Overall assessment

Canada’s financial system has continued to function well despite US tariffs and trade uncertainty. But a more turbulent global environment poses risks to financial stability, particularly if several vulnerabilities crystalize at the same time.

The Canadian financial system continues to be resilient. Households and businesses remain in stable financial condition, and banks have strengthened their capacity to absorb shocks.

However, vulnerabilities have increased in some parts of the system. Valuations of many financial assets have continued to rise, increasing the risk of a sudden correction. At the same time, global sovereign debt issuance is growing, and hedge funds have increasingly absorbed this debt in recent years.

Individually, these vulnerabilities are manageable. But with increased economic and geopolitical risks, it is more likely a new shock or a combination of shocks could cause multiple vulnerabilities to crystalize at once. If this were to happen, these vulnerabilities could interact and reinforce each other.

In the extreme, a cascading series of events could cause a sharp loss of investor confidence. This could lead to liquidity hoarding or rapid asset sales, putting pressure on core funding markets. Stress could then spread across the financial system and the broader economy.

Financial system resilience

At the time of the previous Report, the United States had only recently begun pursuing its new trade policy. The situation was highly volatile, making it difficult to predict how the Canadian economy and financial system would be affected.

So far, the impacts have been less widespread than was initially feared. Most Canadian trade with the United States remains tariff‑free, the Canadian economy has been resilient, and changes in US trade policy have not led to a broad and lasting deterioration in financial conditions. Still, sectoral tariffs have hurt activity in affected industries, and the future of Canada’s trade agreement with the United States and Mexico remains uncertain.

The war in the Middle East has added to global uncertainty, disrupting shipments of oil and other key commodities through the Strait of Hormuz, damaging regional energy infrastructure and driving up commodity prices. Energy and financial markets have been volatile in response to evolving developments but have so far continued to function well.

Against this backdrop:

• Households and businesses remain in broadly the same financial condition as in the previous Report. After having increased since 2022, indicators of both household and business financial stress have plateaued over the past 12 months. Household indebtedness remains high but below recent peaks, while household wealth and incomes have risen. Businesses have maintained healthy balance sheets (see the Households and Non‑financial businesses sections).
• Canada’s large banks have grown more resilient due to higher profitability and a stabilization in the performance of their loan portfolios. In response to the dramatic shift in US trade policy and its impact on the economy, banks have also set aside more funds to cover potential credit losses (see the Banks section).
• Vulnerabilities related to non-bank financial intermediaries have continued to grow. Asset managers have further increased their use of repurchase agreement (repo) leverage,1 leaving them vulnerable to a sudden increase in liquidity needs or a reduction in the funding available in repo markets. However, some asset managers have taken steps to reduce their risk exposures (see the Non‑bank financial intermediaries section).
• Financial markets have also grown more vulnerable. Geopolitical developments have led to periods of increased volatility, while corporate bond and equity valuations are stretched relative to historical norms. Growing government debt issuance globally is also contributing to rising term premiums in sovereign yields (see the Financial markets section).

Valuations of risk assets remain elevated

Despite recent volatility and temporary pullbacks, valuations of risk assets have continued to climb, driven by elevated earnings expectations and declining risk premiums.

Moreover, a growing share of stock market capitalization is concentrated in a handful of large technology firms that are heavily invested in artificial intelligence (AI). This large and increasing concentration means that a correction in these sectors would have an outsized impact on broader stock indexes.

An abrupt repricing or a deterioration in economic fundamentals could cause asset managers to face significant losses, a sudden increase in liquidity needs and forced asset sales to reduce leverage.

Hedge fund activity increases vulnerabilities in sovereign debt markets

As global sovereign debt issuance has grown in recent years, the role of hedge funds in government bond markets has also grown. In Canada, hedge funds account for over 40% of purchases of government bonds at auction, roughly the same level as at the time of the previous Report. They also account for around one‑quarter of trading between Canadian bond dealers and clients, a slight decrease.2 This activity improves sovereign debt market liquidity and efficiency but also creates vulnerabilities.

Hedge funds typically rely on leverage obtained from overnight or short‑term funding. Disruptions to their access to funding or sharp changes in the prices of the securities underlying their trades could lead hedge funds to suddenly sell off their holdings of government bonds. This could have important repercussions across the financial system (see In focus: A resilient repo market is important for financial stability).

Because hedge funds use a range of strategies and trade in many different markets—including across borders—they can transmit stress during periods of turmoil.

