Canadian Financial Stability Report—2025
Navigating Trade War and Geopolitical Uncertainties
Executive Summary
The Bank of Canada's Financial Stability Report 2025 indicated that while Canada's financial system remains resilient, US trade policy uncertainty posed significant risks to financial stability. The 2026 report (released May 28, 2026) confirms the system has continued to function well, but notes a more turbulent global environment — with the Middle East conflict and AI disruption to the software sector joining trade war uncertainty as key risk drivers. The primary concern is that multiple vulnerabilities could crystallize simultaneously.
Key Risk #1
Geopolitical shocks (Middle East war, trade war) triggering multiple vulnerabilities at once
Key Risk #2
Hedge fund repo borrowing amplifying fixed-income market volatility during stress events
Key Risk #3
AI disruption to software sector and ongoing job losses in trade-exposed industries
Market Reaction to Trade Policy and Geopolitical Events
The April 2025 tariff shock — the largest single episode of trade-war-driven volatility since COVID-19 — has partially subsided. Equity markets recovered through mid-2025, and volatility indicators declined through year-end as participants adapted to the new trade environment. The US dollar and Treasuries have partially reclaimed their safe-haven role.
A new volatility driver emerged in early 2026: the Middle East conflict, which has caused one of the largest disruptions to global energy markets in history, pushing up oil prices and adding inflationary pressure. By May 2026, markets had partially stabilised, though volatility remains above pre-2025 norms and geopolitical risk remains elevated.
Market Volatility Indicators
Financial System Risk Assessment
Risk Distribution
Risk Assessment Comparison
Banking System Resilience
Canadian banks remain well positioned to support the financial system and the broader economy. The common equity Tier 1 (CET1) capital ratio averaged 13.7% in Q1 2026 — approximately 2 percentage points above pre-pandemic levels and well above the regulatory minimum of 8%. Bank profitability has increased, supported by higher revenues from capital market activities.
Banks have increased their accumulated provisions for anticipated loan losses and continue to hold sufficient liquidity to meet short-term obligations. Even under a severe stress scenario with a 5.1% GDP decline and 9.2% unemployment, capital would remain above regulatory minimums (IMF stress tests).
Bank Capital Ratios Under Stress Testing
International Financial Contagion
The global financial system is highly interconnected, with shocks in one region often spreading rapidly to others. Canada's economy is particularly sensitive to developments in the United States due to deep trade and financial linkages. The US remains the largest single source of contagion risk, though its relative share has edged down as investors have diversified away from US assets.
A significant new contagion channel emerged in 2026: the Middle East war, which has caused one of the largest disruptions to global energy markets in history, pushing up oil prices and putting pressure on inflation worldwide. This adds to existing trade-war-driven pressures on the Canadian economy.
Hedge funds — which now purchase up to 50% of Government of Canada bonds at auction and account for roughly 30% of secondary market trading volume — have continued to increase their repo borrowing. Their activity supports market liquidity but could leave fixed-income markets more vulnerable to sudden sell-offs during periods of stress.
International Financial Contagion Risk
Key Vulnerabilities by Sector
Household Vulnerabilities
The national mortgage arrears rate reached 0.29% in May 2026 — the highest count (14,061 mortgages 90+ days past due) in more than a decade, and more than double the record low of 0.14% recorded in 2022. Ontario's rate has climbed to 0.23%, overtaking the national average for the first time since 2012. Mortgage delinquency balances are up roughly 32% year-over-year nationally and 52% higher in Ontario (Equifax Q1 2026).
Despite the rise, most renewing households have managed the transition: over 90% of borrowers who renewed in the past 12 months did so at rates below their qualifying rate, and approximately 70% of those who refinanced extended their amortization by an average of six years. The final wave of pandemic-era renewals is expected over the next 12 months, with this risk projected to have fully passed by the second half of 2027.
Mortgage Arrears Projection
Housing Market Vulnerability Index
Housing Market Vulnerabilities
Canadian housing markets have softened over the past 12 months. Price acceleration vulnerability has declined markedly from its 2025 peak, and overvaluation pressures have eased in most urban centres. The Bank continues to closely monitor the risk of a price correction, particularly given that household mortgage debt remains elevated.
Debt service vulnerabilities remain the primary concern, driven by the ongoing wave of pandemic-era mortgage renewals. However, the mortgage stress test has provided a meaningful cushion — most renewing borrowers qualified at rates significantly above current levels — and the debt-to-income ratio has declined from 173% (2025) to below its 2022 peak.
Overbuilding risk has also edged down as construction activity has moderated in response to softer demand conditions.
Business Sector Vulnerabilities
Non-financial businesses have generally remained in solid financial health. Business debt levels are elevated but stable, and pockets of stress remain concentrated in trade-exposed and highly leveraged sectors. The share of borrowers falling behind on debt payments stabilised over the past 12 months after rising for four consecutive years.
