Bank of Canada outlines top risks to banking system

OTTAWA (Reuters) - The Bank of Canada expects Canadian credit markets to gradually return to normal but listed some major uncertainties on Thursday that could put that outcome at risk.

"Uncertainties remain around the timing of the likely return to more normal financing conditions, and there is a significant risk of mutually reinforcing weakness in the financial sector and in the real economy," it said in its Financial System Review.

In the central bank's assessment of risks to the Canadian financial system, produced by Governor Mark Carney and his five deputies, it said lenders' lack of confidence in the current environment could aggravate funding and liquidity problems.

Also, banks could be further harmed by longer or deeper-than-expected economic downturns in the United States and globally, an increase in household debt defaults, and a possible abrupt depreciation of the U.S. dollar.

The risk outlook is a new addition to the bank's regular report, which normally contains research by staff only, and it is an attempt to enhance understanding at a time when global policy makers are trying to tweak financial regulations to prevent future crises of this magnitude.

Outlining the actions taken to strengthen global financial markets, it noted that some Canadian banks have more work to do in complying with new rules on disclosure and transparency.

The Bank of Canada has injected more than C$40 billion into the financial system through a variety of liquidity instruments, and the government has also taken liquidity action.

Canadian banks, ranked by the World Economic Forum as the world's soundest, have largely implemented the recommendations of the Financial Stability Forum -- an advisory body of central banks, regulators and finance ministries of rich countries -- or are in the process of doing so.

But the bank noted two fault lines in that process, urging some Canadian banks to further improve their disclosure, particularly with regard to how they value their assets.

Secondly, progress has been slow to improve transparency, it said.

"On the issue of transparency of structured products, progress in implementing the FSF recommendations has been slow to materialize, and there is a role for provincial securities commissions to advance this initiative," it said.

Another concern is the way the over-the-counter derivatives market works, the bank said, suggesting that a major shock to the global system such as a major corporate default could amplify the credit crisis.

(Reporting by Louise Egan; editing by Peter Galloway)