Canada
Financial System Stability Assessment
Author: International Monetary Fund. Monetary and Capital Markets Department
Publication Date:
24 Jun 2019
eISBN:
9781498321112
Language:
English
Keywords:
ISCR; CR; housing market; financial system; credit risk; government bond; capital ratio; finance characteristic; banking sector; return on equity; investment funds; mortgage borrower
Download PDF (2.7 MB)

This Financial System Stability Assessment paper discusses that Canada has enjoyed favorable macroeconomic outcomes over the past decades, and its vibrant financial system continues to grow robustly. However, macrofinancial vulnerabilities—notably, elevated household debt and housing market imbalances—remain substantial, posing financial stability concerns. Various parts of the financial system are directly exposed to the housing market and/or linked through housing finance. The financial system would be able to manage severe macrofinancial shocks. Major deposit-taking institutions would remain resilient, but mortgage insurers would need additional capital in a severe adverse scenario. Housing finance is broadly resilient, notwithstanding some weaknesses in the small non-prime mortgage lending segment. Although banks’ overall capital buffers are adequate, additional required capital for mortgage exposures, along with measures to increase risk-based differentiation in mortgage pricing, would be desirable. This would help ensure adequate through-the cycle buffers, improve mortgage risk-pricing, and limit procyclical effects induced by housing market corrections.

Abstract

This Financial System Stability Assessment paper discusses that Canada has enjoyed favorable macroeconomic outcomes over the past decades, and its vibrant financial system continues to grow robustly. However, macrofinancial vulnerabilities—notably, elevated household debt and housing market imbalances—remain substantial, posing financial stability concerns. Various parts of the financial system are directly exposed to the housing market and/or linked through housing finance. The financial system would be able to manage severe macrofinancial shocks. Major deposit-taking institutions would remain resilient, but mortgage insurers would need additional capital in a severe adverse scenario. Housing finance is broadly resilient, notwithstanding some weaknesses in the small non-prime mortgage lending segment. Although banks’ overall capital buffers are adequate, additional required capital for mortgage exposures, along with measures to increase risk-based differentiation in mortgage pricing, would be desirable. This would help ensure adequate through-the cycle buffers, improve mortgage risk-pricing, and limit procyclical effects induced by housing market corrections.

Executive Summary

The financial system’s performance has been strong. The banking sector has enjoyed solid profitability and sizeable capital buffers. The insurance sector has remained financially sound even in the low interest rate environment. Other nonbank sectors have grown considerably, with pension funds and mutual funds dominating the institutional and retail asset management landscape. System-wide liquidity conditions are stable. Major banks, life insurers and pension funds have expanded their footprints abroad. Canada has strong financial linkages with the United States.

Macrofinancial vulnerabilities—notably, elevated household indebtedness and housing market imbalances—remain substantial, posing financial stability concerns. During the decades-long credit upcycle, low interest rates and low capital charges for mortgage lending, together with policies promoting housing affordability, have fueled borrowing to finance home purchases in the face of rapidly rising house prices. Downside risk to house prices in the medium term are sizeable given existing overvaluation, and Canada-specific housing finance characteristics may amplify procyclical effects of falling house prices due to borrowers’ refinancing pressures and lenders’ sudden adoption of risk-based mortgage pricing. During severe downturns, the household sector would be affected, with a significant increase in debt belonging to financially weak households, while the corporate sector would remain more robust.

The financial system would be able to manage severe macrofinancial shocks, but mortgage insurers would probably need additional capital. In a severe adverse scenario, major deposit-taking institutions would be able to rebuild their capital positions to meet the regulatory requirements. These institutions also hold sufficient liquidity buffers to withstand sizeable funding outflows. By contrast, mortgage insurers would face some capital shortfalls. Nevertheless, financial stability implications are limited given the government’s backstopping of mortgage insurance contracts. Large life insurers appear somewhat exposed to financial market stress and lower interest rates. Housing finance is broadly resilient, but the non-prime mortgage lending segment, albeit small, shows some vulnerabilities.

Additional required capital for mortgage exposures, along with measures to increase risk-based differentiation in mortgage pricing, are desirable. While banks’ overall capital buffers are adequate, lenders’ risk weights for mortgage exposures should be higher. Mortgage insurers’ capital requirements should also be tightened. In addition to properly accounting for through-the-cycle credit risk, these measures can help improve mortgage risk-pricing and limit procyclical effects of falling house prices. Furthermore, the policy framework for managing a housing market downturn should be developed, with the aims to facilitate necessary economic adjustments, limit moral hazard and safeguard taxpayers’ interest.

Enhanced monitoring is warranted given emerging vulnerabilities. These concerns stem from banks’ external, foreign-currency funding, extensive use of derivatives, rising risk-taking by life insurers, pension funds and other nonbanks, non-prime mortgage lending, and potential spillovers from overseas operations and cross-border exposures. Continued efforts to address data gaps are essential to support more effective risk monitoring and analysis.

