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The Bank of Canada says its aggressive actions to provide liquidity and stability to pandemic-strained financial markets are working, adding that the country’s banks are well capitalized to weather even more pessimistic scenarios of recovery.

But the central bank’s annual Financial System Review cautioned that household and corporate borrowers still face serious pressures and uncertainties due to the shutdowns and lost incomes stemming from the crisis.

“To be clear, the pandemic remains a massive economic and financial challenge, possibly the largest of our lifetimes, and it will leave higher levels of debt in its wake,” Bank of Canada Governor Stephen Poloz said in a teleconference with reporters following the release of the report.

However, he said, “I am confident that a strong financial system will help Canada emerge from this episode in relatively good shape.”

The bank noted that some of the pressures on the financial system have been “amplified” by the high debt levels of households and businesses going into the crisis – vulnerabilities the bank has long warned about.

“Without the aggressive policy responses, banks would be faring much worse, with important negative effects on the availability of credit to households and businesses,” the report said.

The Financial System Review normally discusses the health of the financial system and assesses its vulnerability to risks. But with this year’s report coming out in the midst of a severe shock, the review focused largely on analyzing the effectiveness of the wide range of market measures the central bank has taken to shore up financial markets and credit channels – measures that have swelled its balance sheet to $400-billion from about $120-billion before the crisis began.

The bank defended its market actions, in particular its decision to launch large-scale purchases of federal, provincial and corporate bonds – a first for the central bank.

“These programs have succeeded in restoring good functioning to many key financial markets that had been showing signs of significant stress,” Mr. Poloz said. “Bid-ask spreads and yield spreads in many markets have narrowed significantly. Access to liquidity for financial institutions has greatly improved. And many of our programs to support financial markets are being used less and less as conditions stabilize.”

The bank reiterated that it remains prepared to “adjust the scale of these programs as market conditions change.”

The Financial System Review is Mr. Poloz’s last major report as head of the central bank. His tenure ends June 2. Tiff Macklem, a former second-in-command at the bank, was named this month as his successor.

“It’s clear Governor Poloz is willing to do more if necessary. However, he’ll be handing the reins to Tiff Macklem in a couple of weeks, so we’ll see if the tone changes once the new governor is in place,” said Bank of Montreal economists Benjamin Reitzes and Robert Kavcic in a research note.

The bank’s report said its measures have helped keep much-needed credit flowing to businesses and consumers. It said that in March and early April, businesses drew down about 15 per cent of their credit lines, but use was much higher in the battered energy sector, where companies drew down almost 40 per cent of their credit lines. Mortgage-secured lending to households in March grew at its fastest rate in almost three years.

“According to a recent survey, almost 30 per cent of businesses requested additional credit from a financial institution in the first quarter. Small and medium-sized enterprises have reported a high rejection rate compared with normal times, indicating some stress,” the bank said.

“What started as a cash flow problem could develop into a solvency issue for some businesses. This becomes more likely if the loss in revenues extends over a long period."

Mr. Poloz said the ability of companies to survive the COVID-19 shutdowns is "a very central phenomenon” in determining how well the economy is able to recover in the coming months. “Each month you’re adding more and more stress onto those companies,” he said, adding that if significant numbers of businesses were to fail, it would result in a “scarring” of the economy.

The bank’s analysis estimated that in the “pessimistic” case that the lockdowns last significantly longer than expected, the rate of non-performing business loans could rise to 6 per cent – well above previous recession-fuelled peaks in 2003 (4.8 per cent) and 2010 (4.1 per cent).

However, Mr. Poloz expressed confidence that the supports and lending facilities the federal government has put in place for businesses, as well as the Bank of Canada’s actions to keep the credit taps open, will limit the damage.

“I’m comfortable that this thing is going to work,” he said. “But it all depends on how long this containment period lasts. We’ve got some positive signs now that we’re starting to open things up, and that’s going to make all the difference.”

The bank said the pressure on the highly indebted household sector has been greatly eased by the federal government’s emergency programs, which provide $2,000 a month to people who have lost their jobs and subsidize wages for employers. In addition, it said, lenders have allowed 700,000 households to defer their mortgage payments.

However, it warned that households will come under pressure once these deferral periods end.

“The proportion of households with debt-service payments of more than 40 per cent of their income, an indicator of household vulnerability, is likely to rise,” it said. It added that the situation in Alberta and Saskatchewan, which have been even harder hit due to the slump in the oil sector, “is of particular concern."

It estimated that mortgage arrears in the “dire” scenario of extended lockdowns, as Mr. Poloz called it, could peak at about 0.8 per cent next year, almost double the peak in 2009.

“The longer the income shock lasts, the greater the risk of a rise in consumer insolvencies.”

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