Canada’s financial system isn’t immune to downturns.
The International Monetary Fund (IMF) has praised Canada’s risk management efforts, but it’s also pinpointed weaknesses. It says our regulators often fail to collaborate, which is concerning given how large and fractured our financial sector is.
And despite strong earnings, our banks remain vulnerable to a housing crash, a sharp rise in interest rates and a global economic crisis.
That’s why banks undergo regular stress tests, which help measure the potential impact of downturns on their earnings, solvency and liquidity. These tests also indicate whether the financial industry can continue to support the economy, given that the health of banks is directly tied to how much people save and invest, and whether consumers and businesses are supporting spending and employment.
Each year, Canada’s banks must conduct internal, bottom-up tests, as well as any extra tests ordered by the Office of the Superintendent of Financial Institutions (OSFI)—how often stress tests occur depends on the size of an institution and the risks it faces. Every other year, OSFI and the BoC collaborate on additional macro, top-down tests of Canada’s six big banks and HSBC only, which have been designated as systemically important.
But, as the sector evolves, so too should crisis prevention measures.
Recognizing this, the federal government is reviewing the stability of Canada’s financial system. Additionally, BoC deputy governor Lawrence Schrembi has been pushing central banks to focus on crisis prevention and to collaborate with federal regulators, rather than use reactionary measures and now-exhausted monetary policy tools.
There are two ways to improve Canada’s stress testing framework.
First, the entire financial sector, not just the banks, should undergo robust, standardized, macro stress testing every year. That means all institutions would benefit regularly from both bottom-up internal tests and top-down tests conducted by the federal regulator. These tests should also examine how all types of institutions might interact during crises, which means regularly looking at their exposures to and effects on one another (this is mainly done through macro testing of only big banks currently, and through federal reviews of cross-system risk management practices).
Second, test results should be public. This is done in the U.S. and Europe, but OSFI says stress testing isn’t a pass or fail exercise in Canada. In a May 2016 release, the regulator pledged to “continue the policy of not publishing stress testing results” since it finds the tests are best used as tools to supervise banks, as opposed to using results to judge them.
Canada’s financial institutions remain strong, and investors and businesses shouldn’t depend solely on stress test results when assessing the financial sector—given that the scenarios such tests present are hypothetical. But if the current stress-testing framework is improved, it could be more effective as a tool for investors.
The BoC and federal government will never be able to prevent economic downturns. But muting the impact of recessions through superior risk management is far better than central banks and governments scrambling to boost growth after the damage has already been done.
Stress testing around the world
Canada: Systematically important banks must conduct annual stress tests internally; these tests are designed by OSFI, which collects the results and also reviews institutions’ risk management systems. OSFI and the BoC also collaboratively conduct tests every other year, but neither these results, nor the former, are public. Organizations such as CMHC and large pensions also conduct stress tests.
U.S.: The Federal Reserve annually assesses whether large bank holding companies have effective capital planning processes and sufficient capital to absorb losses under stress. The Fed publishes its Comprehensive Capital Analysis and Review each year to show test results.
EU: Authorities use stress tests to evaluate the resilience of individual European banks and to assess their recapitalization needs under stress. The European Banking Authority’s EU-wide stress tests are bottom-up tests that are designed in cooperation with the European Systemic Risk Board, the European Central Bank and the European Commission. The results are published.