Financial Stability Report—2025

A stable and efficient financial system is essential for sustaining economic growth and raising standards of living. In the Financial Stability Report, the Bank of Canada assesses the resilience of the Canadian financial system and focuses on key risks that could undermine its stability. Ultimately, financial stability benefits all Canadians.

Bank of Canada analysis and research about the structure and efficiency of the financial system can be found on the Financial System Hub.

Overall assessment

The financial system began 2025 with increased resilience

From the time of the 2024 Report until the beginning of 2025, major central banks eased monetary policy as inflation fell worldwide. Lower policy interest rates helped reduce vulnerabilities in the financial system related to debt serviceability.

Despite brief periods of volatility in global markets, Canadian fixed-income and other core funding markets functioned well, and debt issuance conditions remained solid. Banks maintained elevated levels of capital and liquid assets. Non-financial businesses also kept healthy balance sheets. As interest rates declined, the pressure on businesses and households with variable-rate debt and those facing mortgage renewals also eased.

At the same time, some risks increased. Financial asset prices rose, and valuations in some markets appeared elevated. Global debt levels also increased. Leverage of some non-bank financial intermediaries (NBFIs) continued to grow alongside a rise in their participation in core funding markets.

The trade war and pervasive uncertainty have rattled markets

Since January, the unpredictability of US trade policy has caused a sharp increase in uncertainty and market volatility. The new tariffs announced by the United States in early April were significantly larger than market participants had anticipated. This led to sharp repricing in equity, bond and currency markets as investors revised their economic outlooks. Benchmark equity indexes fell sharply before recovering almost entirely, while stock market volatility rose to its highest level since the COVID-19 crisis. Sovereign bond yields in Canada and the United States saw large swings. Many investors appeared to diversify away from US assets. The US dollar and US Treasuries weakened in tandem with stocks instead of playing their traditional safe-haven roles amid uncertainty. Part of that weakening may reflect an unwinding of leveraged positions by hedge funds and other market participants.

Even as volatility spiked and liquidity at times diminished in some asset classes, markets continued to function relatively well both globally and in Canada. But market participants in Canada have been cautious. Some have pre-emptively adjusted their portfolios or investment strategies, reduced the amount of risk they take on or sought additional protection against losses. Many are also reviewing whether their hedging strategies need to be adjusted to reflect recent market conditions.

The trade war and ensuing uncertainty have reshaped the global backdrop, lowering the prospects for global growth and raising inflation expectations.

Vulnerable households and businesses may struggle with debt, causing credit losses

In Canada, uncertainty about the scope and duration of the trade war has weighed on consumer and business sentiment and decisions.

To assess how a trade war could affect the Canadian economic outlook, the Bank’s April 2025 Monetary Policy Report (MPR) presented two illustrative scenarios spanning a wide range of paths for US trade policy. In Scenario 1, most new tariffs get negotiated away and their impact is limited, although uncertainty remains. In Scenario 2, a long-lasting global trade war with large and permanent tariffs brings severe economic consequences for Canada, including a year-long recession. These are two of many possible outcomes and, importantly, they are not forecasts.

At the same time, the MPR acknowledged the presence of further downside risks to these scenarios from potential worsening of financial stress. Permanent tariffs could cause high unemployment and business insolvencies that result in defaults on household and business debt. This would lead to credit losses for banks and would test the financial system’s resilience.

Canadian banks have maintained healthy balance sheets, putting them in a good position to absorb higher credit losses (Box 1). Nevertheless, credit losses could lead banks to reduce lending. This could exacerbate an economic downturn.

The trade war increases the risk of disorderly market sell-offs

Continued US trade policy uncertainty could spur further market volatility and an abrupt repricing of assets, which in turn could lead to acute and persistent liquidity pressures that test the financial system’s resilience.1

A further correction in asset prices could be amplified if leveraged investors were to quickly unwind their trading positions. Asset managers might hoard cash and sell fixed-income assets to meet fund redemptions or margin calls. Liquidity in core funding markets could deteriorate if volatility caused hedge funds to step away from these markets or to quickly reduce leverage. This risk is exacerbated by the increasingly large presence of hedge funds in sovereign bond markets, including in the Government of Canada securities and repurchase (repo) markets.

