Financial System Survey highlights—Autumn 2021

The Bank of Canada conducts the Financial System Survey (FSS) twice a year to solicit the opinions of senior experts who specialize in risk management of the financial system. These experts provide their views on the risks to, and resilience of, the Canadian financial system as well as on emerging trends in financial products and practices. The survey results are a useful benchmark to compare Bank views and analytical work with outside opinions. Bank staff also use these results to identify new topics for research and analysis.

The autumn survey, completed by 60 respondents, was conducted between September 7 and September 24, 2021. In addition to recurring questions, this survey included a set of questions on the implications of low interest rates on strategies and risks. We have modified some of the recurring questions to enhance the quality of the insights provided by the survey. These changes are described in Box 1.

Highlights

  • Respondents believe the risk of a shock that could impair the financial system is low. However, this risk is viewed as slightly higher in the medium term than in the short term because of the prospect of rising:
    • interest rates
    • inflation
    • geopolitical tensions
    Nevertheless, respondents’ confidence in the resilience of the financial system is at the highest level since the first FSS in 2018.
  • Cyber risks remain the top risk that organizations face. Asset pricing risks—the potential for asset price corrections—are the second most frequently cited. These top risks faced by organizations are also relevant for the financial system as a whole, as highlighted in the Bank of Canada’s 2021 Financial System Review.
  • Overall, the prolonged period of low interest rates over the past decade has worsened respondents’ abilities to meet their profit or return goals. As a result, asset managers, pension funds and insurers have increased their exposures to riskier assets and may have taken on more leverage. However, many respondents noted that their overall risk profile has not changed significantly.
  • In response to a sudden repricing of risk assets, most respondents would:
    • increase exposure to cash and other highly liquid assets
    • decrease exposure to riskier assets
    Pension funds, however, would act countercyclically, viewing a sudden repricing of risk assets as an opportunity to buy these assets at more favourable valuations.

Box 1: Changes to recurring questions

Box 1: Changes to recurring questions

To provide clearer insights into market participants’ views on financial system risks, we changed two recurring questions. These changes will be maintained in future surveys.

  • We stopped asking participants in the Financial System Survey (FSS) to rank top risks to the financial system because this is not where participants can offer the best insights. They are experts on the top risks to their individual organizations, thus offering unique perspectives. We can then draw conclusions about the implications for the broader financial system by aggregating this information.
  • We changed the question on shocks that could impair the financial system. We now ask about the likelihood of a shock (Chart 1) in addition to the evolution of the likelihood over the past six months (Chart 1-A). This new formulation will allow us to better track changes over time.

Chart 1-A: Change in short- and medium-term risk of a shock that could impair the financial system

Note: Respondents report how much risks have changed over the past six months. The change-in-risk index measures the average reported change, not the level of risk. Change-in-risk index weights: decreased materially: -2 points; decreased slightly: -1 point; remained unchanged: 0 points; increased slightly: 1 point; increased materially: 2 points. There was no Financial System Survey in spring 2020 due to the COVID‑19 pandemic.
Source: Bank of Canada

Risks to the financial system

Overall perceptions of risk and confidence

Respondents believe that the likelihood of a shock that could impair the financial system is higher in the medium term (one to three years) than in the short term (less than one year) (Chart 1). Respondents cited rising interest rates, inflation exceeding the Bank’s inflation target and rising geopolitical tensions as reasons for the higher likelihood of a shock in the medium term.

Chart 1: Short- and medium-term risk of a shock that could impair the financial system

Chart 1: Short- and medium-term risk of a shock that could impair the financial system

Note: Risk index weights: not at all likely: 0 points; slightly likely: 1 point; somewhat likely: 2 points; moderately likely: 3 points; extremely likely: 4 points. 
Source: Bank of Canada

However, 97 percent of respondents are at least fairly confident that the Canadian financial system will remain resilient (Chart 2). Respondents frequently cited the following reasons for their continued confidence:

  • the well-capitalized banking sector
  • the well-regulated financial system
  • the pandemic response from fiscal and monetary authorities

A few respondents believe that both fiscal and monetary authorities would support markets again if large negative shocks were to occur.

Chart 2: Confidence in the financial system’s ability to withstand a large shock

Chart 2: Confidence in the financial system’s ability to withstand a large shock

Note: Confidence index weights: not at all confident: 0 points; not very confident: 1 point; fairly confident: 2 points; very confident: 3 points; completely confident: 4 points. There was no Financial System Survey in spring 2020 due to the COVID‑19 pandemic.
Source: Bank of Canada

Most important risks

Respondents ranked the three risks that would have the greatest negative impact on their organization if they were to occur (Chart 3).

