UPDATE 2-U.S. recession could hurt Canada banks, BoC warns

(Adds details about banks with U.S. loan exposure)

OTTAWA, June 12 (Reuters) - The possibility of a U.S. recession is the biggest risk for the global financial system, and would have dire consequences for the Canadian economy and domestic banks, the Bank of Canada said on Thursday.

However, the central bank said the threat of a deeper-than-expected U.S. downturn is low and that Canadian financial institutions are well-placed to absorb such a shock even though their increased exposure to U.S. securities has made them more vulnerable.

If the U.S. economy does worsen more than anticipated, Canadian banks would likely see further writedowns, shrinking profits and higher loan loss provisions. This in turn would jack up bank funding costs and lead to tighter credit for consumers and business.

"While the probability of such outcomes materializing is relatively low, they nonetheless warrant careful consideration by financial institutions because of the potentially large negative repercussions," the bank said in its semi-annual Financial System Review.

Royal Bank of Canada (RY.TO) and Toronto-Dominion Bank (TD.TO) both made U.S. acquisitions in the past year that boosted their U.S. banking businesses and added to their portfolios of U.S. consumer and commercial loans. Bank of Montreal (BMO.TO) also has a Chicago-based U.S. retail banking presence.

"It is our belief that we are simply seeing the beginning of credit deterioration in the United States," Dundee Securities analyst John Aiken said in a report this week on the banks.

Those with retail loan exposure outside of Canada will see steeper increases in provisions for loan losses in the second half of 2008, he predicted. Aiken also expects domestic credit quality to begin to weaken noticeably in 2009, but mainly in the commercial/corporate loan area, not in retail lending.

"There is a distinct negative story brewing" about provisions for loan losses, Aiken wrote.

While the Canadian banks are in better financial shape than their U.S. or international rivals, strong earnings growth could remain "elusive" into 2009, the analyst added.

The Bank of Canada also warned that the recent growth in Canada of subprime mortgages and mortgages with no down payment or longer amortizations has left a segment of the population more vulnerable to a worsening economy.

Still, subprime mortgages account for less than 5 percent of all housing mortgages, compared with 14 percent in the United States and is considered to be of better quality.

"A sharp housing market correction, similar to that in the United States, is unlikely in Canada," the bank said.

Policymakers at the bank are closely monitoring the mortgage market but have not yet seen any indication that banks have been hurt by the collapse of the market for some of the more opaque, structured products that have been in trouble during the credit crisis.

"The financial market turmoil -- with its associated weakening effect on securitization activity and market-based finance -- has not yet had a noticeable adverse impact on the overall growth of credit in Canada," it said.

The rise in household debt has outpaced that of income and the proportion of debt owed by "vulnerable households" rose to 6.5 percent in 2007 from 6.2 percent in 2006.

"At present, however, the financial situation of households does not pose a threat to the stability of the Canadian financial system." (Reporting by Louise Egan and Lynne Olver; Editing by Frank McGurty)