A stable and efficient financial system is essential for sustaining economic growth and raising standards of living. In the Financial System Review, the Bank of Canada identifies the key sources of concern for the financial system in Canada and explains how they have evolved over the past year.
The structure of the Financial System Review is undergoing a series of changes to more clearly communicate the risks to financial stability. For 2023, the Bank is no longer discussing financial system vulnerabilities and risks separately; these are now combined under several key areas of concern. This approach reduces repetition, improves readability and allows for a more concise and direct analysis of the nature and level of risk. In short, it allows the Bank to take a more deliberate look at what could go wrong and what the implications would be for financial stability. Another key change is removing from the publication the discussion of issues related to the efficiency of the financial system. These issues will be covered through regular postings to the Financial System Hub.
Over the past year, financial conditions have tightened globally in response to monetary policy actions aimed at reducing inflation. Recent stresses in the banking sector in the United States and Switzerland further tightened financial conditions. Authorities in these countries reacted swiftly, limiting the spillover effects to the broader financial system.
These events have exposed vulnerabilities—notably, business models that rely excessively on an environment of low interest rates and low volatility—and serve as a reminder that risks can emerge and spread quickly. As the financial sector adjusts to higher interest rates, participants, regulators and central banks must be more vigilant about vulnerabilities and risks.
Canadian regulators have taken important steps to help safeguard the financial system. Canadian banks remain robust, but they are not immune to international developments. The reliance of Canada’s large banks on wholesale funding makes them vulnerable to deteriorating conditions in global financial markets. If the cost of wholesale funding were to rise significantly due to a persistent period of global financial stress, it could lead to Canadian banks tightening lending conditions, making it more difficult and expensive for Canadian households and businesses to access credit.
In light of higher borrowing costs, the Bank of Canada is more concerned than it was last year about the ability of households to service their debt. More households are expected to face financial pressure in the coming years as their mortgages are renewed. The decline in house prices has also reduced homeowner equity, and some signs of financial stress—particularly among recent homebuyers—are beginning to appear.
A large negative shock, such as a severe global recession with significant unemployment that further depresses house prices, could increase loan defaults among households. If defaults on uninsured mortgages with negative equity were to occur on a large scale, they could result in sizable credit losses for Canadian lenders.
Elevated funding costs and persistent periods of stress can reduce the capacity of the banking sector to provide market liquidity. This liquidity is crucial to financial stability given the growing importance of non-bank financial intermediaries, such as asset managers, and their reliance on fixed-income liquidity. If a significant spike in demand for liquidity were to occur, it could lead to a potentially destabilizing decline in asset prices.
The Bank remains concerned about threats to financial stability from a major cyber incident, particularly in the context of rising geopolitical tensions and Russia’s ongoing war in Ukraine. A successful cyber attack that damages activities in one part of the financial system could spread quickly, undermining the public’s confidence.
Climate change also poses significant risks. These risks include disruptions from more frequent and extreme weather events and uncertainty about the transition to a low-carbon economy. The measurement of these risks remains inconsistent globally, and their disclosure, insufficient. For these reasons, assets exposed to these risks may be mispriced. An abrupt repricing of these assets could lead to losses for financial system participants.
Cryptoasset markets do not currently represent a significant concern for the stability of the Canadian financial system. They remain small and mostly separate from the financial system. If they do become more interconnected, shocks in these markets could spread to the broader financial system and affect financial stability.
The Bank will continue to closely monitor the financial system for early signs of strain and has the tools to provide emergency liquidity to the financial system if severe stress were to develop.
Global macrofinancial conditions
- In March 2023, the US and Swiss banking sectors faced acute stresses. Authorities in those countries reacted swiftly, limiting spillover effects. But these events highlight the fact that financial institutions need to adapt to higher interest rates after more than a decade of low rates. The adjustment will be more difficult for institutions with business models based on low interest rates, weak risk management practices or both. In this context, financial system participants and authorities must increase their vigilance.
- If a sustained period of financial stress were to occur, it could further reduce liquidity in fixed-income markets. It could also add to bank funding pressures and the cost of credit, further challenging the ability of some households to service their debt.
The global financial system came under stress in early March 2023
Deposit runs at Silicon Valley Bank and Signature Bank led the US Federal Deposit Insurance Corporation to take control of both institutions and offer extraordinary support to their depositors.1 Soon after, Credit Suisse came under severe stress, and Swiss authorities responded by facilitating a takeover by UBS. These events increased volatility in US government bond markets from already-elevated levels (Chart 1).
The deposit runs at these institutions unfolded rapidly by historical standards, showing that social media and digital banking can accelerate such developments. The seizure and sale of First Republic Bank in early May suggests that the adjustment of the regional banking sector is ongoing. Concerns around the negotiations on the US debt ceiling are also contributing to volatility in the short-term US Treasury market, and this volatility will likely increase if a resolution is not found.