Chart 3: Top risks to your organization

Chart 3: Top risks to your organization

Note: Risk index weights: 1st choice: 3 points; 2nd choice: 2 points; 3rd choice: 1 point. There was no Financial System Survey in spring 2020 due to the COVID‑19 pandemic.
Source: Bank of Canada

The top three risks to organizations are:

  1. external risks—predominantly cyber risks. Respondents manage these risks through investments in cyber security defences (including software, third-party contracts and employee training) as well as general technology infrastructure.
  2. asset pricing risks—risks that assets could experience a significant price correction following a shock, such as an increase in inflation or other financial market shocks. Respondents manage these risks by implementing robust liquidity management practices, inflation protection and exposure diversification. Asset pricing risks were cited as the most important by asset managers and insurers.
  3. domestic fiscal and monetary policy and domestic macroeconomic risks. These risks tied for third place. Domestic fiscal and monetary policy risks include rapidly rising interest rates and the withdrawal of monetary policy support, while domestic macroeconomic risks include high inflation and a slower-than-expected economic recovery.

External risks, which were also cited as the top risk in the spring 2021 FSS, have the highest risk index since the first FSS. Asset pricing and domestic macroeconomic risks increased significantly in this survey after ranking in only seventh and eighth place in the spring 2021 FSS. The two risks that declined the most were:

  • real estate sector risks, from second place to sixth
  • market liquidity risks, from fourth place to eighth

Risks to an organization’s activities are important when assessing system-wide risks because disruptions or difficulties in one organization can spread rapidly to others in Canada’s interconnected financial system. The top two risks identified by participants are also valid for the financial system as a whole. In the 2021 Financial System Review, we highlighted that:

  • cyber threats remain an important vulnerability given the highly interconnected nature of the financial system
  • a global repricing of risk assets could lead to deteriorating financial conditions

New developments

Respondents listed new developments that their organization’s have started monitoring within the past year (Chart 4). Since these could develop into risks, understanding these trends at an early stage is important for informing the Bank’s assessment of vulnerabilities in the financial system.

Chart 4: Top new developments that organizations are monitoring

Chart 4: Top new developments that organizations are monitoring

Note: "Others" includes credit rating agencies, credit unions, exchanges and clearing houses, finance/trust companies and public institutions. ESG stands for environmental, social and governance.
Source: Bank of Canada

The top two new developments are:

  1. climate change and environmental, social and governance. This top new development is consistent with the increasing influence of climate change considerations on the investment decisions that market participants make, as mentioned in the 2021 Financial System Review. The asset pricing, regulatory and reputational channels through which respondents think this development could affect their organizations are consistent with findings in the autumn 2019 Financial System Survey.
  2. higher inflation. Respondents believe that higher inflation could expose their organizations to asset pricing risks. This is consistent with the fact that a reassessment of global inflation risks could trigger a repricing of assets, as mentioned in the 2021 Financial System Review.

Implications of low interest rates on strategies and risks

We used the autumn 2021 FSS to enhance our understanding of how the prolonged period of low interest rates has influenced market participants. We asked them about:

  • changes they made to their strategy and the associated risks and benefits of these changes
  • scenarios that could trigger a sudden repricing of risk assets and how they would respond to these scenarios if they were to occur

Impact of low interest rates over the past decade

Overall, the prolonged period of low interest rates has worsened respondents’ abilities to meet their profit or return goals (Chart 5). Reasons for this included lower returns on fixed-income securities and compressed profit margins. However, the effect has been uneven. Insurers, pension funds and banks experienced the greatest difficulty meeting their profit or return goals. Other respondents were better able to meet these goals thanks to the appreciation of real assets and equities and lower costs of funding.

Chart 5: Effect of low interest rates on the ability to meet profit or return goals

Chart 5: Effect of low interest rates on the ability to meet profit or return goals

Note: "Others" includes credit rating agencies, credit unions, exchanges and clearing houses, finance/trust companies and public institutions.
Source: Bank of Canada

In this context, respondents have modified their asset exposures (Figure 1). The survey question did not specify whether to report changes in exposure in absolute or relative terms. Respondents seem to have interpreted the question differently, with banks and broker-dealers allocating more to all asset classes. That said, two patterns emerged between:

  • asset managers, pension funds and insurers, on one hand
  • banks and broker-dealers, on the other hand

This is not surprising given the differences in their business models and the ways they may be affected by a low interest rate environment.

Figure 1: Changes in asset exposures driven by the prolonged period of low interest rates over the past decade

Figure 1: Changes in asset exposures driven by the prolonged
period of low interest rates over the past decade

Asset managers Pension funds Insurers Broker-dealers Banks
Cash and equivalents -0.9 -0.4 -0.7 1.3 0.6
Government of Canada and guaranteed bonds -1 -0.9 -0.3 0.8 0.6
Other government fixed-income securities -0.8 -0.4 0.2 0.4 0.5
Investment grade corporate credit 0.8 -0.5 0.3 0.4 0.4
High-yield corporate credit 0.8 0.8 0.6 0.5 0.3
Private debt and lending 0.8 1.2 1.2 0.5 0.5
Residential real estate 1 0.3 -0.3 0.8 1.2
Commercial real estate 0.8 0.3 0.2 0.5 1
Infrastructure 0.8 1.1 1 0.5 0.7
Publicly traded equity 0.6 -0.5 -0.6 0 0.1
Private equity 0.7 1.1 0.8 0.5 0.2

Decreased materially

Unchanged

Increased materially

Note: Change in exposure index weights: decreased materially: -2 points; decreased slightly: -1 points; unchanged: 0 points; increased slightly: 1 point; increased materially: 2 points.
Source: Bank of Canada

Asset managers, pension funds and insurers

Over the past decade, asset managers, pension funds and insurers have engaged in a search for yield, reducing their exposure to safer assets and increasing exposure to riskier assets. These respondents have also increased their use of leverage and the maturity of their assets.

