High levels of household debt and red-hot housing markets in Toronto and Vancouver pose the biggest threats to the stability of the country’s financial system, the Bank of Canada said Thursday.

The housing price and the household debt problems are linked, as Canadians are taking out riskier loans to buy homes priced at more than $1 million in some markets, the bank said in its semi-annual Financial System Review.

The Bank of Canada report also raises concern over the “fragile liquidity” of some fixed-income markets and the threat cyberattacks could pose to financial institutions.

Stephen Poloz, Governor of the Bank of Canada, said the Canadian financial system is “resilient,” especially as the country’s economy has shown fresh signs of strength over the last six months.Yet threats remain, and it’s the job of the central bank to document those risks twice a year with its Financial System Review.

“The two most important vulnerabilities for Canada’s financial system — the elevated level of household indebtedness and imbalances in the Canadian housing market — have moved higher over the past six months,” Poloz said at a news conference in Ottawa.

Mortgages and home equity lines of credit make up 90 per cent of Canada’s household debt levels, and the Bank of Canada is concerned that mortgage credit has been growing faster than disposable income. A growing number of highly indebted people are taking out uninsured mortgages with long amortization periods, and this is a concern for the bank.

“Highly indebted households have less flexibility to deal with sudden changes in their income. As the number of these households grows, it is more likely that adverse economic shocks to households would significantly effect the economy and the financial system.”

Much of the growth in household debt is linked to rising housing prices in Toronto and Vancouver.

Yet there are signs the quality of the mortgage market is improving. The bank said policy measures introduced by the federal government in late 2016 have reduced the number of highly indebted mortgage borrowers across the country. Still, rising home prices worry the bank. Imbalances in the Canadian housing market have increased since the previous Financial Service Review was published in December, the bank said.

Canadian home prices were 20 per cent higher in April, year-over-year. Outside of the Toronto and Vancouver areas, price increases have been modest. But the housing price situation in B.C. and Ontario could have national consequences. The areas in those provinces in which housing prices are growing the fastest account for about half of the value of Canada’s housing stock, and about one-third of the country’s population.

“Where house prices have grown at a faster pace than can be readily explained by fundamentals — such as in the Toronto and Vancouver areas — there is an increased likelihood of a price correction that could lead to financial stress,” the bank said.

The overheated housing markets in Toronto and Vancouver have caught global attention. The Paris-based Organization for Economic Co-operation and Development said Wednesday that Canada needs take more “macroprudential” measures to cool its housing markets. And Moody’s recently downgraded the credit ratings of Canada’s six largest banks to account for the surge in Canadian household debt.

The bank is hopeful that government policies will help reduce the risk of a housing correction.

“Macroprudential and housing policy measures are, however, expected to help mitigate this vulnerability over time. They may already be playing a role in the recent sharp increase in listings, slowdown in resales and moderating price growth in the GTA,” the bank said.

Canada’s economy had a robust start in the first quarter, and that eases the chances of recession.

Still, the bank examined a couple of scenarios.

In the first scenario, that of a severe recession, there would be widespread job losses, a decline in income, and a housing price correction. In a second scenario, the bank said a significant housing price correction isolated to the Toronto and Vancouver areas would have spillover effects that would hurt other regions and sectors of the economy, but likely wouldn’t trigger widespread unemployment.

Meeting with reporters, Poloz said the housing price and indebtedness issue might lead some to ask about the situation involving alternative lender Home Capital.

“While we don’t generally discuss individual financial institutions, I can say our assessment is that the situation reflected firm-specific factors,” Poloz said. “The regulatory and supervisory system worked as it is designed to do, and we are not seeing signs of broader stress.”

Financial Post