Financial System Survey highlights—Spring 2022

The Bank of Canada conducts the Financial System Survey (FSS) twice a year to solicit the opinions of senior experts in risk management. These experts provide their views on the risks to, and resilience of, the Canadian financial system as well as on new developments they are monitoring. 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 spring survey, completed by 52 respondents, took place between February 22 and March 18, 2022. Russia’s invasion of Ukraine occurred during the survey period. Tensions between Russia and Ukraine therefore featured prominently in responses.

In addition to recurring questions, this survey included a set of questions on the potential risks associated with the global normalization of monetary policy. Market participants were starting to revise their expectations for policy normalization during the survey period. As a result, aggressive policy tightening was another notable theme in responses.

Highlights

  • Respondents believe the risk of a shock that could impair the financial system has increased since the last survey because of concerns related to:
    • increased geopolitical risks
    • withdrawal of monetary policy support
    • higher inflation
    Nevertheless, respondents’ confidence in the resilience of the Canadian financial system is at its highest since the first FSS in 2018.
  • Cyber incidents remain the top risk that organizations face. Geopolitical tensions are the second most important risk. In addition to posing risks to individual organizations, these risks are relevant for the broader financial system:
    • a successful cyber attack on a financial institution or a major financial market infrastructure could result in system-wide disruptions
    • geopolitical tensions could weigh on the pricing of risk assets globally, affecting a range of investors and issuers
  • Overall, respondents are concerned about the impacts that unexpected monetary policy normalization scenarios could have on their organizations. Respondents believe that:
    • faster-than-expected normalization could result in a recession and repricing of risk assets
    • slower-than-expected normalization would initially lead to higher inflation but could be followed later by an aggressive policy correction that leads to a more severe recession and repricing of risk assets
  • To prepare for these scenarios, some respondents have reduced their risk exposure or ensured they hold sufficient liquidity.
  • Following an unexpected monetary policy normalization scenario, some asset managers, insurers and banks1 plan to either:
    • reduce their risk exposure
    • be more selective when increasing their exposure to risk assets
    Other asset managers and pension funds intend to act countercyclically and purchase risk assets.

Risks to the financial system

Overall perceptions of risk and confidence

Respondents believe the likelihood of a shock that could impair the financial system has increased (Chart 1). They also indicated that this likelihood increased more for the short term (less than one year) compared with the medium term (one to three years). Respondents cited similar reasons for both horizons, which included:

  • increased geopolitical risks
  • withdrawal of monetary policy support
  • high inflation

Chart 1: Short- and medium-term risk of a shock that could impair the Canadian 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. This question was added to the survey in autumn 2021.
Source: Bank of Canada

Even so, confidence in the resilience of the Canadian financial system reached its highest level since the first FSS (Chart 2). Reasons cited for this continued confidence were consistent with those from the autumn 2021 FSS:

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

Some respondents also continue to expect fiscal and monetary policy authorities to support markets if a large negative shock were to occur again.

However, a few respondents expressed concerns about the ability of fiscal and monetary policy authorities to respond to future shocks given already-elevated levels of public debt and central bank balance sheets.

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

Chart 2: Confidence in the Canadian 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. They also assigned each of their risks to a broader category. Chart 3 reports the top risk categories, in order of their risk index—a weighted measure of how frequently risks are ranked by participants.

Respondents reordered the importance of risks to their organization since the autumn 2021 FSS. External risks remained the top risk category, despite a small decline in their risk index. International economic and political risks experienced the largest increase and now rank second. Domestic macroeconomic risks also increased and remain third. At the same time, the risk index for asset pricing risks declined.

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.
Source: Bank of Canada

The top three risk categories are:

  1. External risks—these are predominantly the risk of a cyber incident. Banks and insurers cited cyber incidents as the most important risks. Respondents are managing the risk of a cyber incident through:
    • continued investments in cyber security
    • employee training
    • outsourcing some information technology processes
    In addition to threats to their organizations, some respondents expressed concerns about a successful cyber attack from Russia on critical infrastructure as retaliation for economic sanctions.
  2. International economic and political risks—these are mainly geopolitical tensions. Asset managers and pension funds cited geopolitical tensions as the most important risks. The most frequently mentioned geopolitical tensions related to the Russian invasion of Ukraine. Respondents reported no or minimal direct exposure to Russia, but they voiced concerns about geopolitical spillovers, such as China:
    • supporting Russia and facing economic sanctions
    • invading Taiwan
    Some were also concerned that greater uncertainty around geopolitical tensions could increase the risk of a price correction in high-yield debt and emerging markets. Respondents have intensified their monitoring of their exposures to high-yield debt and emerging markets; however, they have not changed their asset allocation.
  3. Domestic macroeconomic risks—high inflation and low economic growth were the most frequently mentioned domestic macroeconomic risks. Some respondents are managing these risks through:
    • increased inflation protection, including through their exposure to private assets
    • diversifying asset exposures to reduce market risks
    Some respondents were concerned that tensions between Russia and Ukraine could further increase inflation and slow growth. This echoes the discussion in the April 2022 Monetary Policy Report about how Russia’s invasion of Ukraine has:
    • reduced global growth
    • increased inflation through higher commodity prices
    • further disrupted supply chains

