Risks to Canada's financial stability rose sharply in the second half of the year largely because of the European sovereign debt crisis, even though domestic banks remain stronger than in most other countries, the Bank of Canada said on Thursday.

The Governing Council judges that the risks to the stability of Canada's financial system are high and have increased markedly over the past six months, the bank said in its twice-yearly Financial System Review.

The central bank said the overall level of risk to the banking sector was high, a notch above the elevated characterization given in June.

As in June, the biggest threat is the potential spillover effects from tensions in the euro zone. This risk has partly materialized, the bank said, adding that so far the impact has been limited because of banks' low exposure to the most troubled European countries and weak trade links to the region.

An economic downturn in advanced economies, including a possible U.S. recession, is the other risk factor that has risen in recent months, the bank said.

High household debt was the only domestic development identified as a risk, although its magnitude remains unchanged from June.

The bank said while the government's moves to tighten mortgage rules have helped slow debt accumulation, credit continues to rise as a share of personal disposable income, and the overall financial situation of households remains strained.

Despite the risks to the Canadian financial system, the Bank of Canada characterized it as strong. It said domestic markets have not been as volatile and prices have not fallen as much as in most other countries, and the ability of banks to raise funds in wholesale markets has not fallen noticeably.

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