Financial sector oversight is high-quality, but there are important areas for improvement. In general, the regulatory frameworks are strong, and the supervisory approaches are well-structured and adaptive to risk profiles. Consolidated supervision also effectively captures major financial institutions’ overseas operations. Nevertheless, cooperation between federal and provincial authorities should be further improved, supported by additional memorandums of understanding (MoUs). The roles and responsibilities of the authorities that oversee financial market infrastructures (FMIs) should be further clarified. Given macrofinancial vulnerabilities, the regulatory and supervisory frameworks of deposit-taking institutions regarding credit risk related to real estate exposures should be strengthened. Furthermore, the Cooperative Capital Markets Regulatory System (CCMRS) initiative can help overcome risks from dispersed oversight of securities markets. Other important sector-specific gaps require strengthening of insurance group-wide supervision, putting a greater emphasis on high-impact securities market intermediaries, and ensuring readiness to handle market-wide stress in securities markets.

The federal safety net is well-established and covers a substantial part of the financial system, but contingency planning and preparation can be further strengthened. The bank resolution regimes and deposit insurance systems for federal and Québec jurisdictions are generally aligned with international best practices. Recovery and resolution planning, which is advanced for major deposit-taking institutions, should be expanded. Given the likelihood of compensation to bail-in-able debt holders, the valuation framework should be further developed to increase certainty about bail-in outcomes. Depositor preference should also be adopted to facilitate resolution and minimize losses of deposit insurers. The Bank of Canada’s framework for managing liquidity during stress is well-defined. However, indemnity agreements still need to be established to operationalize emergency liquidity assistance (ELA) to provincially regulated financial institutions. Contingency plans for market-wide support—particularly, intervention in securities markets and provision of foreign-currency liquidity—should be further developed.

Modernization of the financial stability architecture would help enhance systemic risk oversight and crisis preparedness. A single body in charge of systemic risk oversight would be the first-best solution. Second-best solutions include formalizing and strengthening the BOC’s leading role in systemic risk surveillance and creating a federal-provincial platform to discuss systemic risk issues and formulate policy responses. For the latter, one option is to reconstitute the Heads of Agencies Committee (HOA). The new arrangement should be supported by a robust transparency framework. Regarding system-wide crisis preparedness, which is still missing, the Senior Advisory Committee (SAC) should oversee development and testing of contingency plans for the entire financial system, in collaboration with key provincial authorities.

Macrofinancial Context

A. Financial System Structure

1. Canada has one of the largest and most developed financial systems in the world (Figure 1, Table 3). As of end-2018, total assets of financial institutions reached US$10.2 trillion or 626 percent of GDP, and outstanding debt securities and stock market capitalization amounted to US$2.2 and US$1.9 trillion, or 133 and 119 percent of GDP, respectively. Deposit-taking institutions, pension funds, mutual funds, and insurers dominate the financial system, accounting for about 45, 18, 17, and 13 percent of financial institutions’ total assets, respectively. Each segment of Canada’s financial system—deposit-taking, insurance, pension, asset management, and capital markets—is among the largest in the world in nominal terms.

Figure 1.
Figure 1.

Canada: Financial System Structure

Citation: IMF Staff Country Reports 2019, 177; 10.5089/9781498321112.002.A001

Sources: Bank of Canada; Bloomberg; FSB, Global Monitoring Report on Non-Bank Financial Intermediation 2018; Haver Analytics; IMF, Financial Development Index database and World Economic Outlook database; and IMF staff calculations.1/ For more details about the financial development index, see IMF SDN/15/08 and IMF WP/16/5.
Table 1.

Canada: 2019 FSAP Key Recommendations

article image
Note: Institutions in the parenthesis are the agencies with leading responsibilities. The * denotes macro-critical. In terms of the timeframe, NT and MT stand for near-term (within one year) and medium-term (within 2–3 years).
Table 2.

Canada: FSAP Risk Assessment Matrix (RAM)

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The RAM shows events that could materially alter the baseline. The relative likelihood is the staff’s subjective assessment of the risks surrounding the baseline (“low” is meant to indicate a probability below 10 percent, “medium” a probability between 10 and 30 percent, and “high” a probability between 30 and 50 percent). The RAM reflects staff views on the source of risks and overall level of concern as of the time of discussions with the authorities. Non-mutually exclusive risks may interact and materialize jointly.
Table 3.

Canada: Financial System Structure

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Sources: FSB, Global Monitoring Report on Non-Bank Financial Intermediation 2018; IMF, World Economic Outlook database; Haver Analytics; SNL; and IMF staff estimates.