The recent events in the banking sector followed other periods of stress in the non-bank financial system over the past year. One notable example was the strain faced by pension funds in the UK gilt market in autumn 2022. This event required an extraordinary intervention by the Bank of England to restore normal functioning in the gilt market.
High and persistent inflation led major central banks to rapidly increase policy interest rates
The recent bank stresses occurred against the backdrop of major central banks tightening monetary policy to reduce inflation. The Bank of Canada increased its policy rate by 425 basis points (from 0.25% to 4.5%) between March 2022 and January 2023 and began quantitative tightening in April 2022.
As intended, financial conditions have tightened globally over the past year in response to these monetary policy actions. Yields on nominal sovereign bonds have increased significantly (Chart 2). Bank funding costs have risen, and the US Federal Reserve reports tighter lending standards on commercial and industrial loans, commercial real estate lending and residential mortgages.2
The adjustment to higher interest rates is exposing weaknesses in the business models of some financial institutions
Recent events serve as a reminder that stresses can quickly emerge when business models are not robust to increases in interest rates or to volatility in asset prices. Banks that have failed or come under severe stress since early March had some or all the following characteristics:
- significant mismatches between the maturities of their assets and liabilities
- large unrealized losses resulting from higher interest rates
- concentrated depositor bases, including many depositors with holdings greater than deposit insurance limits
Future financial stress could increase existing financial vulnerabilities in Canada
As the adjustment to higher interest rates continues, future periods of stress are possible, and they could persist longer than the acute stress that happened in March. This could exacerbate two existing vulnerabilities discussed in this document:
- Fragile liquidity in fixed-income markets—in an environment of increased asset price volatility and elevated funding costs, banks could have less capacity to provide liquidity to financial market participants.
- The ability of households to service their debt—additional sharp increases to bank funding costs could result in higher lending rates. This would add to the high debt-service burden many mortgage holders already face, leaving them more vulnerable to a decline in income.
- To date, spillover effects in Canada from the recent stresses in the global banking sector have been limited. This partly reflects the swift actions by US and Swiss authorities that mitigated contagion effects. It also reflects the small direct exposures of Canadian banks to the troubled institutions as well as sound risk management and supervisory practices in Canada.
- More generally, higher global interest rates are increasing funding costs for Canadian banks, both in wholesale markets and through a reduction in demand deposits. This is part of the normal transmission of tighter monetary policy. The recent market volatility led to reduced issuance in wholesale funding markets. Future episodes of market stress—if they last long enough—could put additional upward pressure on the cost of funding and reduce banks’ capacity to provide liquidity to market participants.
- If a severe recession were to occur, the balance sheets of Canadian banks could face pressures through credit and funding channels. Significant unemployment and a large drop in house prices could lead to a deterioration in asset quality and increased credit losses for banks. This could weaken market sentiment and raise funding costs. In response, banks would likely reduce the supply of credit to households and businesses as well as that of liquidity to non-bank financial intermediaries.
Spillover effects to Canada from recent stress in the global banking sector have been limited
During the recent period of banking sector stress, equity prices of Canadian banks were not affected as much as those of US and European banks (Chart 3). In part, this reflects limited direct exposure to the troubled institutions. Investors have also favoured banking sectors with diversified funding sources and strong business models, including low mismatches between the maturities of their assets and liabilities.
Bank funding is becoming scarcer and more expensive
The banking system plays a key role in transmitting changes in monetary policy to the economy. As expected, higher global interest rates are increasing the funding costs of Canadian banks, both in wholesale markets and through increased interest rates on deposits.
This greater reliance on wholesale funding primarily reflects the fact that Canadian banks keep a larger share of loans and mortgages on their balance sheets than US banks do. As a result, Canadian banks are more reliant on sources of funding that are susceptible to price fluctuations due to market stresses. The cost of wholesale funding depends on financial market conditions, including the prevailing interest rate environment. During the recent stress in the global banking sector, the Bank’s regular engagement with financial system participants revealed that the volume of wholesale funding at terms greater than one year declined significantly, reflecting higher costs.
Retail and commercial deposits are the largest sources of funding for Canadian banks. As interest rates rise, customers move their funds from demand deposits, such as chequing and savings accounts, to term deposits, such as guaranteed investment certificates (Chart 5). Banks typically offer higher interest rates on term deposits, which provide a more stable source of funding but also increase their funding costs.4
In the early stages of the pandemic, deposits in the banking system rose partly because of some of the support programs put in place, including quantitative easing and the Canada Emergency Business Account (CEBA) program. But the unwinding of these programs could lead to future declines in deposits from the banking system.
- As the Bank uses quantitative tightening to reduce the size of its balance sheet, non-bank participants may increase their holdings of Government of Canada bonds, which would reduce the level of their bank deposits.5
- Some firms will repay the loans they received through the CEBA program.
The rise in bank funding costs to date largely reflects the normal transmission of tighter monetary policy. However, future periods of financial system or banking stress, particularly if they were prolonged, could further raise funding costs and increase volatility in asset markets. When volatility rises, the risks associated with holding securities on balance sheets increase, and this could reduce the capacity of large banks to provide sufficient market liquidity in response to a spike in demand for liquid assets.
