Overview 9. Elevated household indebtedness and housing market imbalances continue to pose financial stability concerns. During the decade...
Overview 9. Elevated household indebtedness and housing market imbalances continue to pose financial stability concerns. During the decades-long credit upcycle, low interest rates and low capital charges for mortgage lending, together with policies promoting housing affordability, have fueled borrowing to finance home purchases in the face of rapidly rising house prices. Risk mispricing has contributed to debt accumulation among financially weak households, with problems more exacerbated in regions experiencing larger housing market imbalances. During severe downturns, Canada-specific housing finance characteristics may amplify procyclical effects of falling house prices, and the impact on growth could be protracted due to household balance sheet adjustments. 10. Market data suggests that systemic stress of financial institutions is low. Based on the market-based analysis of 19 large financial institutions as of December 2018,
the probability that several financial institutions experience distress simultaneously was near historical lows. The systemic stress measure, which captures the number of institutions potentially becoming distressed and the system-wide expected loss, has been broadly stable over the past few years. Nevertheless, potential contagion effects appear to have risen over the past decade, reflecting interconnectedness among financial institutions and/or growing common exposures to the housing market. 11. The financial system would be able to manage severe macrofinancial shocks, but additional required capital for mortgage exposures would help improve its resilience. While major deposit-taking institutions would remain resilient, mortgage insurers would be vulnerable. Furthermore, larger capital buffers to account for potential sharp deterioration of credit quality of mortgage exposure during severe downturns, along with measures to improve mortgage risk-pricing, can help moderate procyclical effects driven by housing market corrections. The non-prime mortgage lending segment, albeit small, shows some vulnerabilities. Existing government support, which underpins the overall Sources: Bloomberg; Moody's Analytics; and IMF staff estimates. 1/ The analysis is based on the “Surveillance of Systemic Risk and Interconnectedness” approach. See Segoviano and Goodhart (IMF WP/09/4) and Technical Note on Systemic Risk and Interconnectedness Analysis, 2016 United Kingdom FSAP (IMF Country Report No. 16/164). The sample includes 10 depoittaking institutions, 7 insurers, and 2 other nonbank entities. 2/ Cascade effects capture the probability that at least another institution become distressed given than a particular institution became distressed. 3/ The systemic stress measure comprises (i) number of institutions to become distressed given than at least one became distressed; and (ii) expected loss related to the 1st-percentile tail risk. Both indicators are combined based on their percentile ranking. 0.0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1.0 0 10 20 30 40 50 60 70 80 90 100 2005M3 2007M12 2010M9 2013M6 2016M3 2018M12
Cascade effects of systemic banks and insurers (probability; right scale) 2/ Joint probability of default Systemic stress measure 3/ Market Perception of Systemic Stress, 2005-181 Index between 0 and 100, representing from low to high systemic stress CANADA INTERNATIONAL MONETARY FUND 13 robustness of housing finance, should be guided by a policy framework that achieves proper riskpricing and promotes financial stability. 12. Vulnerabilities are emerging due to rising risk-taking by nonbanks and increased interconnectedness, warranting enhanced monitoring. In response to the low interest rate environment, institutional and retail investors are taking greater risks to achieve higher returns, contributing to compressed risk premiums. The rapid unwinding of these investment positions could amplify market volatility. Furthermore, Canada’s financial system continues to evolve rapidly, with complexity and interconnectedness potentially masking vulnerabilities and amplifying spillovers. Key Macrofinancial Risks and Vulnerabilities 13. Macrofinancial vulnerabilities have declined recently but are still substantial. Given relatively limited fiscal and external vulnerabilities (Figure 3), financial stability risks remain heightened mainly due to:1 High household indebtedness (Figure 4). Household debt reached 96 percent of GDP at end2018. Canadian households are among the most indebted in advanced economies. Their debtservicing obligations, already relatively large, could increase as interest rates rise. Households as a whole have large buffers, with net wealth of 489 percent of GDP. However, the share of debt belonging to households with excessive indebtedness or weak debt-servicing capacity exist has increased significantly over the past decade. Persistent housing market imbalances (Figure 5). Overvalued house prices (relative to fundamentals such as income or rent) continue to underpin the imbalances. House price-at-risk analysis suggests that house price overvaluation and tight financial conditions have contributed to downside risk to house prices. Based on current macrofinancial conditions, a large housing market correction in the medium term is possible. With a 5 percent probability, average real house price could fall by at least 12 percent year-on-year over the next three years, with potential larger price declines in major cities such as Toronto and Vancouver. Growing corporate debt (Figure 6).
Corporate debt has risen rapidly to 111 percent of GDP at end-2018, largely driven by debt issuance (including in foreign currency) and non-mortgage borrowing. Overall profitability has recovered from the economic slowdown, but firms in the oil and gas and mining sectors continue enduring weak earnings. The rapid increase in debt of firms in the real estate sector raises a concern, especially given their weak income growth. The share of debt belonging to financially weak firms (with publicly available financial statements) is small. 14. Growth-at-risk analysis points to substantial downside risk to growth due to significant macrofinancial vulnerabilities. Growth-at-risk analysis provides a distribution of real GDP growth forecasts conditional on financial conditions and macrofinancial vulnerabilities, the 1 See Appendix II for the methodologal details of macrofinancial vulnerabilities analysis. CANADA 14 INTERNATIONAL MONETARY FUND latter capturing corporate and household sector vulnerabilities, housing market imbalances, and credit-to-GDP gap. As of 2018Q3, the analysis suggests a 5 percent probability that real GDP growth would be -1.7 percent or less over the next year, and -1.6 percent (annualized) over the next three years. Downside risk to growth has declined over the past year due some reductions in housing market imbalances and credit-to-GDP gap
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