* BoC says household debt, housing market still pose risks
* Bank says imbalances will be slow to unwind
* Says euro zone crisis the No. 1 risk to financial system
* Canadian shadow banking merits closer monitoring
By Louise Egan and Randall Palmer
OTTAWA, June 13 Canada's housing market is stabilizing after the heated conditions of the past several years but progress will be slow, the Bank of Canada said on Thursday as it also warned that record-high household debt levels would persist through this year.
The bank added in a semi-annual report that the risks to the economy posed by debt and the housing market remain unchanged at "elevated", even though the situation appears to have improved over the past six months.
"The level of indebtedness is still elevated, and the bank's stress test simulations suggest that households are vulnerable to adverse economic shocks," the bank said in its Financial System Review.
"These imbalances, which built up over many years, will take some time to correct. While a gradual unwinding of imbalances is expected, there is a risk of a sharper correction," the bank said in the first such report to be published under its new governor, Stephen Poloz.
Canada's post-recession housing boom, fueled by historically low borrowing costs, has long worried the government and the central bank, which fear Canadians won't be able to afford their mortgages when interest rates rise.
The housing market began to cool in mid-2012 after Ottawa tightened mortgage lending rules for the fourth time. Official data on Thursday showed new home prices rose a relatively tame 2 percent in the year to April.
Most economists forecast a soft landing for the housing market, while a few still are sounding the alarm on what they see as pending disaster.
Mazen Issa, economist at BMO Capital Markets, said he agreed with the central bank's view on the trend in housing.
"Some of the work we have done suggests that the impact of tighter mortgage regulations is only transitory; nonetheless, we see the housing market as stabilizing over the balance of the year and construction activity growing more in line with demographic fundamentals," he said in a note to clients.
The Bank of Canada report said overall risks to the Canadian financial system have diminished but still remain "high", the same risk classification it designated six months ago.
The highest risk level of "very high" was reserved for the euro-area crisis, although the bank said that was down slightly due to the policies of the European Central Bank.
The No. 1 domestic risk comes from household finances and the housing market.
Since the bank's last assessment in December, household debt accumulation has slowed, housing resale activity and starts have moderated, and prices have stopped rising in most major cities.
However, the bank pointed to stretched housing valuations in some areas and signs of overbuilding in the condo market. The imbalances "will take some time to correct" and should unwind gradually, it said, though there is a risk of a sharper correction.
The household debt-to-income ratio will likely remain near the current record high 165 percent this year, the bank forecast.
The report also contained an analysis of Canada's small shadow banking sector, which will come under closer scrutiny as new financial regulations come into force.
Some areas warrant focused monitoring, the bank said, including the strong growth in securitization of insured mortgages.]
The shadow banking sector, which includes financial intermediation activities done by hedge funds and private capital funds, has been growing since the financial crisis of the last decade and stood at $67 trillion worldwide last year, according to the Financial Stability Board, the global task force for financial reform.
The FSB is expected to make proposals on how to regulate this area of the financial sector before the G20 autumn summit in Russia, where the issue will be debated.