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Assessing risks helps manage financial stability

We want a financial system resilient enough to perform its critical functions even when things go wrong. Otherwise, risks could have severe effects on the economy.

To promote financial stability, we monitor financial system vulnerabilities, such as high household indebtedness and imbalances in the Canadian housing market. But to understand the possible effects of vulnerabilities, we need to understand how they could interact with adverse shocks (bad events) to create very bad outcomes. We refer to this as the materialization of risks to the financial system.

Quantitative assessment of risks helps manage financial stability in two ways. It allows us to

  • map out the channels that can turn adverse shocks into very bad outcomes, helping us plan how to address different vulnerabilities; and
  • measure the severity of different risks and whether the financial system is resilient enough to handle them.

Tool kit for assessing systemic risks

To evaluate and address risks to the financial system, we need to analyze their effects, on both the overall economy and the different parts of the financial system.

We do this using a suite of models, known as the Framework for Risk Identification and Assessment (FRIDA). FRIDA measures how risks spread and affect households, businesses and large banks. [Read Technical Report No. 113 "The Framework for Risk Identification and Assessment".]

Since FRIDA can assess how well banks withstand a risk scenario, it can be considered a type of stress testing tool. But our goals are quite different from those of a supervisory stress test. We do not focus on the risk management of individual banks. Instead, we take a system-wide perspective to

  • assess the resilience of the financial system, and
  • understand how risks spread and grow.

The risk of a house price correction

A key risk to the Canadian financial system is a house price correction. Compared with three years ago, house prices are

  • up by close to 40 per cent in the Toronto area, and
  • more than 55 per cent higher in the Vancouver area.

House price growth has slowed significantly in these markets over the past year. But the large price increases of past years remain. Although house prices in these markets are supported by strong demand and limited supply, it is possible that the price increases were fed, in part, by unsustainable expectations of continued price growth. If this were true, prices could reverse rapidly. This could put some households and lenders under stress, potentially affecting the financial system and the economy.

We examine a hypothetical scenario where prices fall by 20 per cent on average nationwide, with the largest decreases in the Toronto and Vancouver areas. This is not a forecast of what we think will happen, but rather a low-probability risk scenario that allows us to examine different transmission and amplification channels for a financial system under stress.

The following diagram shows how we use FRIDA to examine this hypothetical scenario.

Results from the model

Using FRIDA, we consider the macroeconomic impact of a house price correction and an increase in financial stress. Stress can result from heightened uncertainty and sharp price corrections happening simultaneously across several financial and asset markets. If this occurs, the negative effects on employment and economic growth from lower house prices could be amplified.

The slower economic growth combines with other effects of the house price correction to increase both household and corporate defaults. This causes higher loan losses for banks.

But Canada’s large banks have strong capital and liquidity positions that would help them absorb losses arising in the risk scenario. This is partly because reforms to the financial sector over the past decade have improved the quantity and quality of bank capital. Large banks can also manage their loan losses in this scenario through high earnings and international diversification. Overall, the risk scenario would result in slower dividend growth and less capital accumulation but would not threaten banks’ capital positions. [Read Staff Analytical Note No. 2018-36 "Modelling the Macrofinancial Effects of a House Price Correction in Canada".]

Sources of uncertainty

The financial system is likely to remain resilient in this hypothetical and unlikely risk scenario. But the results are less important than the broad lessons we learn from risk analysis. FRIDA helps us understand how financial system vulnerabilities can transmit and amplify shocks and the uncertainty around these channels.

FRIDA handles uncertainty in two ways:

  1. FRIDA allows us to add expert judgment at various stages. This is needed because models based on historical data cannot fully capture rare events like financial system risks.
  2. Some components of FRIDA directly model uncertainty. They generate a range of possible macroeconomic impacts, default rates or losses for banks for a given scenario.

The framework also helps us think about what other factors might increase or decrease the impact of this risk on the financial system. Some important examples include the following:

  • The house price correction in the Vancouver and Toronto areas, and the spillover effects on other markets could be larger or smaller than we assume.
  • If the confidence of domestic or foreign investors were adversely affected by a house price correction, financial system stress might react more strongly.
  • This risk scenario might be combined with other risks, such as a severe nationwide recession (Risk 1 from the June 2018 Financial System Review) or a sharp increase in global risk premiums (Risk 3 from the June 2018 Financial System Review). We plan to quantitatively examine some of these other risk scenarios in the future.
  • Banks and public authorities have tools beyond those modelled in FRIDA that they can use to respond to stress situations. For example, banks could raise new equity, and authorities could use fiscal policy actions to counter recessionary forces.

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