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Public enemy No. 1 for Canadian investors, according to investor advocate Daniel Solin? The Big Six banks.

KEVIN VAN PAASSEN/THE GLOBE AND MAIL

They aren't yet in the clear, but Canada's bank chiefs can breathe a bit easier.

That's the official word from the Bank of Canada in its latest Financial System Review, which runs through the biggest threats to the stability of Canada's financial system. The central bank concluded the environment today is much less risky relative to when it released its last review half a year ago.

Some data points that demonstrate why the situation isn't so dire: sovereign debt yields have dropped significantly in Europe; Canadian household borrowing is definitely slowing; and the U.S. fiscal cliff hasn't nearly been the devil some feared it would be.

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However, the Bank still cautions that overall level of risk in Canada's financial community remains in the 'high' category. And in this market, investors themselves aren't quite sure how to respond to new data, so they can quickly overreact. Just look at 10-year U.S. Treasury yields for proof.

Europe remains the biggest quagmire. Although at-risk countries can now borrow at much more manageable interest rates, "financial fragmentation across the euro area remains 'high,' and there has been limited further progress on the reforms needed to address underlying structural imbalances and to increase potential output growth," the report noted.

"In the euro area, reform fatigue could weaken the political will to proceed with the necessary fiscal and structural reforms. Such an outcome would slow the repair of public and private balance sheets in the region and make them more vulnerable to changes in market sentiment, which could lead to renewed funding pressures and tighter lending conditions," the Bank of Canada added.

Here's some tangible proof of the thin ice they're skating on. Just last week, U.S. Federal Deposit Insurance Corp. vice chairman said Deutsche Bank is "horribly undercapitalized," which means that if the environment turned toxic again, the bank's investors could get quite freaked.

Canadians' household debt levels are also problematic, despite finally plateauing. Anyone who now has a mortgage is at the mercy of the housing market, and the bank still thinks there's a decent chance of a price correction.

Plus, the Bank isn't so sure that Canadians understand the interest rate risk they're exposed to when their mortgages must be re-financed. "Households need to assess their ability to service their debt over the entire maturity of their loans, especially since borrowing rates will eventually return to a more normal level," the report noted.

To sum it up, the report reads as though the Bank of Canada is cautiously optimistic. Whether that pushes the banks' stock prices higher remains to be seen, but analyst Andre-Philippe Hardy at RBC Dominion Securities is extremely bullish -- noting Monday that he thinks bank stocks could offer total returns of 15 to 22 per cent in the next year.

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"We believe that current bank valuations already reflect modest expected growth in earnings, while book value growth and dividend yields are attractive. We do not expect material multiple compression, short of bouts of risk aversion or the market expecting a recession, while there is modest upside to multiples in a healthier economic growth environment," he noted.

(Tim Kiladze is a Globe and Mail Reporter.)

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