Stress testing the Canadian banking System : a System-wide approach

Over the past few years, financial sector authorities and financial institutions around the world have increased their use of stress testing to examine risks to the financial system. Stress testing assesses the impact of various potential risks to financial institutions and illustrates the channels through which these risks would be transmitted. While most stress-testing models focus on solvency risk (the risk of losses stemming from the failure of borrowers to repay loans or meet contractual obligations), the 2007–09 financial crisis showed that, in times of stress, liquidity risk and network spillover effects associated with interconnections among banks can also be significant. The Bank of Canada has developed an innovative stresstesting model, the MacroFinancial Risk Assessment Framework (MFRAF), which realistically captures the various sources of risk for banks—solvency risk, liquidity risk and spillover effects. In 2013, Canada participated in a Financial Sector Assessment Program (FSAP), a comprehensive, in-depth analysis of the country’s financial sector conducted by the International Monetary Fund (IMF) that included a stress-testing exercise to gauge the resilience of financial institutions to severe macrofinancial stress.1 The FSAP stress scenario embodied the realization of two key risks to the Canadian financial system that had been identified in previous issues of the Financial System Review: (i) weaknesses in euro-area banks and sovereigns, and (ii) imbalances in Canadian household finances and the housing market. Several stress-testing approaches and models, including MFRAF, were used to estimate the impact of these risks on the Canadian banking system should they be realized. Overall, the results confirm the strength of the Canadian banking system as a whole, and the IMF views the resulting capital shortfall as manageable.