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The rising probability of a recession and a spike in riskier borrowing by Canadian companies are among the growing threats to the country’s financial system, the Bank of Canada says.

Risks to the system have increased “slightly” over the past year, largely because the probability of a severe recession is “elevated and increasing,” the central bank warned Thursday in its annual Financial System Review.

“Global uncertainty is rising and risks to financial stability have edged up in the past year,” Bank of Canada Governor Stephen Poloz told reporters in Ottawa.

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The bank blamed the deteriorating financial environment on a slower economy, the U.S.-China trade standoff and persistent weakness in Canada’s oil and gas sector.

However, the central bank is not predicting a recession, traditionally defined as two consecutive quarters of falling GDP. Its official forecast, released last month, calls for the economy to grow 1.2 per cent this year and 2.1 per cent in 2020.

“Risks are only that, without a trigger to turn them into reality,” Toronto-Dominion Bank economist Brian DePratto said in a research note. He added that, by definition, the financial system review “should give us a bit of a scare.”

The bank said it recently conducted a stress test to see how Canada’s large banks would handle a severe nationwide recession, marked by a 40-per-cent drop in housing prices and a six-percentage-point rise in the jobless rate. It concluded that while banks would suffer substantial losses, they are “well positioned” to manage them thanks to their large capital buffers.

Mr. Poloz told reporters he expects financial risks to recede in the coming months as the economy bounces back from a slowdown in the first few months of the year.

Meanwhile, the bank’s dominant concerns of recent years – a housing crash and Canadians piling on too much debt – have “declined modestly” since the bank’s last report in June, 2018. That’s because the pace of borrowing has slowed and the country’s two hottest real estate markets – Toronto and Vancouver – have cooled owing to higher interest rates and stricter mortgage rules.

“These are encouraging signs,” Mr. Poloz said.

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The report highlights a major new vulnerability facing the financial system – “fragile” borrowing by Canadian companies.

The Bank of Canada said it is also closely monitoring a surge in borrowing by non-financial companies, particularly those exposed to lower prices for oil and other commodities. The ratio of debt to corporate income now stands at 315 per cent, or “well above” the historical average.

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Opinion: Growing list of economic good news complicates Bank of Canada’s interest-rate outlook

Many of these companies are turning to the bond market for cash, particularly in the United States. Non-financial companies more than doubled their bonds outstanding to $580-billion from $270-billion between 2008 and 2018. And 60 per cent of those bonds are being issued in U.S. dollars, compared with just 40 per cent in 2007.

Companies with lower credit ratings are also increasingly tapping into the U.S. syndicated loan market. Outstanding loans of this type to Canadian companies now total $175-billion, up from $80-billion four years ago.

This exposure makes companies vulnerable to shifting investor sentiment, particularly as these loans come due, the bank said.

Some bond-rating agencies say worries about rising corporate debt, in Canada and elsewhere, may be overblown. While total corporate debt is up, the ratio of debt to cash flow has remained relatively stable over the past decade, even for energy, pipeline and mining companies, according to a report this month by Toronto-based DBRS Ltd.

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And DBRS pointed out that low interest rates mean companies can manage more debt. It said the risk profiles of the Canadian companies it tracks “remain sound and generally within the investment-grade category.”

The Bank of Canada has also begun tracking the financial risk posed by climate change, working with other central banks around the world.

“Climate change continues to pose risks to both the economy and the financial system,” the report said. “These include physical risks from disruptive weather events and transition risks from adapting to a lower-carbon global economy.”

The bank pointed to research that suggests Canada is warming significantly faster than the rest of the world.

The report warned of a “limited understanding and mispricing of climate-related risks,” and that could inflate the cost of transitioning to a low-carbon economy.

“Few firms disclose the financial impact of climate change on their assets and operations,” the bank said. “There are inconsistencies in how firms report climate-related risks across industries and regions.”

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