Mark Carney: Current issues in household finances
Remarks by Mr Mark Carney, Governor of the Bank of Canada, at The National Forum
(Canadian Club of Toronto and Empire Club of Canada), Toronto, 16 December 2009.
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Introduction
As the holiday season approaches, our attention turns naturally to the home front.
Accordingly, my comments this afternoon will focus on households. I would like to
concentrate in particular on the implications of Canadian household finances for financial
stability in our country.
I spoke here in Toronto a year ago, almost to the day. Then, the global financial sector crisis
was buffeting the real economy. Businesses were postponing large investments, and
households were hesitating over major purchases. It was clear then that 2009 would be a
difficult year, and so it has proved. With more than 400,000 jobs lost and a $30 billion fall in
output, the Canadian economy has suffered a deep, albeit brief, recession.
Today, the outlook has improved. While significant fragilities remain, the global economic
recovery is now supported by several factors. First, feedback between financial markets and
the real economy has reversed direction. In most major economies, the inventory cycle has
turned and housing sectors are stabilizing. In addition, considerable fiscal expansion and
monetary stimulus are supporting domestic demand.
Nonetheless, the Bank expects underlying private demand in many economies to recover
only slowly, as significant balance sheet and structural adjustments have yet to run their
course. In particular, the rebound in U.S. consumption is projected to be more moderate than
in previous cycles. This will have direct implications for Canada. While the Canadian
economy will likely grow faster than the other G-7 countries next year, the Bank expects our
recovery to be more protracted and more reliant on domestic demand than usual (Chart 1).
In the near term, Canada will grow despite - not because of - the pace of external activity.
The behaviour of Canadian households will thus be particularly important. Before turning to
that in more detail, I would like to briefly review the challenges facing U.S. households, both
for their direct impact on Canada and for the insights they offer for financial stability.
U.S. household sector
For a generation, U.S. households increasingly "saved" through capital appreciation rather
than from current income. Over the last three decades, U.S. consumer spending grew
substantially faster than national income, driving the ratio of consumption to GDP from 62 per
cent to a record 70 per cent (Chart 2). In the same period, the personal savings rate fell from
11 per cent of disposable income to 1 per cent, while household debt doubled from 84 per
cent of disposable income to 165 per cent.1
Financial innovations, including home equity loans and securitization, drove these trends.
Initially, they increased financial system efficiency, diversified risk, and smoothed
consumption. Over time, however, these financial technologies were applied increasingly
indiscriminately. Prudence gave way to exuberance to the extent that the subprime-mortgage
market became a mainstay of the expansion.2 When the U.S. housing bubble collapsed
under its own weight, households with the least resilience were the hardest hit.
An important lesson of the American experience was that the costs were not confined to the
most vulnerable households. In a now-familiar chain, problems in subprime quickly spread to
prime mortgages, structured products in general, core funding markets, and, ultimately, the
capital bases of most major financial institutions. Eventually, virtually every financial asset in
the world was repriced. Financial stability is as much about linkages as it is about specific
risks. Shocks can have large, unanticipated consequences.
A lengthy period of adjustment for the U.S. consumer has just begun (Chart 3). A decline of
roughly 30 per cent in wealth has promoted a quadrupling of the U.S. personal savings rate
to 4.5 per cent. Nonetheless, household debt levels have not fallen substantially, and
consumer spending as a share of GDP actually rose to a new high of 71 per cent in the third
quarter.3 Given the historic declines in net worth and the need to save for retirement, it
appears clear that U.S. household savings need to remain elevated for an extended period of
time.
The new equilibrium for household savings will depend on multiple factors, including wealth
effects, risk aversion, the evolution of the financial system, the employment outlook, and the
credibility of fiscal policy.4 The Bank currently projects that the U.S. personal savings rate will
average around 5.5 per cent over the next two years. This judgment is consistent with
ultimately stabilizing the U.S. net foreign liability position and rebuilding U.S. household
wealth.5
This sustained, higher savings rate will produce a historically weak recovery in
U.S. consumer spending and accounts for the Bank's relatively subdued forecast for overall
U.S. economic growth (Chart 4).
