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Household debt emerges as greatest risk to Canada's financial system Add to ...

Surging household debt is emerging as the greatest risk to Canada's financial system, the Bank of Canada said Monday.

On the whole, the country's banks and credit markets are as strong as could be expected amid the deepest global recession since the Second World War, the bank said in its bi-annual Financial System Review.

"Despite the severe impact of the global crisis, the Canadian financial system has continued to perform well compared with those of other countries," the Bank of Canada said in coming to the conclusion that overall risks to the financial system are unchanged from its last report in December.

That's largely because the hundreds of billions of dollars of liquidity that major central banks have injected into the global financial system. Rock-bottom interest rates have lowered the cost of borrowing.

But the risk posed by household balance sheets has grown, the Bank of Canada. The level of debt to income reached a record in the fourth quarter as real net worth dropped 6.7 per cent from the same period a year ago, the central bank said.

While stressing that the possibility of a mass bankruptcy is remote, the ability of Canadians to repay their bank loans has replaced frozen credit markets as the main fear factor among policy makers, the report said.

"There has been a further deterioration in the financial position of the Canadian household sector as a result of the continued turmoil in financial markets, the deepening global recession, and worsening labour market conditions," the report said. "Nonetheless, in aggregate, the financial situation of Canadian households remains reasonably healthy."

Canadians' household debt is about 140 per cent of disposable income, compared with about 150 per cent in Britain and almost 170 per cent in the United States. The level is about 90 per cent among the countries that use the euro.

To test the financial system's vulnerability to a shock from a wave of bankruptcy and default, the Bank of Canada ran a simulation assuming an unemployment rate of 10 per cent - well above the 8.4 per cent jobless rate in May.

The central bank ran a test assuming an average duration of unemployment of 20 weeks and an average duration of 25 weeks. The result: the proportion of insolvent households would increase by 1.4 per cent and 2.1 per cent respectively; the resulting losses at financial institutions would equal about 10 per cent of their Tier 1 capital.

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