Bank of Canada warns its own low rate policy poses risk to financial stability

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The Bank of Canada is seen in Ottawa on September 6, 2011. THE CANADIAN PRESS/Sean Kilpatrick

OTTAWA - The Bank of Canada is warning that its own low interest policies and those of central banks around the world are adding another layer of risk to the already stressed global financial system and economy.

The Canadian central bank said Thursday near record level interest rates in place since the 2008-09 recession are taking their toll on insurance companies, pension funds and even increasing the appetite of investors to take risks in search of higher returns.

In Canada, they have been a prime mover to the other major domestic risk — an overheated housing market and high levels of consumer debt as Canadians take advantage of cheap money to buy real estate.

Bank governor Mark Carney has warned about the dangers of low interest rates — which many Canadians consider a good thing — sporadically in the past, but this time the bank's governing council has thought the concern grave enough to add it to the list of risks facing Canada and the world.

"The low interest rate environment in major advanced economies represents another risk to the financial system, both in Canada and globally," the bank's governing council says in its semi-annual financial systems review paper issued Thursday.

"This risk involves increased vulnerability for financial institutions with long-duration liabilities (life insurance companies and pension funds), and increased incentives for excessive risk taking in a search for yield, which could distort the pricing of both real and financial assets."

And in a repeat of past alerts, the bank warned that construction of new condos, particularly in Toronto, is outstripping traditional levels of demand.

"If the upcoming supply of units is not absorbed by demand as they are completed over the next 18 to 36 months, the supply-demand imbalance will become more pronounced, increasing the risk of a sudden correction in prices," it said.

The report, which was released at 10:30 a.m. ET, had no perceptible effect on money markets.

Risk-taking, a major contributor to the 2008-09 financial meltdown, remains moderate, but is increasing, the bank says.

"Evidence of excessive risk-taking behaviour by pension funds and life insurance companies, and in global financial markets more generally, remains limited, although there have been some indications that investor tolerance for risk is increasing."

Insurance companies are impacted, the report states, because they are forced to reinvest cash flows at a lower yield that they thought would be the case. Canadian insurance firms are affected more than those in the U.S. because of the higher accounting standards here, the bank said.

The solvency of defined-benefit pensions funds are also jeopardized because as "long-term interest rates decline, the present value of the plans' future liabilities increases."

The council says central banks have kept interest rates low because the alternative is worse — that is increasing the cost of borrowing and undermining an already fragile recovery. What's more, it says it expects rates to remain low for an extended time.

Earlier this week, the Bank of Canada kept its overnight rate at one per cent for the 18th consecutive policy announcement meeting, a stretch that goes back to September 2010.

Although Carney kept in place his mild tightening bias, most economists believe neither out-going Carney, nor his successor who takes the helm in June, will be in position to make good on the bias until 2014, and then only to implement very modest hikes.

Meanwhile, the U.S., China and some other important countries continue to ease in an effort to keep their economies from falling back into recession.

But the bank warns that policy-makers must also be wary of the side-effects of the medicine they are administering, especially since those super-low rates are likely to stay in place for some time.

Overall, the Bank of Canada's new financial systems review finds that the risks in the world remain "very high," as they were in the last report in June.

"Although global financial conditions have improved since June, largely reflecting important announcements by major central banks and European authorities, the level of uncertainty is elevated," the review judges.

Despite the headwinds, Canada's financial system remains robust, the Bank of Canada says. But the country is also in a sense prisoner to external circumstances, including whether the U.S. is able to resolve its budget impasse early next year and Europe can keep muddling along without triggering a new crisis.

The next big challenge is the so-called "fiscal cliff" due to kick in on Jan. 1 unless the U.S. Congress can come to an agreement to extend a series of tax cuts and spending measures that represents about four percentage points of U.S. gross domestic product.

"Such an outcome would undermine the still-fragile state of private domestic demand and push the U.S. economy into recession," the bank says. Canada too could be pushed into a period of economic contraction if the U.S. crisis lasts long enough, economists believe.