Based on National Balance Sheet Accounts, thus not reflecting consolidated balance sheets of financial institutions that have overseas operations. This statistical concept is different from the above text chart, which is based on the consolidated balance sheet basis (a typical FSAP approach).

Only including securities firms (e.g. brokers-dealers) that are not part of banking groups.

Including captive financial institutions and money lenders (CFIMLs), which are largely set up for financial management, asset restructuring and fund-raising purposes to channel funds within the corporations. In 2017, CFIMLs’ total assets amounted to Can$3.3 trillion.

Based on the FSB’s definition. In 2017, 73 percent of nonbank financial intermediation was related to collective investment schemes with features that make them susceptible to runs, and 18 percent was related to credit provision that is dependent on short-term funding.

Based on consolidated balance sheet basis.

Only representing regulated entities in federal and Québec jurisdictions.

2. The financial system has enjoyed solid overall growth and international expansion since the 2014 FSAP. Total assets of financial institutions have increased by 31 percent (since end-2013), underpinned by robust assets growth of banking sector, mutual funds and pension funds. Overall banking sector growth is partly driven by the expansion of U.S. operations, with total claims on nonresidents increasing to 41 percent of banking sector assets (from 31 percent). Royal Bank of Canada became a global systemically important bank in 2017. Mutual funds and pension funds have also expanded their cross-border investment, driving Canada’s international portfolio investment assets to 95 percent of GDP (from 60 percent). Domestically, banks finance about two-thirds of private sector credit, while bond issuance and nonbanks are important alternative funding sources.

uA01fig01

Financial System: Size and Internationalization, 2003–18

(In percent of GDP)

Citation: IMF Staff Country Reports 2019, 177; 10.5089/9781498321112.002.A001

Source: Bank of Canda; IMF, Internationall Financial Statistics and World Economic Outlook database; Haver Analytics.
uA01fig02

Composition of Financial Institutions’ Total Assets, 20171

(In trillions of Canadian dollar)

Citation: IMF Staff Country Reports 2019, 177; 10.5089/9781498321112.002.A001

Source: IMF staff estimate based on data from Canadian authorities, FSB, Haver Analytics and OSFI.1/ Based on consolidated balance sheet basis.2/ Excluding captive financial institutions and money lenders.

3. The financial system is highly concentrated. The six largest banks and Québec’s major credit cooperative group—designated as domestic systemically important financial institutions (D-SIFIs)—account for about 90 percent of deposit-taking sector assets, while the three largest life insurers account for about 70 percent of total net premiums. These banks and life insurers, together with large public pension funds, are globally active and systemically relevant for Canada’s financial system. Major banks’ main businesses comprise retail and wholesale banking, wealth management, and capital markets; their subsidiaries are among leading securities market intermediaries and asset managers.

4. Financial markets also provide an important venue for public and private sector financing. While bond markets continue to expand by about 39 percent since end-2013, Canadian corporates and financial institutions have increasingly issued debt internationally, driving up the share of foreign-currency debt securities from 26 percent to 34 percent. The public debt market also comprises provincial debt securities and government-guaranteed mortgage-backed securities (MBS), which jointly account for two-third of public debt instruments. Other core funding markets include money markets (repo, securities lending, and bankers’ acceptances) and foreign-exchange markets (spot and swap).

5. The government plays a central role in housing finance. The government provides mortgage insurance through CMHC and backstops private insurers’ mortgage insurance (subject to 10 percent deductibles). Furthermore, CMHC provides a timely payment guarantee for securitization of qualifying insured mortgages. As of 2018Q3, insured mortgages and government-guaranteed MBS (i.e., National Housing Act (NHA) MBS) amounted to Can$723 and Can$485 billion, respectively.

B. Macrofinancial Conditions

6. The economy regained momentum following a slowdown driven by low oil prices (Figure 2, Table 4). Canada has enjoyed macroeconomic stability since the global financial crisis (GFC). Amidst a sharp decline in oil prices, real GDP growth moderated significantly in 2015, with resource-rich provinces being particularly hard hit. The economy recovered during 2016–17, led by robust private consumption, and performed well in the first three quarters of 2018. With weak performance in recent quarters, real GDP growth is projected to be at 1.5 percent in 2019 before picking up to 1.9 percent in 2020, respectively. The medium-term outlook looks less promising, with growth expected to slow to around 1.6 percent by 2024, reflecting longstanding structural problems related to low labor productivity growth, population aging, and deteriorating international competitiveness.

Figure 2.
Figure 2.
Figure 2.