Business Sector Vulnerabilities
Manufacturing remains the most exposed sector, combining high US trade dependence with elevated debt and thin cash reserves. A new 2026 risk has emerged in the technology sector: AI disruption concerns have led to a substantial widening of spreads on leveraged loans to software companies, and stocks of some software firms have fallen sharply. Technology firms now show materially higher financial vulnerability scores compared with 2025.
Emerging Risk: Climate Change Financial Impact
While the trade war dominates near-term financial stability concerns, climate change remains a significant medium to long-term risk to the Canadian financial system. The transition to a low-carbon economy could have substantial implications for certain sectors of the Canadian economy.
Transition risks arise from policy changes, technological disruption, and shifting market preferences as the economy adapts to climate change mitigation efforts. Physical risks include direct damage to assets and disruption to supply chains from extreme weather events and long-term climate shifts.
The Bank of Canada continues to develop its approach to assessing climate-related financial risks, including through scenario analysis and stress testing methodologies.
Climate-Related Financial Risk
Risk Monitoring Focus
Near-Term Monitoring (2026)
- Mortgage arrears trajectory: Whether the 0.29% national rate stabilises or climbs further through the final renewal wave
- Energy market volatility: Spillover from Middle East conflict into Canadian inflation and credit conditions
- Repo and funding markets: Signs of hedge fund deleveraging or sudden sell-offs in Government of Canada bond markets
- Software sector credit: Further widening of leveraged loan spreads linked to AI disruption concerns
Medium-Term Concerns (2026–2027)
- Final mortgage renewal wave: Completion of pandemic-era renewals; risk expected to pass by H2 2027
- Unemployment in trade-exposed sectors: Particularly manufacturing and agriculture under prolonged trade war
- AI-driven sector disruption: Broader contagion from software sector stress to financial and technology employment
- Geopolitical escalation: Potential deepening of Middle East conflict with further energy market implications
International Mitigation Strategies: Lessons for Canada
Several peer economies facing similar challenges — high household debt, housing market vulnerabilities, hedge fund activity in sovereign bond markets, and geopolitical uncertainty — have deployed policy tools that offer direct lessons for the Canadian context.
Australia — APRA Debt-to-Income Caps
Macroprudential · Effective Feb 2026APRA activated a binding debt-to-income (DTI) limit in February 2026: banks may lend no more than 20% of new residential mortgage volume at a DTI ≥ 6×. This directly targets the highest-risk segment of the mortgage book without constraining mainstream borrowers.
- Complemented by a 3% mortgage serviceability buffer and 1% countercyclical capital buffer
- New housing construction exempted to avoid constraining supply
- Measured quarterly per bank, with separate owner-occupier and investor portfolios
New Zealand — LVR + DTI Two-Pillar Framework
Macroprudential · DTI active since Jul 2024The RBNZ operates a two-pillar approach combining loan-to-value ratio (LVR) restrictions with DTI limits. Owner-occupiers face a DTI cap of 6× gross household income; investors face 7×. LVR restrictions allow banks up to 25% of new owner-occupier lending above 80% LVR, and up to 10% of investor lending above 70%.
- DTI restrictions designed to be countercyclical — tightest when rates are low and markets are strong
- Result: national house prices broadly flat for 3 years; high-risk lending share manageable
- LVR restrictions eased in December 2025 in exchange for DTI limits taking effect
Norway — Mandatory Amortisation Requirements
Structural · Long-term debt reductionNorwegian mortgage regulation requires self-amortising mortgages as the default: borrowers must repay principal throughout the life of the loan, preventing the interest-only lending that can allow debt balances to grow unchecked. Strong nominal wage growth and lower principal payments through self-amortisation have together cushioned Norwegian households against income shocks.
- Norges Bank 2026 H1 FSR assesses the Norwegian financial system as robust
- Household and firm debt-servicing capacity described as solid, with no material changes in structural vulnerabilities
- Household credit growth stable at 4.7% year-over-year in 2026
United Kingdom — System-Wide Stress Testing & MMF Reform
NBFI resilience · BoE July 2026 FSRThe Bank of England's Financial Policy Committee is conducting its second System-Wide Exploratory Scenario (SWES) exercise, explicitly modelling how stress propagates from banks through non-bank financial intermediaries (NBFIs) — including hedge funds whose gilt repo positions reached their highest level on record in early 2026.