The exposure of Canadian banks to the commercial real estate sector is generally small
Banks with high lending exposure to industries already facing challenges could be subject to additional credit risk. A notable example is the commercial real estate sector, where the demand for office space has declined because of the shift to more remote work. As a result, market valuations of firms in the office space subsector have decreased (Chart 6). If some of these commercial real estate firms were to default on their loans, lenders could face credit losses.
The Canadian banking sector’s exposure to commercial real estate is small: non-residential mortgages account for about 2% of the total value of bank assets. However, differences exist across institutions, with some lenders more exposed than others, especially among small and medium-sized banks.
A severe recession could lead to credit losses for banks
Canadian banks maintain a high share of uninsured mortgages on their balance sheets. While a minimum down payment of 20% is required to avoid mortgage insurance, house price declines over the past year have reduced this equity buffer. A severe recession with significant unemployment could further depress house prices and increase defaults among households. If defaults were to rise on uninsured mortgages with negative equity, banks could face credit losses.
Overall, the banking system in Canada remains robust
Market participants continue to express confidence in the Canadian financial system, including the banking sector (Chart 7).
All federally regulated financial institutions in Canada must comply with the Basel III standards, regardless of the size of the institution. As a result, banks must maintain capital and liquidity buffers that help to withstand an economic downturn or episode of market stress. Previous work from Bank staff shows that, in a stress-test scenario with a severe recession, the capital position of major Canadian banks would be weakened but would not breach minimum requirements.6 Moreover, Canada rebuilt its domestic stability buffer after the onset of the COVID-19 pandemic.7 This means Canadian banks are holding additional capital buffers in case of a severe economic downturn.
Non-bank financial intermediaries
- Volatility in fixed-income markets has increased over the past year. A resurgence of global banking sector stress—or a different shock to the global financial system—could further strain liquidity in fixed-income markets. Participants who need to raise cash quickly may have to liquidate assets at reduced prices. In the extreme, this kind of market dynamic can exaggerate downward price movements, further contribute to market stress and cause a contraction in credit.
Concerns about liquidity in fixed-income markets have increased
Over the past year, macroeconomic and geopolitical events have led to greater volatility in fixed-income markets and a deterioration in market liquidity. The cost of trading has steadily increased over this period, reflecting decreased liquidity in these markets (Chart 8). More recently, the global banking stress temporarily caused a further reduction in fixed-income market liquidity.
Asset managers require market liquidity due to asset-liability mismatches and leverage
Fixed-income mutual funds, in particular, face liquidity mismatches between their assets and liabilities: they offer daily redemptions to investors but invest in less-liquid assets. Liquidity mismatches and the use of leverage generally increased in the low interest rate environment that followed the 2008–09 global financial crisis due to asset managers seeking the higher returns offered by less-liquid assets.8 In addition, some asset managers increased leverage in their investment portfolios through repurchase agreements (repos) and derivatives markets.9, 10
When a change occurs in the prices of the assets underlying derivatives contracts or when contracts experience mark-to-market losses, counterparties may be forced to pledge additional collateral as margin, which can force the sale of assets. Some Canadian public pension funds have indicated that derivatives linked to foreign exchange and equity markets generated large margin calls at the peak of market volatility in March 2020. Movements in market prices can also cause the amount of leverage in asset managers’ investment portfolios to change, which can force them to sell assets to de-lever their positions.
While commercial banks have standing access to central bank liquidity, asset managers must either have cash on hand or obtain cash by borrowing against or selling securities in their portfolios to meet their obligations. As a result, asset managers depend on robust levels of market liquidity to be able to quickly convert their securities into cash without significant price reductions.
Results of the Bank of Canada’s 2023 Financial System Survey show that Canadian market participants would primarily pledge assets and cash on hand to meet margin calls that fall within their stress-testing limits.11 For margin calls that exceed these limits, respondents would increasingly rely on external sources of funding, such as asset sales, securities financing markets and lines of credit (Chart 9).
If many asset managers attempt to sell assets at the same time, significant price reductions may be required to clear the market. Asset prices that are falling sharply can, in turn, generate additional volatility and cash needs for asset managers, creating a downward spiral. At the extreme, this dynamic can lead to a freeze in fixed-income market liquidity and a loss of access to wholesale funding markets for banks and non-financial businesses.
If a market-wide liquidity crunch were to occur, the Bank could provide liquidity to the Canadian financial system through its various standing and extraordinary facilities. In cases of extreme market-wide stress, the Bank could activate the Contingent Term Repo Facility, which allows it to provide liquidity directly to asset managers.
Data gaps and the risk of fragile market liquidity must be addressed
The Bank works closely with provincial, federal and international partners to better understand and mitigate the risk of fragile fixed-income market liquidity. For example, the Bank chairs a subgroup of the Systemic Risk Surveillance Committee (SRSC) to study how fixed-income mutual funds in Canada manage risk arising from liquidity mismatches. The group is currently focused on fund managers’ stress-testing practices.
