My favorite business reading of the year was out yesterday. Here are a few takeaways that I found worth highlighting:
🏘 Household debt
▶ Higher interest rates and declining house prices have reduced financial flexibility for many households, resulting in early signs of financial stress.
▶ The share of households affected by higher interest rates will continue to rise over the next few years as homeowners renew their mortgages.
▶ High debt-servicing costs and low homeowner equity make households more vulnerable to default if they experience a drop in income.
▶ The share of indebted households that are behind on payments for at least 60 days in any credit category is below its pre-pandemic average but has been increasing since the middle of 2022.
▶ Over the past year, homebuyers have increased their reliance on credit card debt, indicating a greater reliance on credit cards among recent homebuyers to finance debt. Arrears on credit cards have also been rising and are close to pre-pandemic levels, in contrast to those on mortgages, which remain near historical lows.
🏪 Small and medium enterprises (SMEs)
▶ The balance sheets of SMEs remain healthy and many SMEs continue to hold historically high levels of cash.
▶ Businesses could face financial strain because they heavily depend on bank financing for their operations.
▶ Nonetheless, financial stress is rising mostly among small businesses. About one-half of the firms that received government support during the pandemic reported that repaying the funds before the end of 2023 would be a challenge, especially for small firms.
🏢 Commercial real estate (CRE)
▶ Decrease in market valuations of firms in the CRE subsector. If some of these firms were to default on their loans, lenders could face credit losses.
▶ However, the Canadian banking sector’s exposure to CRE is small, with non-residential mortgages accounting for about 2% of the total value of bank assets. Differences exist across institutions, with some lenders more exposed than others.
🏦 The Banking and asset management Sector
▶ Recent stresses in the global banking sector have exposed vulnerabilities in business models that rely excessively on an environment of low interest rates and low volatility.
▶ Additionally, if a sustained period of financial stress were to occur, it could further reduce liquidity in fixed-income markets and add to bank funding pressures.
▶ If banks tighten their lending standards, this could worsen a potential downturn.
▶ Asset managers require market liquidity due to asset-liability mismatches and leverage, and if many asset managers attempt to sell assets at the same time, significant price reductions may be required to clear the market.
▶ The Bank of Canada could provide liquidity through its standing and extraordinary facilities, and in cases of extreme market-wide stress, it could activate the Contingent Term Repo Facility to provide liquidity directly to asset managers.
The full version of the Bank of Canada’s 2023 Financial System Review is available here.