- Money Market Fund (MMF) reforms locked in: new liquidity and redemption-gate requirements across the UK and Europe
- FPC exploring further changes to support gilt repo market resilience against sudden hedge fund deleveraging
- Capital framework modernisation: simpler, more proportionate, better calibrated to current risks
Euro Area (ECB) — Geopolitical Reverse Stress Testing & NBFI Policy
ECB Financial Stability Review, May 2026Geopolitical Reverse Stress Testing
The ECB made geopolitical risk the focus of the adverse scenario in its 2025 stress test and will assess banks on geopolitical risk management in its 2026 reverse stress test — working backwards from failure to identify which shocks would cause a bank to breach its capital floor. Canada could apply a similar reverse-scenario approach to trade-war and Middle East energy disruption pathways.
Comprehensive NBFI Policy Response
ECB and ESRB issued a joint 2026 report analysing financial stability risks from geoeconomic fragmentation across banks and NBFIs. The ECB calls for a comprehensive macroprudential framework for the non-bank sector — not just monitoring but binding leverage and liquidity requirements — applicable to hedge funds, private credit funds, and money market funds.
AI & Operational Resilience Standards
In response to AI-driven disruption risk (AI data centre buildout generating up to USD 3 trillion in financing demand, much from private credit), the ECB is developing new operational resilience standards for AI deployment in financial institutions. This directly parallels Canada's emerging software-sector leveraged loan stress.
Canada vs. Peers: Policy Gap Summary
| Tool | Canada | Australia | New Zealand | Norway | UK |
|---|---|---|---|---|---|
| Mortgage stress test / serviceability buffer | ✅ | ✅ | ✅ | ✅ | ✅ |
| Binding DTI limits on new mortgages | ❌ | ✅ | ✅ | ✅ | ⚠️ LTI cap |
| LVR restrictions | ⚠️ Partial | ⚠️ Phased | ✅ | ✅ | ✅ |
| Mandatory amortisation (no interest-only default) | ❌ | ⚠️ APRA rules | ⚠️ Partial | ✅ | ⚠️ Partial |
| System-wide stress testing (banks + NBFIs) | ❌ | ⚠️ Exploring | ❌ | ⚠️ Partial | ✅ SWES |
| Binding macroprudential rules for hedge funds / NBFIs | ❌ | ⚠️ Exploring | ❌ | ⚠️ Partial | ⚠️ Developing |
| Money Market Fund reform (liquidity gates) | ❌ | ⚠️ Consulting | ❌ | ✅ via ESB | ✅ |
| Geopolitical reverse stress testing | ❌ | ⚠️ Exploring | ❌ | ⚠️ Partial | ⚠️ Partial |
✅ In place · ⚠️ Partial or in development · ❌ Not in place
Conclusion
The Bank of Canada's 2026 analysis confirms that Canada's financial system has continued to function well despite ongoing trade uncertainty and new geopolitical shocks. Bank capital ratios have strengthened to an average CET1 of 13.7%, the mortgage renewal risk is approaching resolution, and housing market vulnerabilities have softened. These improvements provide meaningful buffers.
Nevertheless, a more turbulent global environment means the risk of multiple vulnerabilities crystallising simultaneously has increased. The Middle East conflict, AI-driven sector disruption, and continued hedge fund growth in sovereign bond markets are new dimensions that require careful monitoring. The Bank will work closely with federal and provincial financial authorities to address potential emerging issues and to foster a stable and resilient financial system that absorbs shocks rather than amplifies them.
"A stable and resilient financial system—one that absorbs shocks and does not amplify them—can help the economy through periods of turbulence."
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Sources
- Bank of Canada. (2026, May 28). Financial Stability Report—2026. Bank of Canada.
- Bank of Canada. (2025, May 8). Financial Stability Report—2025. Bank of Canada.
- Bank of Canada. (2025, April). Monetary Policy Report, April 2025.
- International Monetary Fund. (2025). Financial Sector Assessment Program: Canada.
- Equifax Canada. (2026, Q1). Canadian Mortgage Delinquency Report.
- Canada Mortgage and Housing Corporation. (2026). Mortgage Renewal Wave: Regional Impacts.
- Australian Prudential Regulation Authority (APRA). (2026, February). Activating Debt-to-Income Limits as a Macroprudential Policy Tool.
- Reserve Bank of New Zealand. (2026, May). Financial Stability Report May 2026.
- Norges Bank. (2026, May 12). Financial Stability Report 2026 H1.
- Bank of England Financial Policy Committee. (2026, July). Financial Stability Report — July 2026.
- European Central Bank. (2026, May 27). Financial Stability Review, May 2026.
- ECB & ESRB. (2026, January). Joint Report: Financial Stability Risks from Geoeconomic Fragmentation.
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This analysis was produced by the Governing Council of the Bank of Canada: Tiff Macklem, Carolyn Rogers, Toni Gravelle, Sharon Kozicki, Nicolas Vincent, Rhys Mendes and Michelle Alexopoulos.
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