unexpected rise in the Canadian dollar, would reduce the profitability of Canadian exporters and increase stress on Canadian businesses, households, and financial institutions,” it says. “This would have a significant effect on the Canadian financial system.”

The Bank alos suggests that it is unlikely that financial markets will return to their pre-turbulence state, as the narrow credit spreads did not adequately reflect the risks that were being taken, and it expects some changes in the functioning of the financial system because of the difficulties highlighted by the recent market events.