The Bank is also collaborating with the SRSC to improve the collection and sharing of data on asset managers. Current data gaps limit the ability of the Bank and Canadian regulators to monitor key vulnerabilities among non-bank financial intermediaries.12 For example, understanding the types of collateral and other funding sources that asset managers hold for liquidity purposes, and how they might use them, would provide greater insight into which markets are susceptible to forced selling and downward asset price spirals.
The Bank actively contributes to various Financial Stability Board working groups. These groups aim to address concerns around fixed-income market liquidity, including:
- monitoring the global non-bank financial intermediation sector
- clarifying regulatory expectations of mutual funds’ management of liquidity risks
- improving understanding of margining practices
- Elevated interest rates and declining house prices have reduced the financial flexibility of many households. While most households are proving resilient to increases in debt-servicing costs, early signs of financial stress are emerging. The share of households affected by higher interest rates will continue to rise over the next few years as homeowners renew their mortgages.
- High debt-servicing costs and low homeowner equity make households more vulnerable to default if they experience a drop in income. A severe recession with significant unemployment could lead to more defaults and therefore credit losses for lenders. A rise in credit losses typically causes banks to restrict how much credit they offer to households and firms, potentially amplifying a recession.
Households have less financial flexibility
In recent years, some households have stretched their budgets to get into the housing market, taking on large mortgages with lengthy amortization periods. The use of variable-rate mortgages has also increased. The share of new mortgages with an amortization period longer than 25 years increased from 41% to 46% over 2022. In 2019, this share was 34%. A longer amortization period reduces the size of monthly payments, helping lower debt-servicing costs, but increases the period of household vulnerability because equity is built more slowly.
Higher interest rates are now increasing debt-servicing costs for many mortgage holders (Box 1). Debt service ratios (DSRs) for recent homebuyers have increased significantly. The median DSR on new mortgages rose from 16% to more than 19% over 2022, and the share of new mortgages with a DSR of more than 25% increased from 12% to 29% during the same period. Higher DSRs reduce flexibility for borrowers who experience unforeseen increases in expenses or losses in income.
Higher interest rates have also contributed to declines in house prices across most regions of Canada over the past year (Chart 10). For households that purchased homes near the peak in prices and made smaller down payments, this decline could result in limited or negative equity in their home. Lower home equity limits a household’s ability to refinance and extend their amortization period to reduce their monthly payment.
A severe recession with significant unemployment and further reductions in house prices could cause substantial financial stress for some households (Chart 11). Lower home equity could limit refinancing options on mortgages, leading to an increase in defaults. Credit losses to lenders would also rise if the liquidation value of a home in default is less than the value of the outstanding mortgage.
Ultimately, if banks endure sufficiently large losses on their loan books or a substantial deterioration in the quality of their assets, they may tighten their lending standards. This could reduce lending across the economy, worsening a downturn.
Households appear to be managing, but pockets of strain are emerging
Indicators of financial stress among households remain low but are rising. The share of indebted households that are behind on payments for at least 60 days in any credit category is below its pre-pandemic average but has been increasing since the middle of 2022.
Over the past year, homebuyers have increased their reliance on credit card debt. A larger proportion of them are carrying an outstanding balance and a higher average amount is being carried over. Both metrics now exceed their pre-pandemic peaks. Households that took on a mortgage between 2020 and 2022 are carrying over about 17% more credit card debt, on average, than those that purchased between 2017 and 2019, suggesting a greater reliance on credit cards among recent homebuyers to finance debt.13
Arrears on credit cards have also been rising and are close to pre-pandemic levels, in contrast to those on mortgages, which remain near historical lows.
More borrowers will see increased payments as they renew their mortgages
To date, about one-third of mortgages have seen an increase in payments compared with February 2022—just before the Bank started raising its policy interest rate (Chart 12). By the end of 2026, nearly all mortgage holders will have seen their payments increase. Assuming mortgage rates evolve according to current market expectations, the median payment increase over the 2023–26 period will be about 20% (Box 1).
While increases in mortgage payments should be manageable for most households, the impact will be more significant for some. Federally regulated financial institutions have stress-tested borrowers at higher interest rates since 2018, which means most households should have a buffer to support higher payments. In addition, the federal government has proposed a guideline to ensure that these financial institutions explore mortgage relief options to help Canadians manage the increase in mortgage rates.14 Also, most households will have experienced some income growth between originating and renewing their mortgages, and this will help support increased payments. For some households, however, the combination of higher DSRs, lower home equity and longer amortization periods will reduce household flexibility in the event of added financial stress, such as reduced income.