Financial system risks

Three key risks to the financial system have emerged

Market participants are navigating a complex and frequently changing series of geopolitical and economic shocks, and there is considerable uncertainty around how and when these issues will be resolved. In this turbulent environment, three key risks have emerged: global trade, geopolitical risk and AI.

US tariffs and trade policy uncertainty persist

If the United States imposes tariffs on a broader set of goods or increases current tariff rates, the resulting impact on cross‑border trade could have significant negative economic effects similar to those explored in the trade war scenario in the previous Report (see In focus: How a severe and long‑lasting global trade war could affect financial stability in the 2025 Report).

Geopolitical risks have escalated

The war in the Middle East has caused one of the largest disruptions to global energy markets in history. The effective closure of the Strait of Hormuz is disrupting supply chains, which is weighing on energy and other commodity prices. This is putting downward pressure on global growth and upward pressure on inflation. The associated market volatility has also led to margin calls and, at times, strained liquidity in certain markets.

Considerable uncertainty remains about whether the war will escalate, how long it will last, how it might be resolved and what it will mean for commodity prices and financial conditions. Even after hostilities end, it will likely be months before the production and distribution of oil, natural gas and other commodities return to normal. The risk premium in oil markets may unwind gradually rather than disappearing immediately.

In a situation where financial conditions amplify an oil price shock, the resilience of the financial system could be tested (see In focus: How a financial market correction could worsen the effects of an oil shock).

AI‑related risks are growing

A wide range of risks related to AI are intensifying and will require close monitoring.

AI could raise productivity and support growth over time, but it could also create disruptions as adoption becomes more widespread. The recent drop in the share prices of some software companies, which was driven by concerns about AI, shows how quickly new developments can affect valuations. This has already led to stress in private credit markets (see In focus: Rapid growth in private credit has created vulnerabilities).

AI may also increase cyber security risks across the financial system by making it easier for software vulnerabilities to be identified and exploited. This means more frequent and time‑compressed software updates will be required, which could create operational risk.

These cyber and operational risks are amplified by the widespread reliance of financial institutions on shared systems, vendors and infrastructure. A cyber attack on any of these shared systems could have significant repercussions. For example, banking or other financial services could be disrupted, confidential data could be compromised, or trading or payments platforms could be forced offline.

There are also risks related to the scale and financing of the build‑out of AI infrastructure, which is expected to be increasingly funded by debt. If earnings fall short of investor expectations for even just a few of these firms, there could be a sharp repricing of AI‑related stocks and credit.

A significant shock could trigger multiple vulnerabilities at once

Over the past 12 months, the global financial system has faced a series of economic and geopolitical shocks. So far, the financial system has been resilient, in part because market confidence has remained strong.

However, vulnerabilities continue to build. If one of these vulnerabilities were triggered by a stress event, the fallout would normally be contained. But because the environment is increasingly volatile and uncertain, the possibility of a significant shock causing multiple vulnerabilities to crystalize at the same time has risen.

If this were to happen, it could set off a cascading series of events where these vulnerabilities interact and reinforce each other. For example:

• A sudden loss of confidence among market participants could lead to a severe repricing of risk. This could cause a sharp correction in asset valuations resulting in sudden liquidity demands such as margin calls or redemptions by fund investors. In turn, this could lead to a forced sale of assets. If traditionally safe and liquid assets such as government bonds were also affected by the correction, it could lead to further losses and liquidity demands. In the extreme, actions taken by market participants to raise cash could result in a self-reinforcing liquidity spiral.3
• A sharp drop in investor appetite for sovereign debt could reduce market liquidity or, in the extreme, disrupt core funding markets. This would also cause strain in other fixed‑income markets, in turn affecting any instrument using government bonds as a pricing benchmark, a hedging vehicle or collateral. Banks and asset managers that rely on repo markets could face significant liquidity pressures.

Other feedback loops could also materialize. If adverse developments in the financial system intensify economic volatility, this could lead to weaker growth and greater uncertainty for households, businesses and market participants. These impacts could, in turn, trigger further financial system vulnerabilities.

Canada’s financial system has proven resilient to recent shocks

Canada’s financial system has shown it can withstand stress. Multiple significant shocks have occurred over the past 12 months. While these shocks generated periods of heightened market volatility and short‑lived liquidity strains in government bond markets, they did not lead to stress in the overall financial system.

The Bank will continue to monitor and assess the health of Canada’s financial system. The objective is to foster a stable and resilient financial system that absorbs shocks and can support the economy through periods of turbulence.

Endnotes