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The Bank of Canada is more concerned than it was a year ago about the risks posed by high household debt to the Canadian financial system as higher interest rates increase the cost of mortgages, according to its latest financial system review.

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Higher borrowing costs mean more households are expected to face financial pressure in the coming years and a decline in housing prices has reduced homeowner equity, according to the annual report published Thursday.

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The bank said many Canadians have less financial flexibility after stretching their budgets to get into the housing market by taking on large mortgages with lengthy amortization periods.

“A longer amortization period reduces the size of monthly payments, helping lower debt-servicing costs, but increases the period of household vulnerability because equity is built more slowly,” the bank stated.

A severe global recession that causes housing prices to fall further could lead to more loan defaults, it said. As Canadian banks hold a high share of uninsured mortgages on their balance sheets, this could result in sizable credit losses if defaults were to occur on a large scale.

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“While most households are proving resilient to increases in debt-servicing costs, early signs of financial stress are emerging,” the review stated.

“High debt-servicing costs and low homeowner equity make households more vulnerable to default if they experience a drop in income. A severe recession with significant unemployment could lead to more defaults and therefore credit losses for lenders. A rise in credit losses typically causes banks to restrict how much credit they offer to households and firms, potentially amplifying a recession.”

While about one-third of mortgages have seen an increase in payments compared with February 2022, just prior to the Bank of Canada’s recent rate hiking campaign, nearly all borrowers are expected to face higher payments by 2026.

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Mortgage payments could spike as much as 40 per cent in three years for those on variable-rate mortgages with fixed payments, while those with fixed-rate mortgages could see their payments increase by 20 to 25 per cent over 2022 levels.

Meanwhile, the recent banking crises in the U.S. and Switzerland have exposed vulnerabilities amid the current environment of high interest rates, the Bank of Canada said in its annual report.

Although spillover effects to Canada from recent stresses in the global banking sector have been limited, the central bank said deposit runs at Silicon Valley Bank and Signature Bank in the U.S. earlier this year showed how quickly things could deteriorate.

The U.S. bank failures highlighted the need for Canadian institutions to be more vigilant as they adapt to higher interest rates, it added, noting that “Canadian banks remain robust, but there are not immune to international developments.”

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“The deposit runs at these institutions unfolded rapidly by historical standards, showing that social media and digital banking can accelerate such developments,” the bank said.

“Recent events serve as a reminder that stresses can quickly emerge when business models are not robust to increases in interest rates or to volatility in asset prices.”

The central bank said if the cost of wholesale funding for Canada’s large banks were to rise significantly due to global financial stress, it could lead to Canadian institutions tightening their lending conditions.

The Bank of Canada, which increased its key interest rate from 0.25 per cent in March 2022 to 4.5 per cent this past January, said adjustments to higher interest rates could also exacerbate stresses such as fragile liquidity in fixed-income markets.

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Financial stress is also rising among small businesses, with about one-half of firms that received government support during the pandemic reporting in a Statistics Canada survey that it would be a challenge to repay those funds by the end of this year.

The central bank added financial stability could also be threatened by a potential major cyber attack, especially in the context of geopolitical conflicts such as Russia’s invasion of Ukraine, and more frequent extreme weather events associated with climate change.

It is also monitoring the growth of cryptoassets and their connection to the financial system, but noted they do not yet pose a systemic threat due to the relatively small size of those markets compared with the broader financial sector.

This report by The Canadian Press was first published May 18, 2022.