Box 1: The impact of higher interest rates on mortgage payments
Box 1: The impact of higher interest rates on mortgage payments
To help assess how higher interest rates will affect mortgage debt-servicing costs in the future, Bank staff conducted a simulation using anonymized loan-level data from federally regulated financial institutions. The simulation analyzed mortgages that have already registered, or will register, a higher payment than in February 2022—just before the Bank started raising its policy interest rate. The sample covered about six million mortgages and assumed that hypothetical interest rates on variable- and fixed-rate mortgages are consistent with market expectations.15
- For fixed-rate mortgages, the average increase in payments at renewal will be greatest in 2025–26, at between 20% and 25%.
- For variable-rate mortgages, the average increase depends on whether the payments are variable or fixed:
- Variable payments—these borrowers have already experienced an increase in payments of close to 50%, with the bulk of the increase taking place in 2022.
- Fixed payments—these borrowers will need to increase their payments by approximately 40% to maintain their original amortization schedule, assuming a renewal in 2025 or 2026.
The Bank collaborates with financial authorities to identify and monitor risks related to elevated household indebtedness
The Bank actively discusses and shares information with various domestic authorities through its membership on a range of committees. In particular, the Bank has been leading a Systemic Risk Surveillance Committee subgroup focused on issues related to mortgage lending.
The Bank also publishes pertinent research and analysis to help households, lenders and policy-makers better identify and mitigate risks.17 And in autumn 2022, the Bank launched a new set of indicators of financial vulnerabilities.
Borrowers, lenders and regulators all have a role to play in maintaining financial system stability.
- Borrowers should plan for the possibility of higher payments when their mortgage is renewed.
- Lenders should continue to apply sound underwriting practices, provision adequately for credit losses and conduct regular stress tests of their balance sheets.
- Regulators should continue to develop and apply sound policies to reduce systemic risk in the mortgage market. The mortgage stress test—aimed in part at ensuring that borrowers have room in their budget to absorb an increase in interest rates—has proven its worth over the past year.18
- The balance sheets of non-financial businesses remain healthy despite the slowdown in economic activity and increases in borrowing costs over the past year. Corporate indebtedness remains low, and businesses continue to hold historically high levels of cash.
- Compared with larger firms that can access a variety of financing sources, small and medium-sized businesses rely more on bank loans. If banks reduce credit in response to higher funding costs or deteriorating economic conditions, it could add pressure on small and medium-sized businesses.
Non-financial businesses remain in good financial health despite slowing economic activity and higher borrowing costs
Statistics Canada’s National Balance Sheet Accounts show that the economy-wide leverage of non-financial businesses, measured by the ratio of total debt to assets, picked up over 2022 but remains below pre-pandemic levels (Chart 13).19 Liquidity, measured by the ratio of total cash to debt, has also reached all-time highs among firms.
However, financial stress is rising mostly among small businesses. In response to Statistics Canada’s Canadian Survey on Business Conditions, about one-half of the firms that received government support during the pandemic reported that repaying the funds before the end of 2023 would be a challenge.20 This challenge was greatest for small firms. The number of firms filing for insolvency—which fell considerably in 2020—has returned to pre-pandemic levels (Chart 14).
Some businesses could face financial difficulties if external financing becomes harder or more expensive to obtain
Most large Canadian firms have access to a variety of financing sources, such as issuing equity or corporate bonds. Small firms, however, depend more on bank financing for their operations. Data from the 2017 Survey on Financing and Growth of Small and Medium Enterprises show that about one-third of small firms rely on loans from banks.21
A sharp tightening of credit conditions, which would make it more difficult or costly to obtain new credit or roll over existing debt, could lead to financial stress for these firms. And because small and medium-sized enterprises account for around 85% of Canadian private employment, financial stress in this sector could reduce employment and therefore strain household budgets.
While adjusting to elevated interest rates is the main challenge facing the financial system, the Bank is also keeping a close eye on other vulnerabilities and risks, including:
- a major cyber attack or operational incident that would threaten overall financial stability
- a disorderly repricing of assets exposed to climate change that would affect the financial system
- the growth of cryptoasset markets and their interconnectedness with the financial system
- A successful cyber attack in one part of the financial system could quickly spread to other parts and threaten overall financial stability. In particular, ransomware attacks—where criminals demand payment for a victim’s data—on critical or widely used third-party service providers remain a source of concern. A severe incident could disrupt the delivery of financial services, lead to significant losses for compromised financial institutions and weaken public confidence in the financial system.
The Bank remains concerned about possible system-wide disruptions caused by cyber incidents
The financial sector reports a larger share of cyber attacks than any other sector (Chart 15). In its latest annual assessment of national cyber security threats, the Canadian Centre for Cyber Security indicated that state-sponsored cyber attacks pose the greatest strategic cyber threat to Canada.22 Such attacks on Canada’s financial system and critical infrastructure have been a key threat since the start of Russia’s war on Ukraine.
If a financial institution, financial market infrastructure or third-party service provider is compromised, it could have detrimental effects on that organization and its clients. As in previous years, many of the respondents to the Bank’s 2023 Financial System Survey identified cyber incidents as one of the top three risks to their organizations.
