According to the BoC, the risks to the financial system are similar to those identified in the June report. However, the BoC judges that the overall level of risk has "increased markedly" over the past six months.
The main risks identified by the BoC in the report are:
- the spillovers associated with a further escalation of the European sovereign debt crisis;
- an economic downturn in advanced economies that could be amplified by remaining weaknesses in the balance sheets of global banks;
- a disorderly resolution of global current account imbalances;
- financial stress in the Canadian household sector; and
- a prolonged period of low interest rates, which may encourage imprudent risk-taking and/or erode the long-term soundness of some financial institutions.
The section of the report on Canada's increased household indebtedness is particularly noteworthy. As I've previously highlighted, Canada's household debt-to-GDP is currently at a record high. According to the report, the situation could take a turn for the worse in the event of a significant decline in house prices and a sharp deterioration in labour market conditions (p.26). With Canada's unemployment rate increasing, business investment slowing and final domestic demand declining, I view the possibility of these risks materializing as being quite real.
Also, in regard to the situation in Europe, the report mentions that the euro area is now experiencing a recession and correctly points out that a comprehensive policy response is urgently needed to resolve the debt crisis. On this point, the report states:
The European sovereign debt crisis is acute, but it can be resolved if policymakers address the situation in a forceful manner. European authorities must take steps to restore confidence, which will create time to refound their monetary union based on credible fiscal arrangements and enhanced governance.Finally, the report indicates that an economic downturn in advanced economies
European authorities are working to strengthen the capital of European banks and provide a more reliable funding backstop for euro-area sovereigns. But, judging from the lingering skepticism of investors, bolder action—including clear decisions and firm implementation—is needed to get ahead of the crisis. (p.14)
would have a substantial impact on Canadian businesses, households and financial institutions. While the most obvious channel of transmission would be via the effects of deteriorating credit quality on bank capital bases, these effects could be amplified by significant vulnerabilities in the global economy, including an intensification of funding pressures and of fiscal strains. (p.14) (emphasis added)According to the BoC, the risk described above is judged to be high and has risen since June, owing primarily to the deterioration in the global economic outlook.
All in all, the picture drawn in the BoC's report is bleak. Therefore, from a macroeconomic policy standpoint, it would be prudent for federal and provincial governments to abandon efforts to cut public expenditures and reduce fiscal deficits. Rather, governments should prepare for the worse and draw up plans to inject additional stimulus into the economy if the need arises in the coming months.