Europe's debt crisis a risk here, Bank of Canada warns

Global financial conditions stemming from the debt crisis in Europe are deteriorating rapidly, placing Canada's economy under greater stress and Canadians with large debts at greater risk, warns the Bank of Canada.

The central bank's semi-annual financial stability review says bluntly that Canadians need to start worrying about the worsening debt mess in Europe, and its ability to hit home hard.

"Since June, the global retrenchment of risk associated with the European crisis has indeed resulted in a significant correction in the prices of equities and other risky assets, as well as a widening of credit spreads in Canada," the bank states.

"Should the crisis deepen and spread further to the larger European economies, transmission to Canada could become more severe ... An adverse outcome for Europe would also raise the risk of a significant impairment of funding conditions for Canadian institutions."

The report notes that the Canadian banking sector's direct exposure to the debt problems in Europe are limited, ranging from virtually zero per cent of the capital they hold in the case of Greece and Portugal, to a high of 3.4 per cent with respect to Italy.

But the analysis adds that the spillover effects on the global economy touches almost every aspect of Canada's economic and financial system, from trade, to the financial system to consumer and business confidence.

"The (bank's) governing council judges that the risks to the stability of Canada's financial system are high and have increased markedly over the past six months," the review states.

Record household debt expected to rise

A major area of concern for the bank is the high level of indebtedness of Canadian households that have taken advantage of the low interest rate environment of the past several years to buy homes, cars and other items on credit.

The bank says while credit growth has slowed recently, it worries that it continues to rise faster than incomes despite persistent admonitions from policy-makers that one day interest rates will rise, and monthly payments to service debt will increase.

Although household debt-to-income is now at a record 149 per cent, higher than even in the United States, the bank fully expects that ratio to increase further.

That leaves Canadian households vulnerable to a shock, such as a sharp rise in unemployment caused by an economic slowdown or a significant decline in house prices, which would sap household wealth.

The bank regards the situation serious enough that it advises the government to "continuously assess the risks arising from the financial situation of the household sector."

Recently, the International Monetary Fund said Ottawa may need to again revisit eligibility rules for obtaining mortgages, even though the federal government have tightened conditions three times in as many years.

The bank doesn't go that far, but notes that after Marchthe last time mortgage requirements were stiffenedmortgage credit slowed, but has since picked up.

The bank also cautions that low interest rates and the weak performance of markets is putting the squeeze on pension plans, which are at a higher risk of being unable to meet their financial obligations.