Participants in the financial system are highly interconnected—operationally, technologically and financially—and share key service providers. An attack on one institution could therefore spread quickly and cause significant service disruptions and financial losses. It could also have lasting effects on the public’s confidence in the financial system.
Similarly, cyber attacks on third-party service providers could have system-wide implications. This is particularly the case if the targeted supplier provides a critical service, such as telecommunications, to a large commercial bank or a prominent financial market infrastructure.23 The financial sector’s concentrated use of third-party service providers, where one firm provides services to many financial institutions, could increase the scale of disruption from a successful cyber attack.24
Financial system participants need to prepare for system-wide events
Predicting an attack with systemic consequences is difficult, which is why financial system participants must have rigorous response and recovery plans. More specifically, financial institutions should:
- adopt sound cyber security practices and defence mechanisms
- assess threats carefully and manage risks associated with third-party service providers
- update procedures regularly for managing cyber security, including contingency plans for critical services
- report all cyber incidents, including attacks, to authorities
The Bank plays a key role in enhancing financial sector collaboration and information sharing
The Bank brings together key financial sector participants from both private and public organizations through the Canadian Financial Sector Resiliency Group (CFRG) and the Resilience of Wholesale Payments System initiative. The Bank is leading an effort through the CFRG to improve collaboration on cyber resilience between the financial sector and other critical infrastructure sectors, such as telecommunications and electricity. The Bank also works with other federal authorities on cyber security issues through the Financial Institutions Supervisory Committee and on broader Canadian initiatives, such as the proposed Critical Cyber Systems Protection Act. The Bank is an active member of the G7 Cyber Expert Group.
Given its oversight role for designated systemically important or prominent financial market infrastructures (FMIs), the Bank also ensures that these FMIs have sound management practices to remain resilient to cyber attacks.25
- Climate change poses both physical and transition risks to the financial sector. Information about firms’ and financial institutions’ exposure to these risks remains insufficient. As a result, assets exposed to climate change may be mispriced. Uncertainty about the path to a low-carbon global economy compounds the challenge of accurately pricing assets.
- Progress on improving the measurement and disclosure of climate-related financial risks is ongoing. This progress will increase the likelihood that these risks are accurately reflected in pricing and better reflected in risk management frameworks.
More consistent measurement and disclosure of climate-related financial risks are needed
The Bank has three distinct but overlapping concerns about how climate-related financial risks affect the financial system. These concerns are:26
- the lack of a consistent, globally agreed-upon method to measure these risks
- inconsistent and generally inadequate disclosure to understand these risks
- uncertainty about the magnitude and timing of the global policy response to transition to a low-carbon economy and the impact on financial assets
In light of these concerns, climate risks may not be accurately reflected in asset prices or fully accounted for in risk management frameworks.27 Authorities are making progress on the necessary measurement, disclosure and reporting standards, but continued progress is needed to ensure these risks are properly reflected in asset prices and risk management frameworks.
The Bank is collaborating with other financial system participants to improve the measurement and disclosure of climate-related financial risks
Data and consistent methodologies are a significant hurdle to evaluating climate-related financial risks. The Bank is working to close these gaps by using its expertise in economic modelling to provide scenarios to the financial sector. It is also conducting two analytical projects, in partnership with the Office of the Superintendent of Financial Institutions (OSFI) and selected financial institutions, examining:
- flood risk and its impact on the banking sector’s portfolios of residential mortgages
- climate transition risk and its implications for the Canadian financial system
The Bank is also working with OSFI and the Canada Deposit Insurance Corporation to draft requirements for regulatory reporting that will address data gaps around physical and transition risks.
The Bank continues to collaborate with a variety of international bodies, including the G7, the G20, the Financial Stability Board and the international Network of Central Banks and Supervisors for Greening the Financial System.
- A series of shocks hit cryptoasset markets over the past year. These incidents reinforce doubts about the long-term viability of cryptoassets without a proper regulatory framework—particularly for fiat-referenced cryptoassets, commonly known as stablecoins.
- These shocks have had little impact on Canada’s financial system, which has few connections to cryptoasset markets. This supports the Bank’s view that cryptoasset markets do not currently represent a systemic risk for the Canadian financial system.
- Domestic and international partners are developing cryptoasset regulations to limit risks to financial stability, but the pace of this work needs to accelerate.
Cryptoasset markets are not currently a systemic risk
Cryptoasset markets have grown rapidly in recent years, exposing more investors to a market that has very limited regulation in place to protect them. However, cryptoasset markets remain small relative to the size of the global financial sector and therefore do not yet pose a systemic threat.
Cryptoassets are not widely accepted as a method of payment because of the significant volatility in their prices and high transaction costs. As well, cryptoasset markets have faced a series of shocks in recent months (Chart 16). This is particularly the case for fiat-referenced cryptoassets.28
Limited data exist on the connections between cryptoasset markets and financial institutions in Canada. However, based on discussions with the banking and asset-management industries and the fact that the financial system was not affected by various stress episodes in cryptoasset markets, the Bank does not see the cryptoasset market as being highly interconnected with Canada’s financial system.