Banks could also cut back on their intermediation services to protect their balance sheets—further disrupting the supply of liquidity when market participants need it most.

For a detailed assessment of the potential impacts of a trade war, see In focus—How a severe and long-lasting global trade war could affect financial stability.

Most mortgage holders are well positioned to manage higher payments

Mortgages that originated during the pandemic had to qualify under a mortgage stress test to show that borrowers could handle payments under higher interest rates.2 Based on current market expectations, more than 90% of mortgage holders with a five-year fixed-rate mortgage will face payment increases at renewal that are smaller than they were stress-tested for. This implies their budgets should already have room to accommodate higher mortgage payments.

In addition, most households renewing their mortgage will have seen their income grow, and many have enough financial assets to fund higher payments for at least a year.3^, 4 Most homeowners have also seen their home equity boosted by increases in house prices. At the same time, the use of home equity lines of credit (HELOCs) has been declining, implying additional capacity to borrow against home equity, if needed.5 Higher levels of equity provide a buffer for mortgage holders who are renewing and choose to refinance to manage their payments.

Taken together, these factors suggest that most households will be able to absorb higher payments as their mortgages renew. But this does not mean it will be easy. Many households will have to adjust their spending to manage higher payments. And some may have trouble keeping up with payments on other debt.

Moreover, the trade war poses risks to employment and income, particularly in industries that depend on trade. Some affected households may find it difficult to manage their debt payments.

Non-financial businesses

Non-financial businesses adjusted well to past interest-rate increases and have generally remained in solid financial health over the past 12 months. Larger firms have been supported by their diversified sources of funding and by the fact that most have long-term financing in place. Last year’s surge in insolvency filings by small businesses proved temporary, as anticipated.

The trade war will test the financial resilience of businesses in industries tied to trade. Those with existing vulnerabilities—high leverage, weak profitability and low cash reserves—are at risk of falling behind on debt payments, which could lead to losses for both banks and investors (see In focus—How a severe and long-lasting global trade war could affect financial stability).

Large businesses have generally avoided the immediate impacts of past increases in interest rates because they tend to use long-term sources of financing. About half of the outstanding debt of publicly listed Canadian businesses will not mature until at least 2030. Until the sharp increase in market volatility in early April, the issuance of new debt was strong, and the cost of financing remained low. Since then, issuance has diminished, and spreads between Canadian corporate and government bond yields have widened, returning close to historical averages.

The surge in small-business insolvencies last year proved temporary

Business insolvencies started to pick up in late 2023 (Chart 4). The Bank’s analysis in the 2024 Report suggested that the surge would likely be temporary—the result of a delay in insolvency filings from mostly small businesses after pandemic-era government support programs ended.6 Business insolvencies have dropped significantly over the past 12 months, which largely aligns with the Bank’s previous analysis.

To date, credit data do not suggest that firms have been drawing pre-emptively on their credit lines to increase their cash balances. However, there has been a slowdown in business loan growth because firms have postponed or cancelled investments given the elevated uncertainty they currently face.

Credit performance remains strong

Among large banks, impairments on loans to households—including mortgages and consumer loans—are low by historical standards, despite a recent upturn (Chart 6). Impairments on business loans have picked up since the end of 2022 but are still modest relative to historical values.

Compared with their larger counterparts, medium-sized banks have seen a bigger increase in loan impairments, including on business and mortgage loans. This largely reflects their different business models, which can be centred around mortgage lending to higher-risk borrowers and business lending concentrated in specific industries or regions. Medium-sized banks account for only a small fraction of total lending by Canadian banks. For example, the total loan portfolio of medium-sized banks is only about $150 billion, compared with more than $4.3 trillion at large banks.

Banks are well positioned to cope with a period of stress

Banks’ balance sheets remain robust. If banks start to face financial pressure due to the economic effects of the trade war, they have ways to manage that pressure.

