Canada's financial system is becoming increasingly exposed to economic shocks as household debt levels continue to climb and major housing markets remain red hot, the Bank of Canada said Thursday.
But even as the central bank warned that the country's most significant weak spots have widened, governor Stephen Poloz said the overall financial system remains resilient and broader economic conditions have shown signs of improvement.
The bank's assessment was rolled into its bi-annual review, which explores and identifies the key vulnerabilities and risks surrounding the stability of the financial system.
The two biggest concerns on the bank's radar are also intertwined. It said the growth in mortgage lending in Toronto and Vancouver has largely fuelled an increase in Canada's overall household indebtedness since the bank's last review six months ago.
"Highly indebted households have less flexibility to deal with sudden changes in their income," said the bank.
"As the number of these households grows, it is more likely that adverse economic shocks to households would significantly affect the economy and the financial system."
The document was released as concerns about the Canadian real estate market, domestically and from abroad, continue to pile up.
This week, the Paris-based OECD became the latest international organization to urge Canada to do more to address risks associated with its high-priced housing markets.
The central bank report also noted Moody's recent credit downgrading of Canada's six largest banks due to growth in private sector debt and higher housing prices.
Over the past year, various governments in Canada have introduced housing measures and policy changes that the bank predicted will help ease the vulnerabilities over time.
However, while recent federal measures have improved the credit quality of insured mortgages, the bank said the share of uninsured mortgages has increased and their characteristics are showing more signs of risk.
The report warned that another financial stability concern could emerge if more and more borrowers accumulate debt elsewhere to enable them to put down bigger down payments because of recent changes to mortgage rules.
The bank also outlined two key risks to the financial system.
The first risk is a large, persistent shock in foreign demand that would lead to a severe recession. While the bank noted the probability of such a risk is low, it said that rising household vulnerabilities mean the severity of such an event, should it occur, has expanded.
The other risk identified in the review, which has a "moderate" chance of occurring, is a regional correction in housing prices in sizzling markets like Toronto, Vancouver and their surrounding areas. Such a development would hurt the broader economy and the financial system, the bank said.