(Adds details on debt loads, background on rate cuts)
By Alastair Sharp
GUELPH, Ontario, Feb 24 (Reuters) - While the vulnerabilities associated with elevated household debt have increased in recent years, the Canadian financial system remains resilient and could withstand a major shock, a Bank of Canada official said on Wednesday.
Record-high consumer debt and hot home prices in parts of the country have raised worries that a sudden retrenching by over-extended Canadians could pose a risk to the economy and financial system.
The Bank of Canada's two interest rate cuts last year prompted criticism from some that the move encouraged more consumer borrowing, though the bank has said that by stimulating the economy it was mitigating such vulnerabilities.
"The financial vulnerability associated with elevated household debt has increased over the past decade," Deputy Governor Lawrence Schembri told the Guelph Chamber of Commerce.
"However, the Canadian financial system is very resilient and could withstand the triggering of this vulnerability."
To assess the risk stemming from indebted households, the bank simulated a persistent increase in the unemployment rate of 5 percentage points, Schembri said, although he noted the probability of this happening was low.
The bank found that household arrears rates could rise from 0.4 percent in 2014 to as high as 1.8 percent after three years, with about 20 percent of that attributable to the increase in debt and greater concentration that has been seen among highly indebted households since 2007.
This could force some homeowners to sell or default on their mortgages and other debt. While a rapid increase in defaults or home sales would have direct impacts on lenders and mortgage insurers, stress tests show that there are sufficient buffers in the financial system to withstand such a scenario, Schembri said.
But there is a low probability of this risk occurring, even with the drop in oil and other commodity prices, he said.
The expected economic pick up will help stabilize household debt as growth, incomes and interest rates eventually rise, said Schembri. He also pointed to measures that have been taken, including new rules from the Liberal government that will force people who want to buy more expensive homes to provide a bigger down payment.
Debt loads and the number of Canadians in arrears are also not nearly as high as they were for U.S. households at the start of the financial crisis, he said. Nonetheless, the bank is concerned about high household debt and will continue to monitor it closely. (Writing by Leah Schnurr and David Ljunggren; Editing by W Simon and Meredith Mazzilli)