Canada: Macrofinancial Developments

Citation: IMF Staff Country Reports 2019, 177; 10.5089/9781498321112.002.A001

Sources: Haver Analytics; and IMF staff estimates.1/ Capturing term premiums, interbank spreads, real long-term interest rates, bond and equity returns and corresponding volatility measures, all in Canada, as well as global financial conditions.2/ Showing percentage balance, with a positive (negative) value indicating tightening (loosening) conditions.Sources: Bank of Canada, Staff Analytical Note 2018–35; Haver Analytics; and IMF staff calculations.
Table 4.

Canada: Selected Economic Indicators

(Percentage change, unless otherwise indicated)

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Sources: Haver Analytics; and IMF staff estimates.

7. Financial conditions remain loose due to still favorable pricing of risk. In response to rising inflationary pressures, the Bank of Canada (BOC) initiated a tightening cycle in mid-2017, with five rounds to rate hikes. More recently, the BOC has communicated that an accommodative monetary policy stance is warranted. Long-term bond yields have subsequently declined following the rise during the tightening phase. Despite some bouts of market volatility in recent months, overall pricing of risk, which captures term and credit premiums, remains near historical lows.

8. Credit growth has moderated in line with the softening housing market due to monetary tightening and prudential measures. As of 2019Q1, credit growth moderated to 4.8 percent year-on-year. Several rounds of policy measures have successfully reduced insured mortgage lending and improved credit quality, with the share of banks’ new lending to highly indebted borrowers falling sharply. Meanwhile, house prices have been broadly stable in the past couple years, and housing market-related activities—including construction, inventory and sales, and mortgage lending—have also moderated. However, home equity lines of credit (HELOCs) have grown rapidly, some of which feature interest-only payment. Borrowers may utilize available credit lines to satisfy the loan-to-value (LTV) requirements when obtaining new mortgages, consolidate existing higher-cost debt, or meet regular payments on other loans.

Risk and Vulnerability Assessment

A. Overview

9. Elevated household indebtedness and housing market imbalances continue to pose financial stability concerns. During the decades-long credit upcycle, low interest rates and low capital charges for mortgage lending, together with policies promoting housing affordability, have fueled borrowing to finance home purchases in the face of rapidly rising house prices. Risk mispricing has contributed to debt accumulation among financially weak households, with problems more exacerbated in regions experiencing larger housing market imbalances. During severe downturns, Canada-specific housing finance characteristics may amplify procyclical effects of falling house prices, and the impact on growth could be protracted due to household balance sheet adjustments.

10. Market data suggests that systemic stress of financial institutions is low. Based on the market-based analysis of 19 large financial institutions as of December 2018, the probability that several financial institutions experience distress simultaneously was near historical lows. The systemic stress measure, which captures the number of institutions potentially becoming distressed and the system-wide expected loss, has been broadly stable over the past few years. Nevertheless, potential contagion effects appear to have risen over the past decade, reflecting interconnectedness among financial institutions and/or growing common exposures to the housing market.

uA01fig03

Market Perception of Systemic Stress, 2005–181

Index between 0 and 100, representing from low to high systemic stress

Citation: IMF Staff Country Reports 2019, 177; 10.5089/9781498321112.002.A001

Sources: Bloomberg; Moody’s Analytics; and IMF staff estimates.1/ The analysis is based on the “Surveillance of Systemic Risk and Interconnectedness” approach. See Segoviano and Goodhart (IMF WP/09/4) and Technical Note on Systemic Risk and Interconnectedness Analysis, 2016 United Kingdom FSAP (IMF Country Report No. 16/164). The sample includes 10 depoit-taking institutions, 7 insurers, and 2 other nonbank entities.2/ Cascade effects capture the probability that at least another institution become distressed given than a particular institution became distressed.3/ The systemic stress measure comprises (i) number of institutions to become distressed given than at least one became distressed; and (ii) expected loss related to the 1st-percentile tail risk. Both indicators are combined based on their percentile ranking.

11. The financial system would be able to manage severe macrofinancial shocks, but additional required capital for mortgage exposures would help improve its resilience. While major deposit-taking institutions would remain resilient, mortgage insurers would be vulnerable. Furthermore, larger capital buffers to account for potential sharp deterioration of credit quality of mortgage exposure during severe downturns, along with measures to improve mortgage risk-pricing, can help moderate procyclical effects driven by housing market corrections. The non-prime mortgage lending segment, albeit small, shows some vulnerabilities. Existing government support, which underpins the overall robustness of housing finance, should be guided by a policy framework that achieves proper risk-pricing and promotes financial stability.

12. Vulnerabilities are emerging due to rising risk-taking by nonbanks and increased interconnectedness, warranting enhanced monitoring. In response to the low interest rate environment, institutional and retail investors are taking greater risks to achieve higher returns, contributing to compressed risk premiums. The rapid unwinding of these investment positions could amplify market volatility. Furthermore, Canada’s financial system continues to evolve rapidly, with complexity and interconnectedness potentially masking vulnerabilities and amplifying spillovers.

