Bank of Canada considers risks posed by highly indebted households

By Andrew Rickard | February 29 2016 01:40PM

720,000 households hold nearly $400 billion in debt, which is about one-fifth of all household debt in Canada. How big of a risk do they pose?

In a speech to the Guelph Chamber of Commerce on Feb. 24, Lawrence Schembri, deputy governor at the Bank of Canada, discussed how much of a threat high levels of household debt pose to the economy.

$400 billion in debt

A small but growing subgroup of borrowers, many of whom are under the age of 45, have taken on significant amounts of debt and have debt-to-gross-income ratios that are equal to or more than 350 per cent. Schembri notes that the size of this subgroup doubled since the financial crisis, growing from around 4% to account for about 8% of indebted households. "That amounts to about 720,000 households holding close to $400 billion in debt, about one-fifth of the overall household debt," he says.

If there were to be a recession, those already carrying heavy debt loads would likely reduce their spending drastically, which could amplify the effect of a shock. In extreme cases, they might default on their mortgages and generate losses for both banks and mortgage insurers. Schembri also notes that highly indebted households are more likely to lose their jobs because they tend to be younger and are less likely to have a post-secondary degree or training.

The magnitude of this potential threat

To understand the magnitude of this potential threat to the financial system, the Bank of Canada has simulated "a large and persistent increase" of 5% in the unemployment rate.

"Our simulations suggest that in response to this shock household arrears rates could rise significantly, from 0.4 per cent in 2014 to reach as high as 1.8 per cent after three years," says Schembri. "About 20 per cent of this estimated rise would be attributable to the increase in debt and its greater concentration among highly indebted households since 2007."

Vulnerable homeowners

In this kind of a scenario, Schembri says that some vulnerable homeowners could be forced to sell their homes or even default on their mortgages. This in turn could cause housing prices to drop sharply across Canada, particularly in Vancouver and Toronto. However, despite the drop in oil prices, the Bank of Canada believes that there is a low probability that these events will come to pass.

Schembri points out that the Bank of Canada has deployed a range of policy responses to mitigate risks, for example by requiring banks to hold more and higher-quality capital and meet new liquidity and leverage requirements, and through its recent tightening of the qualification rules for mortgage insurance. He concluded his remarks by describing the Canadian financial system as "very resilient" and asserting that it "could withstand the triggering of this vulnerability".