Links with the broader financial system could pose financial stability risks
If cryptoasset markets become more interconnected with the Canadian financial system, shocks in these markets could spread to the broader financial system and affect financial stability. Banks that hold the cash deposits of crypto companies could experience funding pressures or even a deposit run if a shock in cryptoasset markets causes these companies to rapidly withdraw their funds. In November, for example, some US regional banks with heavy concentrations of crypto clients saw large withdrawals after the global crypto exchange FTX failed.
Financial stability could also be threatened if a fiat-referenced cryptoasset with large holdings of financial assets, such as commercial paper, faced a loss of confidence. The issuer of the fiat-referenced cryptoasset would be forced to sell its holdings quickly and at a steep discount, affecting the liquidity of financial markets.
Progress on a regulatory framework needs to accelerate
The Financial Stability Board is proposing to regulate cryptoasset markets consistent with the principle of “same activity, same risk, same regulation.”29 It plans to release high-level recommendations on the global regulation, supervision and oversight of cryptoasset activities and markets later this year. In December 2022, the Basel Committee on Banking Supervision (BCBS) finalized a robust regulatory standard for banks’ exposure to cryptoassets, which will come into force by January 2025.30 Implementing both standards will significantly improve the resilience of the financial sector to risks coming from cryptoasset markets.
In Canada, that implementation started when the Office of the Superintendent of Financial Institutions announced an interim approach consistent with BCBS standards that establishes the regulatory requirements for Canadian banks and insurers holding cryptoassets.31 As well, the Canadian Securities Administrators (CSA) has registered many cryptoasset trading platforms as dealers, and in February the CSA announced that new crypto firms that wish to register will need to meet strict requirements to protect investors.32 The first set of requirements prohibits clients from buying or depositing fiat-referenced cryptoassets without the CSA’s prior written consent.
Finally, as announced in the 2022 federal budget, the Canadian government is:33
- conducting a legislative review of the digitalization of money
- holding consultations about cryptoassets
The Canadian government’s 2023 budget included several initiatives to gather useful data on the exposure of the Canadian financial sector to cryptoassets, particularly financial institutions and pension funds that are federally regulated.34
- 1. Just before Silicon Valley Bank and Signature Bank failed, Silvergate Bank—a US regional bank serving the cryptoasset market—underwent a voluntary liquidation.[←]
- 2. For more information, see Board of Governors of the Federal Reserve System, The April 2023 Senior Loan Officer Opinion Survey on Bank Lending Practices (May 8, 2023).[←]
- 3. See M. Truno, A. Stolyarov, D. Auger and M. Assaf, “Wholesale Funding of the Big Six Canadian Banks,” Bank of Canada Review (Spring 2017): 42–55.[←]
- 4. D. Bolduc-Zuluaga and A. Mordel, “How deposit rates respond to changes in Canadian monetary policy,” Bank of Canada Staff Analytical Note (forthcoming) will shed light on the response of deposit rates to changes in monetary policy in Canada.[←]
- 5. See D. Bolduc-Zuluaga, B. Howell and G. Johnson, “How does the Bank of Canada’s balance sheet impact the banking system?” Bank of Canada Staff Analytical Note No. 2022-12 (September 2022).[←]
- 6. See A. Danaee, H. Grewal, B. Howell, G. Ouellet Leblanc, X. Liu, M. Patel and X. Shen, “How well can large banks in Canada withstand a severe economic downturn?” Bank of Canada Staff Analytical Note No. 2022-6 (May 2022).[←]
- 7. For more information, see Office of the Superintendent of Financial Institutions, “OSFI sets Domestic Stability Buffer at 3% and adjusts range,” (press release, December 8, 2022).[←]
- 8. For instance, fixed-income mutual funds increased their aggregate holdings of corporate bonds rated BBB and below from 5.7% of assets under management in 2007 to 33.2% in 2022. These bonds have the lowest credit quality and may be difficult to liquidate during a crisis.[←]
- 9. Leverage is used to increase exposure to certain assets to boost returns or take positions that can offset potential losses (hedging). Regardless of its purpose, any leverage can be a source of vulnerability.[←]
- 10. The gross notional derivatives positions of stand-alone investment funds issued by investment fund managers registered in Ontario increased to $886 billion in 2021 from $684 billion in 2020. Data are from the Ontario Securities Commission Investment Fund Survey. A “stand-alone fund” generally invests in securities and other underlying holdings; in contrast, a “fund of funds” invests in other funds. Most of the derivatives exposure is concentrated among lower-risk currency and interest-rate derivatives generally used to hedge portfolios.[←]
- 11. In the 2023 Financial System Survey, 67% of respondents reported using non-centrally cleared derivatives, which may require posting margin.[←]