Their first line of defence against rising loan impairments is their accumulated provisions. At large banks, this amount is 8% higher than it was one year ago and 26% higher than two years ago. For medium-sized banks, accumulated provisions are 21% higher than one year ago and about 38% higher than two years ago.

In the event of large credit losses that go beyond what they anticipate and provision for, banks rely on capital to absorb losses. Large banks have increased their capital levels in recent years; their common equity Tier 1 capital ratio averaged 13.3% in the first quarter of 2025, about 2 percentage points higher than in the fourth quarter of 2019.7 This rise is partly due to past tightening of regulatory requirements.8

Stress-testing exercises also show that the capital ratios of large banks would remain well above regulatory minimums, even during a period of severe stress (see Box 1).

Banks are also required to hold adequate levels of liquidity to meet their financial obligations, including through periods of stress such as high levels of deposit outflows or challenges accessing wholesale funding in a timely manner. Large banks continue to have sufficient liquid assets on hand to manage these risks. The average liquidity coverage ratio of large banks was 133% in the fourth quarter of 2024, higher than the regulatory minimum.9 Medium-sized banks also carry elevated levels of liquid assets, with an average liquidity coverage ratio over 200%.

Hedge funds’ increased participation in government debt auctions helps the market absorb the elevated level of debt issuance at competitive prices. And their active trading strategies add to the liquidity and efficiency of bond and futures markets.

However, hedge funds tend to finance their investments with leverage and do not face the same contractual obligations and regulatory requirements as bank dealers (e.g., minimum bidding obligations at auctions).17 They may be more likely than bank dealers to pull back from these markets in certain situations. In a period of stress, hedge funds could find it harder to maintain their positions in GoC markets if, for example, they lost access to repo funding or if higher volatility in bond markets led to big margin calls. Foreign-based funds could also decide to abruptly reduce their exposure to GoC markets if trading in them became less attractive or riskier than trading in other markets—for example, due to an increase in funding costs or a sharp rise in volatility.

Further, hedge funds typically borrow money from bank dealers to finance their investment positions, such as through repo transactions or prime brokerage arrangements.18 If bank dealers cut back on lending in a period of stress—because of higher costs, capital constraints or risk management considerations—that could limit the ability of hedge funds to trade. Some funds might even have to unwind their positions.19 Abrupt sales of bonds could, in turn, strain market liquidity and create conditions for a dash for cash, as was seen at the onset of the pandemic.

Government bonds play many important roles in modern financial systems. Market participants use government bond prices as the benchmark for pricing other securities and loans. As well, participants regularly use these bonds as collateral in other core funding markets and in a range of financial contracts. Therefore, markets for government bonds must function properly for other markets to work well. A shock that leads to a rapid unwinding of positions involving government bonds could lead to market dysfunction and have adverse consequences for overall financial stability (Box 3).

Asset managers are using more leverage but also boosting their liquidity

Hedge funds and other asset managers—such as large pension funds—use leverage to enhance returns and manage risk. In periods of heightened volatility, this leverage can make asset managers more vulnerable to sudden liquidity needs because large price swings can lead to margin calls. These asset managers get much of their leverage through repo funding from banks. The use of this repo funding has increased significantly in the past five years, with asset managers’ total leverage through repo borrowing having grown by around 65% since 2020. Indeed, since the previous Report, the value of Canadian-dollar repo funding provided by banks has remained elevated (Chart 8).20 Since the 2024 Report, transaction data show that pension funds and hedge funds were the largest recipients of additional repo funding, with estimated increases of $18 billion and $14 billion, respectively.21

Hedge funds are generally more exposed to refinancing risk than pension funds. Hedge funds typically carry a higher degree of leverage, and about 70% of their overall repo leverage has a maturity of less than a week. In contrast, 40% of pension fund repo leverage has a maturity of more than a month.

