Keeping the Financial System Healthy
We are all better off if the financial system can weather a storm or two. And every one of us plays a role in keeping it that way.
A strong economy depends on it
We rely on our financial system whenever we take out a loan for a house or a car, buy insurance or save for retirement. Businesses rely on it to access working capital and the investments they need to grow. Everyone depends on it to help manage risk and make payments safely and quickly.
But if the system isn’t working well, people have a hard time getting access to the money they need. This can weaken the economy. Although it doesn’t happen often, sometimes things can go really badly. For example, during the financial crisis 10 years ago, more than 5 million Americans and 60 million people worldwide lost their jobs.
Weaknesses can make bad events even worse…
The financial crisis is an extreme example, but bad things happen all the time. Some shocks can have large impacts, causing a recession, an increase in business bankruptcies and layoffs, for example.
A healthy financial system can absorb events like these. But if there are widespread weaknesses—what we call “financial system vulnerabilities”—the impacts of these events can become much worse. The effects can ripple through the financial system and across the economy.
These vulnerabilities are like a crack in the trunk of a tree. In good weather, there is little to worry about. In an intense storm, though, the crack makes the tree vulnerable. Hit by a gust of wind or a lightning strike, the tree could fall, damaging a house or car or even taking power lines down with it.
An important vulnerability in Canada these days is the high amount of debt carried by some families. Low interest rates and higher house prices have led to more borrowing. This helped to support the economy through the global financial crisis and the crash in world oil prices that started in 2014.
But by 2016, about one in five families taking out new mortgages was borrowing more than four-and-a-half times its income. Loans of that size can make it hard to handle payments if a homeowner’s income drops or borrowing rates go up unexpectedly.
…and then we all pay the price
The tree with a crack in its trunk could cost its owner—especially if the tree breaks and lands on her car or house. If the problem ended there, the responsibility could stop with the owner, too. But if the cracked tree takes down a power line or blocks a major roadway, the costs would be large and widespread, affecting many more people.
Similarly, people carrying a lot of debt and the banks that lend to them face risks to their own financial health. But they also increase risks for others. If a recession were to happen and enough borrowers with high debt stopped paying back their loans, banks might reduce their lending to everyone. That would make the recession worse and add further stress on the financial system. And if one financial institution experiences significant financial stress, the impact might spill over to others because the financial system is so inter-connected these days. As well, if many borrowers had to sell their houses quickly to repay their loans, house prices would drop, leaving many other families with less wealth.
This is how weaknesses that start in the financial system lead to negative consequences for the entire economy. History tells us that recessions are more severe when the financial system is weak.
Watching over the system
At the Bank of Canada, we identify and track vulnerabilities in the financial system and advise government on how to deal with them. How we do this is discussed in our Financial System Review and our Financial System Hub, which we invite you to explore when it’s launched in November.
The right tools for the job
Good policies can make the system stronger and the bad scenarios less likely.
The world’s major economies have worked together since the crisis to make the global financial system safer. One key step in this international effort toward greater safety is the requirement for banks around the world to have a bigger cushion to absorb losses from bad loans. This allows them to continue lending even in situations where many borrowers stop making payments.
In Canada, government-backed mortgage insurance also helps keep banks healthy if lots of people can’t make their mortgage payments. Uninsured mortgages require a minimum 20 per cent down payment. This also provides lenders with significant protection.
In addition, the federal government has tightened the rules for getting a mortgage. “Stress tests” check whether borrowers could still afford payments if interest rates go up by 2 percentage points. Although it is too soon to tell for sure, there are signs that the stress tests (along with other measures) are helping to reduce the number of new mortgages with high loan-to-income ratios.
It’s worth the cost
Tighter mortgage rules do prevent some Canadians from getting a mortgage for a more expensive home. And toughening up banking standards can limit bank profits and maybe even their lending.
It can be hard to accept these costs during good times, when bad outcomes seem far-fetched. But experience shows that a weak financial system can lead to serious problems. The costs we bear to manage weaknesses protect us by making the worst outcomes much less likely.