The threats to Canada's financial system have not turned more severe, but the Bank of Canada does fret about the strength of smaller lenders that make risky loans.
In its latest Financial System Review released Thursday, Canada's central bank didn't raise many caution flags about the Big Six banks, but did devote substantial space to smaller financial institutions such as credit unions, trust companies and mortgage investment corporations, citing them as some of the most vulnerable to regional property market shocks.
"Canadian households with very high debt-to-income ratios, who tend to be younger with lower incomes, are even more vulnerable to shocks related to interest rates and income," the Bank of Canada wrote, and "smaller financial entities in Canada are increasing their lending to these higher-risk households, as well as to other risky sectors."
While "domestic systemically important banks" have barely increased their exposure to construction loans and non-residential mortgages since 2007, smaller financial institutions have seen these types of loans jump to just over 30 per cent of their commercial loans, up from roughly 20 per cent in 2007.
There is a silver lining: These financial institutions don't account for a large portion of total domestic lending. The Bank of Canada estimates smaller financial entities issue up to 20 per cent of outstanding household and business credit across the country. Plus, the central bank isn't incredibly worried about a sharp housing price correction.
However, "there are signs of overbuilding in certain segments of the housing market," and the Bank of Canada worries about individual lenders that are susceptible to these individual pockets. Even more troubling, housing downturns have historically, although not always, been regional affairs. This could further hurt smaller financial entities, as they tend to focus on smaller geographic markets and often lack the financial diversity that allows major institutions to better absorb losses.
Should any of these firms get hit during a downturn, the central bank worries about their ability to keep funding themselves – a situation that could lead to a liquidity crunch. "Some of these entities are dependent on less-stable funding sources; for example, brokered deposits (which represent a greater source of rollover risk and interest rate risk), bulk mortgage sales and private-label securitization," the Bank of Canada noted.