The top three risks organizations face are also relevant to the broader financial system:

  • As discussed in the 2021 Financial System Review, a successful cyber attack on a major financial institution or financial market infrastructure could cause system-wide disruptions because the financial system is interconnected.
  • Geopolitical tensions could trigger a deterioration of financial conditions and a repricing of risk assets globally. For instance, the April 2022 Monetary Policy Report discusses how the war in Ukraine initially led to:
    • corporate credit spreads widening
    • equity indices dropping sharply
  • A sharp rise in expected inflation could trigger a repricing of risk assets and, potentially, a recession. For details, see the section on potential risks from monetary policy normalization.

New developments

Respondents also reported new developments that their organizations have started monitoring within the past year. Many of these were similar to their top three risks, such as geopolitical risks and high inflation. Other new developments included:

  • Fintech or open banking—Some respondents raised concerns about losing market share if they cannot compete or partner with fintech companies.
  • Digital and cryptoassets—Some respondents cited disintermediation of the banking sector as well as cyber threats and fraud as a concern. Others mentioned the volatility of cryptoassets.
  • Talent retention and attraction—Some respondents reported facing challenges attracting and retaining employees.

Potential risks from monetary policy normalization

We invited market participants to share their views on potential risks from monetary policy normalization. We provided respondents with two scenarios that differ from their expected path. We then asked them to select the one that would most negatively affect their organization and tell us how:

  • the scenario would affect financial markets
  • they have prepared for the scenario
  • they would adjust their strategies if the scenario occurred

Impact of an unexpected monetary policy normalization scenario

Among respondents, 92% reported that an unexpected monetary policy normalization scenario would negatively affect their organization (Chart 4).

  • Among respondents, 61% believed faster-than-expected normalization would result in the most severe negative impact. They believed this scenario could lead to:
    • reduced demand for goods and services
    • higher unemployment
    • a possible recession
  • Among respondents, 31% believed slower-than-expected normalization would be the most severe. They were concerned that this scenario could initially lead to higher inflation, which could reduce the credibility of central banks and result in unanchored inflation expectations. This could then be followed by aggressive policy tightening to contain inflation, which could trigger an even more severe recession in the future.

In both scenarios, respondents were primarily concerned about the effects of tightening monetary policy quickly. However, respondents’ views differed on the timing of tightening and the associated economic impacts.

Among respondents, 8% believed that neither scenario would negatively affect their organization. These respondents mostly consisted of exchanges and clearinghouses, trading platforms and other financial market infrastructures that reported no direct exposure to risk assets. Some even believed that higher volatility following these scenarios would benefit their organization through increased trading volumes.

Chart 4: Monetary policy normalization scenario that would result in the most severe negative impact for your organization

Chart 4: Monetary policy normalization scenario that would result in the most severe negative impact for your organization

Note: “Others” includes credit rating agencies, credit unions, exchanges and clearing houses, finance/trust companies and public institutions. For the spring 2022 Financial System Survey, “banks” includes “broker-dealers.”
Source: Bank of Canada

Participants expect both faster- and slower-than-expected monetary policy normalization scenarios to trigger a repricing of risk assets (Chart 5). This reaction is consistent with the 2021 Financial System Review, where withdrawing global policy support earlier than expected is discussed as a potential trigger for a repricing of risk assets.

After both scenarios, respondents expect:

  • funding and credit spreads to widen
  • publicly traded equity prices to decline
  • currencies in emerging-market economies to depreciate against those of advanced economies

There are, however, three notable differences between the two scenarios:

  • The government bond yield curve is expected to flatten after the faster-than-expected scenario, driven by higher policy rates and lower expectations for economic growth.
  • In contrast, the yield curve is expected to steepen in the slower-than-expected scenario, reflecting higher future policy rates after an initial period of elevated inflation and unanchored inflation expectations.
  • Compared with the faster-than-expected scenario, in the slower-than-expected scenario:
    • equity prices are expected to decline by less
    • credit spreads are expected to widen by less
    This could reflect differences in how respondents interpreted the slower-than-expected scenario. Some may have focused on the initial effects of lower policy rates, while others focused on the effects of more aggressive policy tightening, which could eventually be required to reduce inflation.
  • Real estate prices are expected to decline after the faster-than-expected scenario. In contrast, the expected price changes following the slower-than-expected scenario are mixed. In that scenario, prices are not expected to change significantly overall. This is potentially due to differences in the horizon for changes to market variables that respondents considered when answering the question.

