Stressed but not Helpless: Strategic Behaviour of Banks Under Adverse Market Conditions

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Central banks and regulators around the world routinely assess the ability of banks to survive hypothetical stress scenarios by conducting bank stress tests. During a stress scenario—think of the financial crisis of 2008–09—we would expect banks to modify their risk exposure and react to actions their competitors take. However, standard stress-test tools do not capture bank behaviours even under extreme stress scenarios. Assumptions about bank behaviours may impact the analysis of bank resilience and regulation during a financial crisis.

Our new stress-testing tool challenges these assumptions. Banks under stress can strategically change their behaviour to maximize their value for shareholders. Using confidential Canadian supervisory data, we assess whether this value-maximizing behaviour can amplify a hypothetical stress scenario.

We show that during a crisis, banks comply with regulatory requirements by reducing their lending. This results in less financial support for businesses and consumers when they need it most. As such, a trade-off exists between banking stability and macroeconomic stability.