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The BoC’s Coté On Risk & Household Debt

Measuring RiskSince the credit crisis, the Bank of Canada has stepped up efforts to quantify the risk lurking in our financial system.

Deputy Bank Governor Agathe Côté spoke about this Tuesday. She explained how the BoC models risks and provided the following factoids on Canadians’ debt exposure.

She said:

  • “…While record-low interest rates in recent years have contributed to a relatively low aggregate household debt-service ratio, the share of Canadian households that are considered most vulnerable – those with a (total) debt service ratio equal to or higher than 40% – has climbed to above-average levels, as has the proportion of debt held by these vulnerable households.”
    (The proportion of indebted households with debt-service ratio ≥ 40% was just about 6% on Dec. 31, 2011. Just for perspective, the maximum allowable debt ratio on a standard mortgage application is 44%.)
  • Rising-rate-riskIf interest rates were to rise to 4.25% by mid-2015, then:
    • the share of highly indebted households would rise from slightly above 6% in 2011 to roughly 10% by 2016
    • the proportion of debt held by these households would rise from 11.5% to about 20% over the same period.
  • “…Household loans in arrears would more than double under a severe labour market shock similar to that observed in the recession of the early 1990s.”
    (That said, double the latest 0.34% arrears rate would still be far less than the modern-day high of 1.02%. The BoC also admits that its models don’t assume that distressed households will sell their homes to avoid default—a realistic option for indebted families with marketable homes and sufficient equity.)
  • Research shows that combining real estate prices and the credit-to-GDP gap (i.e., the difference between private sector credit and its long-term trend) provides “among the most reliable indicators of financial stress.”Here’s a chart showing the credit-to-GDP gap:


(Click chart to enlarge)

And here’s a familiar graph of Canadian home prices, which have been riding the up escalator for more than a decade. Source: Teranet & National Bank.


(Click chart to enlarge)

The full text of Côté’s speech is available here.

Rob McLister, CMT