B. Key Macrofinancial Risks and Vulnerabilities

13. Macrofinancial vulnerabilities have declined recently but are still substantial. Given relatively limited fiscal and external vulnerabilities (Figure 3), financial stability risks remain heightened mainly due to:1

  • High household indebtedness (Figure 4). Household debt reached 96 percent of GDP at end-2018. Canadian households are among the most indebted in advanced economies. Their debt-servicing obligations, already relatively large, could increase as interest rates rise. Households as a whole have large buffers, with net wealth of 489 percent of GDP. However, the share of debt belonging to households with excessive indebtedness or weak debt-servicing capacity exist has increased significantly over the past decade.

  • Persistent housing market imbalances (Figure 5). Overvalued house prices (relative to fundamentals such as income or rent) continue to underpin the imbalances. House price-at-risk analysis suggests that house price overvaluation and tight financial conditions have contributed to downside risk to house prices. Based on current macrofinancial conditions, a large housing market correction in the medium term is possible. With a 5 percent probability, average real house price could fall by at least 12 percent year-on-year over the next three years, with potential larger price declines in major cities such as Toronto and Vancouver.

  • Growing corporate debt (Figure 6). Corporate debt has risen rapidly to 111 percent of GDP at end-2018, largely driven by debt issuance (including in foreign currency) and non-mortgage borrowing. Overall profitability has recovered from the economic slowdown, but firms in the oil and gas and mining sectors continue enduring weak earnings. The rapid increase in debt of firms in the real estate sector raises a concern, especially given their weak income growth. The share of debt belonging to financially weak firms (with publicly available financial statements) is small.

Figure 3.
Figure 3.

Canada: External and Fiscal Vulnerabilities

Citation: IMF Staff Country Reports 2019, 177; 10.5089/9781498321112.002.A001

Sources: IMF, World Economic Outlook database and International Financial Statistics; and IMF staff calculations.
Figure 4.
Figure 4.

Canada: Household Financial Soundness

Citation: IMF Staff Country Reports 2019, 177; 10.5089/9781498321112.002.A001

Sources: CMHC; Haver Analytics; Statistics Canada, Survey of Financial Security; and IMF staff estimates.1/ The 5-percent house price-at-risk measures a potential decline in real house prices (year-on-year) three years ahead with a 5 percent probability.2/ Financially weak households are defined as households whose debt servicing-to-income is above 40 percent. Debt of these financially weak households is considered at risk.
Figure 5.
Figure 5.

Canada: Housing Market Developments

Citation: IMF Staff Country Reports 2019, 177; 10.5089/9781498321112.002.A001

Sources: Canadian Real Estate Association; Haver Analytics; OECD; and IMF staff estimates.1/ The housing market imbalances index comprises house prices, construction, inventory and sales, mortgage, and household balance sheet.2/ For the structural approach assessment, see the Staff Report for the 2019 Article IV Consultation with Canada.3/ The x-percent house price-at-risk measures a potential decline in real house prices with a x percent probability.
Figure 6.
Figure 6.

Canada: Corporate Financial Soundness

Citation: IMF Staff Country Reports 2019, 177; 10.5089/9781498321112.002.A001

Sources: Capital IQ; Haver Analytics; and IMF staff estimates.1/ Financially weak firms are defined as firms whose earnings before interest, tax, depreciation and amortization (EBITA) is less than interest expense (including capitalized interest). Debt of these financially weak firms is considered at risk.

14. Growth-at-risk analysis points to substantial downside risk to growth due to significant macrofinancial vulnerabilities. Growth-at-risk analysis provides a distribution of real GDP growth forecasts conditional on financial conditions and macrofinancial vulnerabilities, the latter capturing corporate and household sector vulnerabilities, housing market imbalances, and credit-to-GDP gap. As of 2018Q3, the analysis suggests a 5 percent probability that real GDP growth would be -1.7 percent or less over the next year, and -1.6 percent (annualized) over the next three years. Downside risk to growth has declined over the past year due some reductions in housing market imbalances and credit-to-GDP gap.

uA01fig04

Distribution of GDP Growth Forecasts, 2018Q3

Based on growth over the next 4 quarters; annualized

Citation: IMF Staff Country Reports 2019, 177; 10.5089/9781498321112.002.A001

Source: IMF staff estimates.
uA01fig05

Financial Conditions and Macrofinancial Vulnerabilities, 1992–2018

Citation: IMF Staff Country Reports 2019, 177; 10.5089/9781498321112.002.A001

Source: IMF staff estimates based on data from Haver Analytics.

15. Canada’s financial system faces a confluence of domestic and external risk factors that could amplify existing financial sector vulnerabilities (Table 2). The key external risks are tighter global financial conditions, significant slowdowns in the euro area and China, and rising protectionism and retreat from multilateralism. On the domestic front, a sharp house price correction could occur on the back of rising unemployment and higher funding costs. Cyber-attacks could also pose significant risk to the financial system.

