OTTAWA, May 8 (Reuters) - A prolonged trade war could increase the risks to Canadian financial stability by hurting banks and other institutions and making it harder for households and businesses to pay down debt, the Bank of Canada said on Thursday.

In its annual Financial Stability Report, the central bank said the financial system was resilient.

But the impacts of tariffs slapped by U.S. President Donald Trump on Canada and Ottawa's subsequent counter-tariffs could hurt financial stability, especially if it continues for a long period of time.

"A long-lasting trade war poses the greatest threat to the Canadian economy. It also increases risks to financial stability," the bank said.

The BoC said in the near term, the unpredictability of U.S. trade policy could cause further market volatility and strains on liquidity. In an extreme case, market volatility could turn into market dysfunction.

In the medium to long term, a prolonged global trade war would have severe economic consequences, it added.

Governor Tiff Macklem told reporters that the uncertainties were so great that "our analysis is not a projection, it is an assessment of vulnerabilities".

If the trade war continues some households, especially those carrying higher levels of debt, might default on their payments, the bank said, adding the risk was concentrated mainly amongst households without a mortgage.

This could hurt a strong banking system which has built a robust liquidity base and access to funds, the BoC said.

"If credit losses occur on a large enough scale, banks could cut back on lending in response. Struggling households and businesses would have less access to credit to get through tough times. This cycle could exacerbate the economic downturn," it said.

The BoC also highlighted a heightened risk from hedge funds which have been taking increasing exposure to Government of Canada bonds. In some cases they have bought almost half of all the auctions of government bonds.

But a bulk of their purchases is supported by debt, making them more likely to pull back from the market in periods of stress, threatening the bond market.

As interest rates started coming down in Canada last year, overall level of household debt dropped and insolvencies amongst businesses fell, and banks and non-bank financial institutions increased ability to absorb shocks.

Those households with a mortgage who will be renewing this year or next are generally in a more resilient position to make payments due to lower interest rates, but if impacted by job loss or loss of income, some households might be hit.

This scenario could be repeated among businesses too, the bank said, adding that those with existing vulnerabilities such as high leverage, weak profitability and low cash reserves are at risk of falling behind on debt payments.

((Reuters Ottawa bureau))

Keywords: CANADA CENBANK/