(Bloomberg) -- Canada’s financial system remains resilient even in the face of the Covid-19 pandemic and moves to keep credit markets functioning have been largely effective, though risks remain, according to the Bank of Canada.

The country’s largest banks remain well capitalized even in the most pessimistic scenario, though some smaller lenders may struggle, and many businesses, especially in the energy sector, face higher funding costs and potential downgrades, the central bank said Thursday in its annual Financial System Review.

Canada entered the crisis with strong banks, the protection of a robust mortgage insurance system and an economy in a solid position, the central bank said. “With these strengths, as well as the aggressive government policy response to the pandemic, the largest banks are in a good position to manage the consequences,” policy makers said in the 39-page report that nevertheless outlines significant, across-the-board risks to the financial system.

Small energy firms, lower-rated companies and some alternative lenders were singled out as potential flash points.

Governor Stephen Poloz and his senior deputy, Carolyn Wilkins, will elaborate on the report in a press conference at 10:30 a.m. in Ottawa.

Policy Response

It’s the central bank’s first comprehensive statement about the risks to Canada’s financial stability since the economy went into lockdown in mid-March. Since then, policy makers have expanded the bank’s balance sheet by about C$270 billion ($192 billion) in efforts to prevent credit markets from seizing up. Purchases of assets including government bonds, bankers acceptances and commercial paper have been successful and in many cases uptake has declined, the central bank said.

The bottom line from the central bank is things would have been much worse without the massive monetary and fiscal response. Yet even with that response, the fallout from the economic shutdown will be worse than the 2008-2009 crisis, policy makers said, and the longer the crisis lasts, the worse things could become for households and businesses.

Running the more pessimistic scenario from the April 15 Monetary Policy Report, which assumes a second-quarter economic contraction of 30%, the bank finds policy actions combined with payment deferrals limit the rise in mortgage arrears, with the rate of around 0.8% in the second half of 2021. That’s still almost double the peak rate in 2009.

Since the Covid-19 shock, higher-risk Canadian firms are finding it difficult to tap U.S. leveraged loan markets, and some alternative lenders have suspended redemptions to cope with liquidity pressures. In addition, other small independent lenders which normally finance small firms “have reported challenging market conditions that, if persistent, could jeopardize the future of their business.”

Alternative lenders, such as mortgage investment corporations, have become increasingly important for the provision of credit to households and small businesses, and now account for 1.5% of residential mortgage lending nationally.

Households Vulnerable

The bank acknowledges that many Canadian households face financial difficulty as jobs have been lost due to Covid-19. A significant share of the labor force is unemployed or underutilized and that will “continue for an unknown period.”

The weakness in the labor market, along with physical distancing, have led to a decrease in housing activity. Both housing sales and listings are down sharply. Households may feel even more financially burdened if they are having difficult selling their homes. Most Canadian households see prices declining over the next six to 12 months.

Highly indebted households will have a hard time managing income losses from lost employment. About 20% of all mortgage borrowers do not have enough liquid assets to cover two months of mortgage payments.

Federal policies are helping to mitigate the economic fallout from a weak labor market. The government’s CERB program provides Canadians who have lost some type of work because of Covid-19 with about C$2,000 a month. The wage subsidy program is also helping keep businesses hold on to their employees. These programs can help cover a large portion of spending for households.

Income losses will result in many Canadians using loan payment deferrals or take on additional debt to pay for items. The nation’s bank have allowed more than 700,000 households to delay their mortgage payments and increased flexibility on payments for credit cards and lines of credit. This is all designed to help keep debt payments down for households.

Still, the bank expects the proportion of households with debt-service payments of more than 40% of their income, which indicates financial vulnerability, to rise.

©2020 Bloomberg L.P.