Pension funds and insurers have decreased their exposure to publicly traded equities. At the same time, they have increased their exposure to private equity. These changes were implemented to enhance returns while reducing volatility and are part of a long-term strategy.1 They were not significantly influenced by domestic and global monetary policy responses to the pandemic.

Banks and broker-dealers

Banks had the largest growth in real estate and infrastructure exposures. In contrast, broker-dealers had the largest increase in cash and equivalents, following the Bank of Canada’s quantitative easing program, which significantly increased liquidity in the financial system. Banks and broker-dealers also increased the maturity of their assets.

Overall effect

Overall, most respondents stated that they are more exposed to risky assets, yet they believe that their level of risk has not changed significantly. Combined with their high level of confidence in the financial system, attributed in part to the pandemic response of authorities, this may suggest moral hazard.2 Alternatively, this may reflect that many participants noted that the banking sector is strong and the financial system well regulated.

Scenarios and strategies for a sudden repricing of risk assets

Participants think that a range of different scenarios could trigger a sudden repricing of risk assets (Chart 6).

Chart 6: Scenarios that could trigger a severe repricing of risk assets

Chart 6: Scenarios that could trigger a severe repricing of risk assets

Note: "Others" includes credit rating agencies, credit unions, exchanges and clearing houses, finance/trust companies and public institutions.
Source: Bank of Canada

Respondents’ concerns about high inflation included the following:

  • higher inflation may not be temporary
  • inflation may rise too quickly
  • higher inflation may lead to stagflation

Respondents who mentioned rapidly rising interest rates as a potential trigger for a sudden repricing of risk assets were concerned about higher inflation and the tightening of monetary policy.

Respondents who cited COVID‑19 were worried about the possibility of new variants and a prolonged pandemic that could result in another decline in economic activity.

Three distinct trends emerge in respondents’ anticipated reaction to a sudden repricing of risk assets (Figure 2):

  • Asset managers, broker-dealers and banks would increase exposure to safer and more liquid assets, while reducing exposure to riskier assets in a flight to safety.
  • Pension funds would act countercyclically, taking this opportunity to increase exposure to riskier assets at more favourable valuations.
  • Some insurers would follow a flight to safety, while others intend to act countercyclically.

Figure 2: Intended changes in exposure given a sudden repricing of risk assets

Figure 2: Intended changes in exposure given a sudden repricing of risk assets

Asset managers Pension funds Insurers Broker-dealers Banks
Cash and equivalents 0.4 -0.2 0 0.3 0.6
Government of Canada and guaranteed bonds 0.3 -0.1 0.3 0.3 0.6
Other government fixed-income securities 0.3 -0.1 0.2 1 0.4
Investment grade corporate credit 0.1 0.2 0 0.3 -0.5
High-yield corporate credit 0 0.5 0.2 0 -0.5
Private debt and lending 0 0.3 0 -0.7 -0.3
Residential real estate 0 0.3 0 -0.3 -0.3
Commercial real estate -0.1 0.3 0.2 -0.3 -0.1
Infrastructure 0 0.4 0.2 0 0.2
Publicly traded equity -0.2 0.8 -0.4 0 -0.6
Private equity -0.1 0.4 0 -0.3 -0.2

Decrease materially

No change

Increase materially

Note: Change in exposure index weights: decrease materially: -2 points; decrease slightly: -1 points; no change: 0 points; increase slightly: 1 points; increase materially: 2 points.
Source: Bank of Canada

These trends suggest that pension funds could be buyers of assets sold by asset managers, banks and broker-dealers. However, the timing and size of buys and sells may not perfectly offset each other, and markets could experience strains at least for some time. For example, market participants that intend to follow a flight to safety may rush to sell their riskier assets. In contrast, pension funds may buy more progressively.3

Endnotes

  1. 1. For an explanation of how investments in alternative assets, such as private equity, can reduce asset valuation volatility, see S. Betermier, N. Byrne, J.-S. Fontaine, H. Ford, J. Ho and C. Mitchell, “Reaching for Yield or Resiliency? Explaining the Shift in Canadian Pension Plan Portfolios,” Bank of Canada Staff Analytical Note No. 2021-20 (August 2021).[]
  2. 2. A few respondents explicitly mentioned that they believe authorities would support markets again if a large negative shock occurred in the future.[]
  3. 3. To learn how most pension funds delayed rebalancing until April 2020, rather than acting countercyclically at the outset of the COVID‑19 shock in March 2020, see G. Bédard-Pagé, D. Bolduc, A. Demers, J.-P. Dion, M. Pandey, L. Berger-Soucy and A. Walton, “COVID‑19 Crisis: Liquidity Management at Canada's Largest Public Pension Funds,” Bank of Canada Staff Analytical Note 2021-11 (May 2021).[]