Asset managers are generally sophisticated users of leverage and have robust liquidity management practices. For example, large pension funds use liquidity coverage ratios to monitor planned and potential outflows.22 Hedge funds typically use scenario analysis frameworks along with risk and leverage limits. Nonetheless, even sophisticated users can run into difficulties during periods of market stress, and the actions of individual participants can have repercussions for others in the financial system. The dash for cash in March 2020 is one example.23

As hedge funds take on a growing role in government bond markets, it is increasingly important for them to have robust funding agreements and sufficient liquidity to weather periods of market stress. The Bank will continue to monitor conditions for markets and market liquidity as well as the use of leverage by NBFIs. The Bank will also assess the impact of the growing involvement of NBFIs in Canadian bond markets.

Businesses in domestic-focused industries may not see a direct impact from tariffs in the early stages of the trade war. But with time, they too would likely suffer from the large drop in overall demand. Because these industries account for the bulk of non-financial corporate debt in Canada, the investors and banks that finance them could see losses if these businesses cannot service their debt.

In a prolonged trade war, existing and new government support programs would likely help businesses and the economy adjust. Governments have already announced some measures to support businesses affected by the tariffs, such as tariff relief or loan facilities.30

Many households would struggle to pay their debt after layoffs

Even with government support, some businesses affected by the trade war may lay off workers as they adjust to lower demand. Faced with a large reduction in income, some of the people who lose their job could have trouble paying their debt.

To better understand how a long-lasting trade war could affect households’ ability to service their mortgage, Bank staff simulated a profile of mortgage arrears under Scenario 2 in the April 2025 MPR (Chart 10).31 The projected increase in mortgage arrears is displayed as a range to show how amplification channels—such as large increases in unemployment or large declines in house prices—could interact, making it difficult to estimate precisely how such a scenario would unfold.32 Results suggest that the share of mortgages in arrears by at least 90 days could rise to a level comparable with or higher than levels reached in the 2008–09 global financial crisis.

Banks may experience large credit losses, which could affect their ability to support the economy

To assess banks’ potential exposure to credit defaults by businesses and households, Bank staff analyzed the balance sheets of Canadian banks.

In general, loans to households or businesses in trade-sensitive industries or regions represent around 15% of the assets of banks in Canada. The balance consists of loans and other assets that have a low direct exposure to trade. Nonetheless, a trade war that generates a marked economic slowdown or recession could still indirectly affect these domestic industries.

Although the direct exposure to trade is similar between large banks and small and medium-sized banks, the composition of their loan book is different. Small and medium-sized banks tend to have a more pronounced focus on mortgage lending. They are also often regionally concentrated, which, in some cases, could imply higher exposure to trade-sensitive industries.

Stress tests indicate banks would remain resilient even in a severe economic downturn (Box 1). Their strong balance sheets would allow banks to keep lending through stress, supporting the economy. But substantial credit losses could still lead them to take defensive measures to protect their capital ratios.

For example, banks could reduce the availability of credit or tighten lending standards, particularly for borrowers who are already financially fragile or operate in sectors most exposed to the trade war. This could spread stress throughout the financial system—potentially amplifying the economic downturn.

A sudden change in market sentiment could spur demand for liquidity

The potential for a more severe or long-lasting trade war has made investors increasingly uncertain about the future economic outlook. However, even as markets have grown more volatile, the risk premiums demanded by investors in equity markets have remained below their longer-term averages. A new escalation of the trade war or a growing belief that tariffs might be permanent could further reduce investor appetite for risk and lead to another, potentially disorderly sell-off of risky assets.

Moreover, in a market-wide shock, participants across the financial system could seek liquidity at the same time. Many households and businesses may want to use their credit lines with banks. Asset managers may seek to raise cash to cover actual or anticipated margin calls or investor redemptions. And to protect their balance sheets, banks may build up larger liquidity buffers to avoid the risk of not meeting their obligations. Combined, these actions could lead to asset fire sales and price spirals. This could precipitate market dysfunction in core funding markets, affecting all market participants that rely on them. At the extreme, authorities might need to provide liquidity to restore market functioning.