16. The adverse scenario assumes a severe recession that would occur concurrently with significant financial stress and a sharp housing market correction (Figure 7, Table 5). The initial trigger are disruptions in international trade and global production chains, followed by disorderly financial market adjustments. Tightening global financial conditions would then set off global housing market and credit cycle downturns. Given domestic macrofinancial vulnerabilities, these external shocks would result in a sharp housing market correction, along with significant financial stress and large currency depreciation, in Canada. This perfect storm would cause a snapback of interest rates, as monetary policy would be tightened initially to stabilize inflation expectations and loosened in later years given recession-induced deflationary effects. The scenario envisages cumulative real GDP growth of -2 percent (annualized) during 2019–21; growth-at-risk analysis suggests that the likelihood of such a severe growth outcome is 3.8 percent.

Figure 7.
Figure 7.

Canada: Key Macrofinancial Variables in the Baseline and Adverse Scenarios

Citation: IMF Staff Country Reports 2019, 177; 10.5089/9781498321112.002.A001

Sources: Haver Analytics; IMF, World Economic Outlook database; and IMF staff estimates.
Table 5.

Selected Economies: Key Macrofinancial Variables in the Baseline and Adverse Scenarios

(In percent; unless indicated otherwise)

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Source: IMF staff estimates.

Interbank spread is defined as the difference between interbank rate and policy rate.

17. The household sector is exposed to severe macrofinancial shocks, while the corporate sector is more robust. In the adverse scenario, the share of household debt-at-risk would increase to 29 percent, up from 17 percent in 2016. Sizeable debt-at-risk not covered by assets suggests material financial stability implications. Fragility is more pronounced for households in British Columbia and Ontario due to higher indebtedness and larger housing market imbalances. In contrast, the share of corporate debt-at-risk would increase to 8 percent, up from 5 percent in 2018, with firms in the utilities and materials sectors among the most vulnerable. While their debt-servicing capacity is weak, only few of these financially weak firms would have solvency problems.

uA01fig06

Household Debt-at-Risk

(In percent of total debt)

Citation: IMF Staff Country Reports 2019, 177; 10.5089/9781498321112.002.A001

Sources: Statistics Canada, Survey of Financial Security; and IMF staff estimates. Note: Financially weak households are defined as households whose debt-servicing obligation is larger than 40 percent of disposable income. Debt of these financially weak households is considered at risk. The sensitivity analysis assumes a decline in income by 15 percent, an increase in interest rates up to 230 basis points (depending on the renewal profile of borrowers), and a decline in house prices by 40 percent.
uA01fig07

Corporate Debt-at-Risk

(In percent of total debt; based on firms with publicly available financial statements)

Citation: IMF Staff Country Reports 2019, 177; 10.5089/9781498321112.002.A001

Sources: CapitalIQ; and IMF staff estimates. Note: Financially weak firms are defined as firms whose earnings before interest, tax, depreciation and amortization (EBITDA) is less than interest expense (including capitalized interest). Debt of these financially weak firms is considered at risk. The sensitivity analysis assumes income shock (i.e., 25 percent decline in EBITDA) and funding cost shock (i.e., 5 percentage points increase).

C. Banking Sector

18. The banking sector’s performance is strong, with solid profitability and sizeable capital buffers (Figure 8, Table 6). Banks have steadily improved their capitalization, benefiting from their robust revenue-generating capacity based on universal banking even in the low interest rate environment. Credit-related impairments have been remarkably low. Large banks have established their footprints overseas, particularly in the United States, and thus become exposed to macrofinancial conditions in those markets. Going forward, the sector’s ability to continue growing domestically while maintaining high profit margins and low capital charges from mortgage lending could be more difficult given market saturation. Banks’ funding appears diversified, largely comprising retail and wholesale deposits. However, banks have increasingly relied on foreign-currency funding (slightly more than half of total funding) mainly to fund their international operations and to a smaller extent their domestic activities. Derivatives-related liabilities are sizeable and have contributed to volatile liquidity profiles.

Figure 8.
Figure 8.
Figure 8.

Canada: Banking Sector Performance1

Citation: IMF Staff Country Reports 2019, 177; 10.5089/9781498321112.002.A001

Sources: IMF, Financial Soundness Indicators database; and IMF staff calculations.1/ For Canada, figures only represent federally regulated banks.Sources: IMF, Financial Soundness Indicators database; OSFI; SNL; and IMF staff calculations.1/ For Canada, figures only represent federally regulated banks.
Table 6.

Canada: Financial Soundness Indicators

(In percent)

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Sources: Haver Analytics; IMF, Financial Soundness Indicators; OSFI; and IMF staff calculations.