- 12. Non-bank financial intermediaries are a diverse set of financial entities that provide or facilitate credit intermediation outside the regular banking system. They include asset managers—such as mutual funds, insurance companies and pension funds—and other financial intermediaries—such as mortgage investment corporations, mortgage finance companies and auto loan companies.[←]
- 13. This calculation is based on the average credit card balance per person on accounts for which the owner carries over a positive balance and incurs interest charges. It is calculated using data from TransUnion for March 2023 and compares the average balance of mortgaged homebuyers from 2020–22 to that of those from 2017–19 for the same number of months after their home purchase. To protect the privacy of Canadians, TransUnion did not provide any personal information to the Bank. The TransUnion dataset was anonymized, meaning it does not include information that identifies individual Canadians, such as names, social insurance numbers or addresses.[←]
- 14. See Financial Consumer Agency of Canada, “Proposed Guideline on Existing Consumer Mortgage Loans in Exceptional Circumstances” (March 21, 2023).[←]
- 15. In the simulation, variable mortgage rates stayed close to their current level of 6% until the end of 2023 before gradually declining to 4.1% in 2026. Five-year fixed mortgage rates were assumed to decline slightly from 5.1% to about 4.8% in 2026.[←]
- 16. If fixed and variable mortgage rates were to rise for the remainder of 2023 by 100 basis points more than current market expectations, the average payment would rise by an extra 9 percentage points in 2023 compared with what is shown in Chart 1-A. The impact on debt-servicing costs in following years would depend on the persistence of the mortgage rate increase.[←]
- 17. Consult the latest research and analysis on the Canadian financial system on the Bank’s Financial System Hub.[←]
- 18. For more information on the mortgage interest rate stress test, see Box 1 in the June 2018 Financial System Review.[←]
- 19. Statistics Canada’s National Balance Sheet Accounts cover private sector, non-financial businesses in Canada. These include businesses of all sizes.[←]
- 20. See S. Tam, R. Fair and C. Johnston, “The state of business financing and debt in Canada, fourth quarter of 2022,” Statistics Canada (December 8, 2022).[←]
- 21. Statistics Canada, “Summary of the Survey on Financing and Growth of Small and Medium Enterprises, 2017” (December 2018).[←]
- 22. Canadian Centre for Cyber Security, “National Cyber Threat Assessment 2023–2024” (October 28, 2022).[←]
- 23. One example is the outage in summer 2022 at Rogers Communications Inc. that interrupted wireless, cable, telephone and internet services across the country. This incident also temporarily disrupted debit card and online payments.[←]
- 24. Successful ransomware attacks over the past year have underscored the Bank’s concerns about the concentration of third-party service providers.[←]
- 25. In 2022, as part of the Bank’s core responsibility to oversee financial market infrastructures, Bank staff reviewed how resilient domestically designated systems are to cyber attacks. The assessment showed that designated systems generally have sound practices to manage cyber risk, but it also found some areas for improvement. See Bank of Canada, “Bank of Canada Oversight Activities for Financial Market Infrastructures: 2022 Annual Report” (March 2023).[←]
- 26. For more information on climate-related financial risks—namely, physical and transition risks—see Bank of Canada, “Climate risks,” Bank of Canada Disclosure of Climate-Related Risks 2022.[←]
- 27. In a recent analysis, Bank staff used information from the financial statements of large Canadian corporations to estimate whether those entities’ reported greenhouse gas emissions affected their stock prices. The results show that emissions appear to play a role in equity prices, but the impact is small. This suggests that assets exposed to climate change remain at risk of a sudden repricing. See M. Ackman, T. Grieder, C. Symmers and G. Vallée, “What we can learn by linking firms’ reported emissions with their financial data,” Bank of Canada Staff Analytical Note No. 2023-4 (April 2023).[←]
- 28. See H. Ding, N. Khan, B. Lands, C. MacDonald and L. Zhao, “Potential benefits and key risks of fiat-referenced cryptoassets,” Bank of Canada Staff Analytical Note No. 2022-20 (December 2022).[←]
- 29. See Financial Stability Board, “FSB proposes framework for the international regulation of crypto-asset activities” (press release, October 11, 2022).[←]
- 30. See Basel Committee on Banking Supervision, “Prudential treatment of cryptoasset exposures” (December 2022).[←]
- 31. See Office of the Superintendent of Financial Institutions, “OSFI announces interim approach to cryptoassets” (press release, August 18, 2022).[←]
- 32. See Canadian Securities Administrators, “CSA Staff Notice 21-332 Crypto Asset Trading Platforms: Pre-Registration Undertakings—Changes to Enhance Canadian Investor Protection” (February 22, 2023).[←]
- 33. See Government of Canada, “Addressing the Digitalization of Money,” Budget 2022: A Plan to Grow Our Economy and Make Life More Affordable.[←]
- 34. See Government of Canada, “Protecting Canadians from the Risks of Crypto-Assets,” Budget 2023: A Made-in-Canada Plan: Strong Middle Class, Affordable Economy, Healthy Future.[←]