Chart 5: Expected change in market variables one quarter after unexpected monetary policy normalization scenarios

Chart 5: Expected change in market variables one quarter after unexpected monetary policy normalization scenarios

Note: Index weights: decrease materially: -2 points; decrease slightly: -1 points; unchanged: 0 points; increase slightly: 1 point; increase materially: 2 points. Checkered bars indicate high response variance among respondents. OIS stands for overnight index swap; EME stands for emerging-market economy; AE stands for advanced economy. “Government” represents the aggregate of US Treasury and Government of Canada bonds given significant similarity between their expected changes.
Source: Bank of Canada

Respondents had similar expectations for market variables in both scenarios, but, again, over different horizons. We therefore combine responses for both scenarios for the rest of this report.

Market participants reported that they would be negatively affected by unexpected monetary policy normalization scenarios through different channels. Some have implemented strategies to mitigate these potential impacts:

  • Asset managers would be most negatively affected by widening investment grade credit spreads and declining equity prices. As a result, some have reduced:
    • their exposures to publicly traded equities and credit
    • the duration of their fixed-income portfolios
  • Pension funds would be most negatively affected by declining equity and commercial real estate prices. They expect to mitigate risks through their:
    • prudent liquidity management strategies, including stress-testing of large liquidity shocks
    • strategies to hedge tail risk
    • reduced leverage
    • greater allocation to assets with stable income streams
  • Banks would be most negatively affected by declining residential and commercial real estate prices. They expect to mitigate risks through their:
    • conservative lending standards
    • prudent strategies for managing liquidity risk
  • Depending on their business model, insurers were concerned about different market variables:
    • life insurers expect that rising 10-year government bond yields would have the most severe impact and have used duration-matching as a risk management strategy
    • property and casualty insurers expect that declining equity prices would result in the most severe impact and have therefore reduced their exposure to publicly traded equities
  • Some respondents said the following factors influenced how much they managed risks:
    • costs and reduced expected returns under stable market conditions
    • low probabilities of either scenario occurring

Strategies following an unexpected monetary policy normalization scenario

Respondents would adjust their strategies differently if an unexpected monetary policy normalization scenario occurred (Chart 6).

  • Overall, asset managers would maintain their strategy. However, their individual responses were mixed:
    • some would:
      • reduce their leverage
      • reduce their exposure to credit
      • increase the liquidity of their portfolio
    • others would increase their risk exposure by raising either:
      • their allocation to risk assets
      • the duration of their fixed-income portfolios

These varying strategies could reflect differences in their clients. Those with clients with long-term investment horizons may have less exposure to redemptions or other needs for liquidity. As a result, they may have more flexibility to increase risk exposure after an unexpected normalization scenario.2

  • Banks and insurers generally plan to either:
    • reduce their risk exposure to increase liquidity
    • be more selective when adding any new risk exposures

This increased caution could occur through a slower pace of adding risk exposure, applying more conservative lending standards or favouring higher-quality assets, such as government bonds.

  • Pension funds generally intend to act countercyclically, taking this opportunity to increase their exposure to risk assets at more favourable valuations. Some funds indicated they would initially purchase publicly traded equities and gradually increase their exposure to private assets.

Chart 6: Expected change in strategy one quarter after an unexpected monetary policy normalization scenario

Chart 6: Expected change in strategy one quarter after an unexpected monetary policy normalization scenario

Note: Adjustment index weights: increased risk exposure; -1, no change; 0, more selective/reduced risk exposure; 1. Solid line shows adjustment index level that indicates no change. For the spring 2022 Financial System Survey, “banks” includes “broker-dealers.”
Source: Bank of Canada

When market participants who intend to reduce their risk exposure sell assets, market liquidity conditions could deteriorate if they sell more assets than banks can intermediate. See “Vulnerability 4: High potential demand for market liquidity relative to supply capacity” in the 2021 Financial System Review for details.

Pension funds and some asset managers who plan to act countercyclically, however, could buy assets that other market participants sell. Differences in timing and size of transactions between buyers and sellers, as well as in the types of assets being traded, could limit how many transactions offset each other:

  • Market participants wanting to sell risk assets may need to do so quickly, whereas those buying more risk assets may prefer to do so gradually3
  • Market participants who intend to increase their risk exposure may do so in different amounts relative to those selling risk assets
  • Most pension funds indicated that they plan to purchase publicly traded equities first, followed by private assets; however, other market participants may be selling different assets

These potential differences could result in markets experiencing strain for some time after an unexpected monetary policy normalization scenario.

  1. 1. For the spring 2022 Financial System Survey, “banks” includes “broker-dealers.”[]
  2. 2. To learn about how Canadian mutual funds experienced large demands for redemptions during the COVID‑19 crisis, see G. Ouellet Leblanc and R. Shotlander, “What COVID‑19 revealed about the resilience of bond funds,” Bank of Canada Staff Analytical Note No. 2020-18 (August 2020).[]
  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 No. 2021-11 (May 2021).[]