Based on federally regulated entities. Unless indicated otherwise, including only Canadian entities.

LICAT stands for Life Insurance Capital Adequacy Test, and MCT stands for Minimum Capital Test.

Including also foreign entities operating in Canada.

Based on total borrowing and net accounts payable.

19. Smaller deposit-taking institutions show some vulnerabilities. Some banks rely on less stable brokered deposits. Credit unions’ loan books are concentrated in residential mortgages, and hence could be hard hit following a significant decline in house prices.

20. D-SIFIs appear resilient to severe macrofinancial shocks (Figure 9).2 Based on the stress tests that covered six domestic systemically important banks (D-SIBs) and Québec’s D-SIFI, the solid revenue-generating capacity would contribute to an upward trajectory of capital ratios in the baseline. In the adverse scenario, the aggregate common equity tier-1 (CET1) capital ratio would decline by 4.8 percentage points to 7.4 percent in 2020 before recovering to 9.6 percent in 2021. During the stress testing horizon, most entities would tap into capital conservation buffers, therefore subject to dividend restrictions. By 2021, all entities would meet the regulatory minimums (including D-SIFI capital surcharges). Larger credit-related impairments, lower net interest income and non-interest income, and increased risk-weighted assets would contribute to a larger capital depletion in the adverse scenario than in the baseline. Staff stress test results are largely aligned with BOC results.

Figure 9.
Figure 9.

Canada: Bank Solvency Stress Test Results

Citation: IMF Staff Country Reports 2019, 177; 10.5089/9781498321112.002.A001

Source: IMF staff estimates.
uA01fig08

Common Equity Tier-1 Capital, 2018–21

(In percent of risk-weighted assets)

Citation: IMF Staff Country Reports 2019, 177; 10.5089/9781498321112.002.A001

Source: IMF staff estimates.
uA01fig09

Contribution to Common Equity Tier-1 (CET1) Capital, 2018–21

(In percent of risk-weighted assets)

Citation: IMF Staff Country Reports 2019, 177; 10.5089/9781498321112.002.A001

Source: IMF staff estimates.

21. The capital dynamics would be largely driven by credit risk. In the adverse scenario, cumulative credit-related impairments would reduce aggregate capital ratios by 4.4 percentage points. Underlying credit quality would also deteriorate significantly, raising risk-weighted assets and thus reducing aggregate capital ratios by 0.8 percentage points.

22. However, additional losses could materialize due to Canada-specific features that were not fully captured in the abovementioned results. The sizeable undrawn exposures in the banking book, including HELOCs, could be drawn at time of stress, resulting in additional credit-related impairments of Can$18.5 billion (0.9 percent of risk-weighted assets) according to sensitivity analysis. Similarly, if lenders adopt a more dynamic risk-based pricing of mortgage spreads by charging larger spreads for financially weaker borrowers, additional credit-related impairments would amount to around Can$14.5 billion.

23. D-SIFIs appears to hold sufficient liquidity buffers to withstand sizeable funding outflows. The cash-flow analysis identifies small liquidity shortfalls for some entities under severe scenarios,3 with aggregate shortfalls amounting up to Can$91 billion. The exercise suggests that a large funding outflow would be needed to generate a liquidity shortfall. The Liquidity Coverage Ratio (LCR) tests confirm similar findings. D-SIFIs would be able to manage large outflows from either retail or wholesale funding segments separately, including by significant currencies. However, certain vulnerabilities exist. Counterparty risk could be material given the sizeable repo books and derivatives exposures (e.g., currency swaps and total return swaps); the latter, potentially associated with complex bank-specific risk profiles, was not assessed due to data limitation.

uA01fig10

Counterbalancing Capacity and Funding Outflows, 2018Q3

(In billions of Canadian dollar)

Citation: IMF Staff Country Reports 2019, 177; 10.5089/9781498321112.002.A001

Source: IMF staff estimates.
uA01fig11

Liquidity Coverage Ratio (LCR), 2018Q3

(In percent)

Citation: IMF Staff Country Reports 2019, 177; 10.5089/9781498321112.002.A001

Source: IMF staff estimates.

D. Insurance Sector

24. The insurance sector’s performance has been strong even in a low interest rate environment (Figure 10, Table 6).4 Return on equity remains stable for the life and mortgage insurance sectors but has declined for the property-and-casualty insurance sector in recent years. Overall, insurers in all sectors maintain strong solvency positions, holding some capital buffers in excess of the supervisory targets. Following the expansion of their business abroad, the three large life insurers have increasingly relied on earnings from their overseas operations (more than half of their net premiums).

Figure 10.
Figure 10.

