Canadian banks aren't overly exposed to worrisome debt from European banks, but if the euro crisis worsens, the impact on Canada's economy would be significant, the central bank warned Wednesday.
In a semi-annual report, the Bank of Canada said the total value of Canadian banks' holdings of debt from Greece, Ireland, Portugal, Spain and Italy is roughly eight per cent of their Tier 1 capital levels.
A bank's Tier 1 capital ratio is the amount of money that a bank holds in reserve versus the amount of money it is allowed to lend out.
The eight per cent exposure rate to government and corporate debt from European economies that are at the highest risk of defaulting pales in comparison to the Canadian banks' exposure to U.S. debt. The central bank noted that the banks' total exposure to all forms of U.S. debt is in excess of 400 per cent of their Tier 1 levels.
In layman's terms, that means the big banks are exponentially more vulnerable to a slowdown in the U.S. economy than they are to the European debt crisis.
"The direct exposure of Canadian banks to the affected European countries is limited," the bank noted in its report. "However, should the crisis worsen and spread further across Europe, the impact on the Canadian financial system could be significant."
"The indirect impacts could become especially important if entities in the United States were significantly affected by the crisis."
Overall, the central bank said the overall level of risk to Canada's financial system is high — the second-highest of the bank's four levels, and the same level as it was in December, the last time the bank issued a version of the report.
Domestically, the level of risk posed by debt levels and the country's housing market remains elevated, although no better or worse than was the case in December.
"The high indebtedness of the household sector and elevated valuations in the housing market require continued vigilance," the report said. "These conditions make households especially vulnerable to adverse shocks."
The central bank also noted that certain segments of the housing market have a persistent oversupply — such as condos in Toronto — and face a higher risk of a price correction.
Using a hypothetical stress test, the bank says a three percentage point increase in unemployment — about the same as what occurred in the recent recession — would almost triple the proportion of indebted households that would go into arrears.
Currently, less than 0.5 per cent of Canadian households are in arrears (meaning, more than 90 days overdue) on their bills. Should the unemployment rate increase by the three percentage points the bank projects, that figure would jump to 1.3 per cent.