The Bank of Canada says the risks buffeting the Canadian financial system have declined for the first time in two years thanks to the fading threat of a euro financial crisis and a slight uptick in long-term interest rates.
The central bank lowered its overall risk rating Tuesday to "elevated" from "high," where it has stood since December 2011, when the four-point ranking was put in place.
The bank's first downward adjustment leaves the ranking just one notch above the lowest risk score on the four-point scale.
"The euro area has continued to stabilize, and there are clearer indications that structural imbalances are subsiding" the bank said in its twice-yearly financial system review. "The likelihood of a euro-area financial crisis has diminished."
Canadian financial institutions have relatively little direct exposure to euro area banks. But they have much more significant ties to U.S. and British banks, which could cause indirect problems in the event of a crisis, according to the bank.
Elsewhere, the risks to the financial system have remained stable since the bank's last snapshot in June.
The main threat to the financial system on the home front remains the housing market, where rising prices and high household debt levels have left borrowers and lenders alike exposed.
"The Canadian financial system will remain vulnerable to macroeconomic shocks that affect the ability of households to service their debts," according to the report. "Stretched housing valuations and the elevated number of units under construction could also lead to a sharp correction in the housing market.
Bank of Canada governor Stephen Poloz and other bank officials have expressed surprise at the recent return to rising home sales and prices in some markets.
The report said this strength is likely to persist "over the coming months." But the bank said it appears to be a more of a blip than renewed boom as buyers "pull forward" purchases to avoid higher interest rates.
In Toronto, some condo builders have begun construction of units early to avoid a planned increase in development charges, the bank said.
The bank remains concerned about the Toronto condo market, where there is an "oversupply" of units and construction activity remains "significantly above" the historical average. The possibility of a correction remains, according to the report.
And yet the report pointed to an encouraging "moderation" in borrowing by Canadians. So while the ratio of household debt to disposable income remains high at 163.4 per cent in the second quarter, the ability of borrowers to carry their debts continues to improve.
The bank also pointed out that the growth of consumer debt is at its lowest level in 20 years and homeowners are doing less refinancing to take equity out of their homes.
"These indications of underlying household caution suggest the broader trend toward more sustainable conditions will resume after the temporary pulling forward of housing market activity has dissipated," according to the 65-page report.
The bank said it expects the closely-watched debt-to-income ratio will "eventually diminish over the coming years," depending on the pace of eventual mortgage rate hikes and the strength of the global recovery.
The rise in longer-term interest rates has already improved the financial health of pension funds and insurers – a concern of the bank in previous reports.
Beyond the housing market and the euro crisis, the other main risks to the financial system include risky behaviour caused by interest rates that stay low for long and problems in emerging markets, including China.