Canada: Insurance Sector Performance

Citation: IMF Staff Country Reports 2019, 177; 10.5089/9781498321112.002.A001

Sources: Haver Analytics; OSFI; and IMF staff calculations.1/ Based on consolidated balance sheets of federally regulated insurers.2/ LICAT stands for Life Insurance Capital Adequacy Test; MCT stands for Minimum Capital Test; and MICAT stands for Mortgage Insurance Capital Adequacy Test.3/ Based on National Balance Sheet Accounts, effectively reflecting total insurance operations in Canada.

25. Large life insurers are somewhat exposed to financial market stress and lower interest rates. The stress tests covered the five largest life insurers and assessed the sensitivity of their solvency to macrofinancial conditions in 2019Q3 (most severe financial market stress) and 2021Q4 (lowest interest rates) in the adverse scenario. In 2019Q3, the aggregate core capital ratio would decline by 34 percentage points to 61 percent, largely driven by the impact of widening credit spreads and falling equity prices. Essentially, life insurers hold a sizeable amount of low-rated and unrated bonds. Some entities would see their capital ratios below the regulatory minimums. In 2021Q4, the aggregate core capital ratio would fall marginally by 5 percentage points. However, life insurers’ solvency would be hit harder in a more sustained low interest environment. For example, a downward parallel shift in the risk-free yield curve by one percentage point would reduce the core capital ratio by 40 percentage points.

uA01fig12

Core Capital Ratio and Its Drivers, 2018–21

Based on Life Insurance Capital Adequacy Test (LICAT)

Citation: IMF Staff Country Reports 2019, 177; 10.5089/9781498321112.002.A001

Source: IMF staff estimates.
uA01fig13

Life Insurers’ Holding of Debt Securities, 2018

(In billions of Canadina dollar; based on five largest life insurers)

Citation: IMF Staff Country Reports 2019, 177; 10.5089/9781498321112.002.A001

Sources: AMF; OSFI; and IMF staff calculations.

26. Mortgage insurers are vulnerable to severe macroeconomic downturns with significant house price declines. Based on the stress tests that covered all three mortgage insurers, cumulative insurance claims would amount to Can$25 billion, consistent with credit losses of banks’ insured mortgage portfolios, in the adverse scenario. Mortgage insurers would need additional capital of Can$15 billion to meet the supervisory solvency target, half of which is for one insurer.

uA01fig14

Capital Ratio and Capital Shortfalls, 2018–21

Based on Mortgage Insurance Capital Adequacy Test (MICAT)

Citation: IMF Staff Country Reports 2019, 177; 10.5089/9781498321112.002.A001

Source: IMF staff estimates.
uA01fig15

Dynamics of Capital Ratio in the Adverse Scenario, 2018–21

Based on the Mortgage Insurance Capital Adequacy Test (MICAT) (In percent of 2018Q4 required capital)

Citation: IMF Staff Country Reports 2019, 177; 10.5089/9781498321112.002.A001

Source: IMF staff estimates.

27. Required capital for insured mortgages may not sufficiently reflect potential deterioration of credit quality during severe downturns. The seven D-SIFIs currently have capital buffers for insured mortgage exposures equivalent to 0.17 percent of outstanding insured mortgages. Accounting for mortgage insurers’ required capital for insurance risk, system-wide capital buffers would amount to 1.96 percent. In adverse scenario, these buffers should go up to 4.32 percent. This would imply additional capital need of Can$28 billion to cover expected and unexpected losses for insured mortgage exposures.

E. Risk-Taking in Nonbanks and Markets

28. The nonbank sector (excluding insurance) has grown considerably in recent years.

Pension funds and mutual funds dominate the institutional and retail asset management landscape, respectively. Other investment funds and special purpose vehicles have a relatively small footprint but are growing rapidly. Together, investment funds have been the main driver for the strong growth of FSB-defined “nonbank financial intermediation”, which reached Can$2 trillion at end-2017. Furthermore, captive financial institutions and money lenders are sizeable (Can$3.3 trillion).

29. Risk-taking of institutional investors is rising, and valuations of certain asset classes are stretched (Figures 11 and 12). Pension funds and other liability-driven institutional investors have increasingly used complex derivatives and borrowing-based strategies (including short-term repos), resulting in increased leverage and liquidity risk. Pension funds have also increased their exposures to illiquid asset classes such as real estate, private equity, and private credit, which typically contain significant additional unreported leverage and contingent liquidity risk. Fixed-income and real estate asset valuations are stretched, while dependence on foreign investors for non-government bond market funding has increased significantly. In the event of market stress, rising liquidity and valuation risks could magnify losses and market volatility, while a retreat of foreign investors could tighten financial conditions sharply.

Figure 11.
Figure 11.
Figure 11.

Canada: Risks from Nonbank Financial Sectors

Citation: IMF Staff Country Reports