Canada's household sector
Canadian household finances were in better shape going into the crisis than those of
Americans. The Canadian personal savings rate was higher and household debt was lower
(Chart 5). The ratio of consumer spending to GDP, at 55 per cent, was below the longer-term
average in Canada. As a consequence, when the crisis struck, Canadian households were
less vulnerable.
Moreover, throughout the downturn, Canadian labour and housing markets held up better
(Charts 6 and 7), meaning that the incomes and net worth of Canadians were not as hard hit
as those of Americans (Chart 3). So, while there is no doubt the financial crisis and
accompanying recession have been painful here, Canadians have had less need to increase
savings to restore their balance sheets.
Still, Canadians have saved more. The personal savings rate in this country rose to an
eightyear high of 5.5 per cent in the second quarter. The Bank projects that this rate will moderate
only slightly over the medium term. We view the sharp increases in household savings as
largely precautionary, that is, reflecting uncertainty about the economic outlook and financial
conditions.
As the economy begins to grow again and confidence is gradually restored, we expect that
some of these precautionary savings will be unwound, and that some consumers will take
further advantage of unusually low borrowing rates. Indeed, our current stimulative monetary
policy is meant, in part, to encourage such behaviour. Stronger growth in domestic
consumption will be necessary to offset weak external demand in order to restore the
Canadian economy to balance and inflation to target. Recent data have been consistent with
these expectations.
Going forward, there are risks, on both the upside and the downside, to this outlook for the
Canadian personal savings rate. Canadian households could remain more cautious,
chastened by the recent financial and economic trauma, leading to more durably elevated
savings. Some of the issues brought to the fore by the crisis, such as retirement funding,
could also alter household savings behaviour over the nearer term. Over the next few days,
the federal, provincial, and territorial finance ministers will meet to discuss these issues, in
recognition of their importance to Canadians. Finally, more protracted U.S. and global
recoveries could restrain Canadian households, by affecting both the confidence and
economic prospects of Canadians.
On the other hand, there is a risk that, as growth returns, the resilience of Canadian
households through the crisis could lead to declines in the savings rate that are sharper, and
increases in household borrowing that are larger, than the Bank has projected.
Whatever happens, the Bank's monetary policy reaction to consumer behaviour will always
be driven by its implications - taken in conjunction with all other relevant factors - for inflation
over the medium-term horizon.
Households and financial stability in Canada
Household finances are also important for financial system stability. As was painfully learned
from the U.S. experience, a stable financial system is fundamental for the effective
functioning of the economy and the financial welfare of citizens.
In this regard, there are two important considerations. First, financial and price stability share
common determinants but have different time horizons. Inflation continuously reflects real
shocks and/or policy responses, while financial vulnerabilities are much less predictable.
They develop over time and can persist for longer than expected. Simply put, behaviour
consistent with price stability over the medium term could simultaneously build financial
stresses over a longer horizon. Second, when evaluating the financial condition of
Canadians, we need to look beyond the aggregate for possible changes in distribution of
debt among households.
The Financial System Review (FSR) is a semi-annual Bank publication that examines
developments in the financial system and provides an analysis of policy directions in the
sector. In our most recent FSR, we judge that most of the risks to the stability of the
Canadian financial system have ebbed in recent months. At the same time, our assessment
of the risks related to household balance sheets is that they have increased further.
As noted in the FSR, the vulnerability of Canadian households to adverse wealth and income
shocks has grown in recent years. Aggregate debt levels have risen sharply relative to
income. Those debt levels have continued to grow fairly rapidly this year, unusually so for a
recession.6 For some households, this additional indebtedness has translated into increased
financial stress. Personal bankruptcies in Canada rose 41 per cent in the third quarter from
the same period a year ago, leaving the number of bankruptcies as a proportion of the
population at its highest level since 1991. Delinquency rates on loans have risen as well, with
the proportion of mortgages with payments in arrears three months or more having increased
by half over the past year.
