UPDATE 2-Central bank says Canada financial system risks up

* Risks rise in funding and liquidity, global imbalances

* Risks from capital adequacy have decreased (Adds details, comment from former central bank deputy governor)

By Ka Yan Ng

TORONTO, June 21 (Reuters) - Overall risk to the stability of Canada's financial system has increased over the past six months as mounting concerns over sovereign debt have "erupted" in markets, the Bank of Canada said on Monday.

The central bank said in its Financial System Review that while the Canadian financial system continues to function well, it is vulnerable to renewed stress if global market tensions increase.

The report, published twice a year by the Bank of Canada's rate-setting Governing Council, flags risks to the country's financial system from both domestic sources and abroad.

Breaking risks down by category, it said risks from funding and liquidity, global imbalances and currency volatility, and the global economic outlook all rose in the last six months, with the latter two categories at high levels of risk.

"Canadian bank funding markets have been largely unaffected by pressures in global short-term funding markets," the report said.

"However, there is a risk of renewed tensions in Canadian funding markets if global pressures intensify, particularly if they are accompanied by a material deterioration in the international economic outlook."

Risks from capital adequacy have decreased, while risks from household balance sheets are unchanged, the central bank said.

The report comes ahead of the G20 summit this weekend in Toronto, at which Canada will ask Group of 20 countries to agree to tough new fiscal targets, though only tackle debt problems once the global recovery is assured. [ID:nN18161587]

The Bank of Canada warned on Monday that the financial system will be vulnerable unless rising government debt levels are dealt with.

"Attaining fiscal sustainability requires credible plans to achieve viable fiscal balances, consistent with the G20 commitment to enact macroeconomic policies promoting strong, sustainable, and balanced growth," the bank said in the report.

"Until these plans are implemented, fiscal challenges will continue to pose a risk for financial stability."

Given the eruption of Greece's financial troubles and broader concerns about sovereign debt levels, it's not surprising that the Bank of Canada sees risks higher than they were six months ago, former Deputy Governor Sheryl Kennedy said in a television interview.

Kennedy also noted that the central bank remains concerned about the high level of household debt in Canada.

"There's a greater percentage of households in vulnerable situations, so when interest rates start to rise, which of course they will, that could be a problem," she said. (With additional reporting by Jeffrey Hodgson; editing by Peter Galloway)