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OTTAWA (Reuters) - The Bank of Canada warned on Thursday of increased risks from rising household indebtedness but said the overall risks to the financial system had decreased modestly in the last six months.
Canadian households should not be lulled by low interest rates into taking on more debt than they will eventually be able to afford, and banks should be careful to assess households' overall debt when extending mortgages, it said in its semi-annual Financial System Review.
"When borrowing funds, especially in the form of mortgages, households need to assess their ability to service these debt obligations over their entire maturity, taking into account likely changes in both income and interest rates and the risks surrounding this outlook," it said.
The bank has conditionally promised to keep its overnight interest rate near zero through mid-2010 but has said that rates will eventually have to rise.
Urging bank caution, it also said: "Financial institutions need to carefully consider the aggregate risk to their entire portfolio of household exposures when evaluating even an insured mortgage, since a household defaulting on an insured mortgage would likely be unable to meet its other debt obligations."
The economic downturn has caused a deterioration in the quality of bank loan portfolios, with losses from the household sector rising, but the central bank said total loan losses should remain manageable.
In addition to household indebtedness, global financial and economic imbalances will emerge as the most prominent risks to the Canadian financial system over the medium term, the bank said.
It saw "a risk of a disorderly adjustment in exchange rates" if the structural causes of global current account imbalances are not addressed.
And in a shot at China, it said the risk of a disorderly scenario would be heightened if major countries did not allow their exchange rates to help resolve imbalances.
It added that Canadian businesses and households would be hurt by rapid shifts in exchange rates.
The assessment represents the collective judgment of Governor Mark Carney and his five deputy governors, the bank said.
Editing by David Ljunggren and Rob Wilson