Bank of Canada issues financial sector update

The review focused on three key components of the global financial system: financial institutions like banks, insurance companies and securities dealers; financial markets in which financial assets are priced and traded; and the clearing and settlement systems that underpin the flow of assets between firms and individuals.

“Past episodes around the world have shown that serious disruptions to one or more of these three components whether they originate from domestic or international sources, can create substantial problems for the entire financial system and ultimately for the economy as a whole,” say the report’s authors.

“As well, inefficiencies in the financial system may lead to significant economic costs over time and contribute to a system that is less able to successfully cope with periods of financial stress. It is therefore important that Canada’s public and private sector entities foster a financial system with solid underpinnings, thereby promoting its smooth and efficient functioning.”

In assessing risks to the stability of the Canadian financial system the report focuses on the vulnerabilities of the overall system, those that could have systemic repercussions, and not on individual institutions, firms or households.

A review of markets show prices for risky assets like equities and emerging market bonds fell briefly in May 2006, retracing most of their appreciation since the December report. The correction occurred in tandem with a sharp rise in market volatility and general retrenchment in metals and other commodity prices.

“This correction in the price of risky assets appears to reflect a change in the perception of global growth fundamentals. There are mounting concerns among investors about stronger than anticipated global inflation, particularly in the United States,” say the report’s authors. “Investors seem to be increasingly concerned that the global reduction in monetary policy stimulus could lead to a decline in global growth. Accordingly, there has been a relatively large decline in the price of assets that are particularly sensitive to the pace of global economic activity.”

One area of concern is growing global current account imbalances — large precautionary savings in Asia, and low savings in the United States. “Although these imbalances have continued to grow recently, there have been some tentative signs of policy shifts that could contribute to an orderly adjustment. Moreover, global economic growth is becoming more broadly based with the strengthening of Japan’s economy and to a lesser extent, that of Europe.”

The risks of a global economic slowdown for Canada include lower export volumes, weaker commodity prices and impaired profits for Canadian companies. Canadian financial institutions however are currently in a good position to withstand shocks, thanks to strong profits and high levels of capitalization.

Structural developments affecting the Canadian financial system include new accounting standards, based on existing U.S. and international standards that come into effect for public companies on October 1. The report says “while the implementation of these standards may result in increased volatility in the value of key financial statement variables for firms whose assets and liabilities are not matched, it will also mean that users of financial statements will have better information on which to base decisions.”

The paper goes on to discuss the revised harmonized internal control reporting requirements released by the Canadian Securities Administrators in March, that would require all publicly traded companies to report on the effectiveness of their internal controls, and two recent development in mortgage insurance that should provide further support to the Canadian housing market — The Canada Mortgage and Housing Corporation and Genworth Financial Canada recently announced increased maximum amortization periods and improved access to mortgage insurance for non-prime customers.

Outside of the financial industry, however, a number of sectors are suffering from the appreciation of the dollar, higher input costs and increased competition in international markets, but the behavior of non-financial corporations in Canada “seems to have been prudent at a point in the cycle when risk taking can often lead to vulnerabilities.” Many non-financial corporations are earning substantial profits and using the capital to reduce debt to equity ratios and accumulate liquid assets.

While growth in household credit has risen to around 11%, the report says the household sector poses a low risk to the financial system, but adds that if economic prospects were less positive or if interest rates were to rise significantly, the finances of some households would undoubtedly be strained.

The paper also includes a brief, top line discussion of the risks associated with an influenza pandemic, a theoretical case study to model shareholder restrictions, ownership concentration and its affects on banking and loan market competitiveness, Bank of Canada oversight activities in 2005 under the Payment Clearing and Settlement Act, Canadian developments in market financing of public-private partnerships, research on using the contingent claims approach to asset credit risk in the Canadian business sector, the impact of unanticipated defaults in Canada’s large value transfer system and how to use high frequency data to model volatility dynamics.

The complete 77-page report can be downloaded from the Bank of Canada website at www.bankofcanada.ca.

Filed by Kate McCaffery Advisor.ca, kate.mccaffery@advisor.rogers.com

(06/15/06)