Stress testing the Canadian household sector
To understand better the vulnerability of Canadian households, and the consequences for
financial stability, the Bank undertakes regular stress tests. The June FSR reported on the
potential impact of a more severe economic downturn on households. The results illustrated
that a hypothetical increase in unemployment could produce loan losses for financial
institutions representing about 10 per cent of their Tier 1 capital.7
While the near-term risks from a further sharp deterioration in labour markets have
diminished, the Bank believes that overall risks to financial stability arising from the
household sector have continued to increase. In particular, the combination of sustained
growth of household debt relative to income and a rising interest rate environment could
increase the vulnerability of households to an adverse shock. In the current FSR, the Bank
conducts stress-test scenarios to examine the potential impact of growing debt and rising
interest rates on the debt-service ratio of Canadian households (Table 1). We look at
scenarios such as these, not because we think they are the most likely outcome, but rather
to provide an assessment of downside risks that could potentially generate stress in the
Canadian financial system.
The simulation generates a scenario indicating that, by the middle of 2012, almost one in ten
(9.6 per cent) Canadian households would have a debt-service ratio greater than 40 per
cent, the threshold above which households are considered financially vulnerable (Table 2).
Moreover, the percentage of debt owed by these vulnerable households would almost
double. Both of these metrics are well above their recent peaks.8
While these simulation results are purely illustrative, they give pause for reflection. It would
not be healthy to have almost 20 per cent of household debt extended to vulnerable
households. Nor is it necessary to secure our recovery.
The risks are not isolated to the most vulnerable. A shock to economic conditions could be
transmitted to the broader financial system through deterioration in the credit quality of loans
to households. In such an event, increased loan-loss provisions and reduced quality of the
remaining loans could lead to tighter credit conditions more broadly and, in turn, to mutually
reinforcing declines in real activity and in the health of the financial sector. While the broader
effects are difficult to anticipate with precision, some sectors, such as retail and housing,
would likely be affected more than others. Such a shock would also affect certain segments
of the capital markets, such as credit card securitization. More fundamentally, strains on the
household sector could also cause a more generalized rise in risk premia, with attendant
negative implications for a variety of asset prices.
Conclusion
At present, the risks arising from the Canadian household sector are relatively low. Indeed,
by some measures, Canadian household finances appear quite healthy. The current rate of
mortgage arrears, for example, remains more than one-third below its peak in the early
1990s. Going into the crisis, Canadian households carried considerably less debt than their
American counterparts. That remains true today. Data released Monday show that
rebounding housing and financial markets increased Canadian household net worth to
589 per cent of disposable income by the end of the third quarter, above its 10-year average.
While asset prices can rise and fall, debt endures. Moreover, the linkages between the real
economy and the financial sector are complex, non-linear, and often opaque. That is why we
cannot afford to be complacent. Indeed, one objective of using the FSR to profile risks to the
Canadian financial system is to help prevent these risks from materializing. When risks are
still manageable is precisely the best time to act. We must be vigilant, and all parties must
fulfill their responsibilities.
Responsibility starts with the individual. Our advice to Canadians has been consistent: We
have weathered a severe crisis - one that required extraordinary fiscal and monetary
measures. Extraordinary measures are the means to an end: the return to the ordinary.
Although we expect the recovery to be gradual and protracted, these measures are working.
Ordinary times will eventually return and, with them, more normal interest rates and costs of
borrowing. It is the responsibility of households now to ensure that in the future, when the
recovery takes hold and extraordinary measures are unwound, they can still service their
debts.
Similarly, lenders have responsibilities. Financial institutions should actively monitor risk
stemming from households and not take false comfort derived from mortgage insurance and
past performance of household credit. As our simulations suggest, the overall credit profile of
Canadian households could well shift if debt continues to grow at current rates. The Bank
expects that Canada's financial institutions will continue to apply their high standards of risk
management, for which they are being justly lauded the world over.
Policy-makers and regulators, including the Bank of Canada, have responsibilities, as well.
The Bank is working intensively with the Office of the Superintendent of Financial Institutions
(OSFI) at the Basel Committee on the design of new international capital and liquidity
standards. The Bank collaborates closely with the Department of Finance and discusses with
federal agencies, as required, to monitor evolving risks and take appropriate actions. The
Bank's ongoing research and analysis of the financial system, including the work I have
discussed today, is an important element of our commitment to helping ensure Canada has a
resilient, secure financial system that enhances the economic and financial welfare of all
Canadians.
BIS Review 168/2009
BIS Review 168/2009
BIS Review 168/2009
BIS Review 168/2009
BIS Review 168/2009