The Bank of Canada conducts the Financial System Survey (FSS) 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 for comparing Bank views and analytical work with outside opinions. Bank staff also use these results to identify new topics for research and analysis.
After the spring 2022 FSS, the Bank reduced the frequency of the FSS from twice to once per year. This change allows staff to collect richer insights through more outreach while reducing the burden on respondents. See Box 1 for details.
The 2023 FSS, completed by 58 respondents, was conducted between February 21 and March 10, 2023. Given this survey period, survey responses did not reflect concerns about turmoil in the banking sectors in the United States and Switzerland. In follow-up discussions, a subset of respondents indicated that their views around the risks to and resilience of the Canadian financial system had not changed significantly since the survey closed.
In addition to recurring questions, this survey included a set of questions on margining practices for non-centrally cleared derivatives.
- Respondents believe the risk of a shock that could impair the Canadian financial system has decreased since the last survey. Their 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 risks are the second most important risk. In addition to posing risks to individual organizations, these risks are relevant for the broader Canadian 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.
- For many of their non-centrally cleared derivatives agreements, respondents indicated that they can pledge both cash and a range of securities to meet their initial and variation margin requirements.
- Many respondents conduct stress tests to assess their ability to meet increases in margin requirements using a range of both historical and hypothetical scenarios.
- Respondents would meet increases in margin requirements smaller than those anticipated in stress tests primarily by pledging assets and cash on hand. If increases in margin requirements were larger than those produced from stress tests, respondents would rely more on other funding sources to raise cash in addition to pledging assets and cash on hand. These funding sources include asset sales, securities financing markets and lines of credit. The 2021 Financial System Review discusses how such increases in margin requirements could contribute to scenarios where the demand for cash exceeds the supply provided by banks, adding to strains on market liquidity.
Box 1: Change to the frequency of the Financial System Survey
The Bank of Canada reduced the frequency of the Financial System Survey (FSS) from twice to once per year to:
- improve the quality of insights collected
- balance the burden the survey places on respondents
The Bank will continue to conduct the FSS annually. The FSS will take place early in the year and be published in the spring. Past surveys have shown that views of the risks to and the resilience of the Canadian financial system do not change significantly over a six-month period and therefore may not justify the time respondents spend completing a semi-annual survey.
To replace the autumn FSS, Bank staff will have additional discussions with respondents to gather views on how risks to their organizations and to the financial system may have evolved. These discussions can also provide financial market participants with an opportunity to raise concerns or risks that may not have been captured in their past FSS responses. These topics can help inform the Bank’s focus for future surveys.
If market developments warrant, the Bank may consider conducting a second FSS in the autumn on an ad hoc basis.
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 decreased since the last survey (Chart 1). Nevertheless, many respondents raised concerns about risks associated with:
- geopolitical tensions
- high inflation
- household debt burdens
Respondents who believed the likelihood of a shock was greater in the medium term (1 to 3 years) cited concerns that high inflation could last and that quantitative tightening could lead to deteriorated market liquidity.1
Respondents’ perceptions of a decrease in the likelihood of a shock were accompanied by a slight increase in their confidence in the resilience of the Canadian financial system. This reached its highest level since the first FSS in 2018 (Chart 2). Reasons cited for this ongoing confidence were similar to those from the spring 2022 FSS:
- the well-capitalized banking sector
- the well-regulated financial system
Some respondents continue to expect that regulators, central banks and governments would intervene if a large shock were to occur. However, a few were concerned about the ability of central banks to respond to future shocks given already-large central bank balance sheets. Deputy Governor Toni Gravelle recently offered thoughts on how the Bank might approach interventions in the future.2
Most important risks
Respondents ranked the three risks that would have the most severe impact on their organization if they were to occur over the next three years. They also assigned each of these risks to a broader category. Chart 3 shows the top risk categories, in order of their risk index—the ranking of each risk category weighted by its frequency among responses.
Following are details on the top three risks:
- International economic and political risks. These are mainly geopolitical tensions and the risk of knock-on effects for the global economy. Insurers cited geopolitical tensions as the top risk to their organizations. The most frequently mentioned geopolitical tensions were the potential for:
- an escalation of Russia’s war in Ukraine
- an increase in tensions between the United States and China
- a Chinese invasion of Taiwan
- increased monitoring of geopolitical developments
- stress-test scenarios of plausible geopolitical developments
- heightened caution around exposures in foreign jurisdictions
- External risks. These are predominantly the risk of a cyber incident. Some respondents also included cyber incidents in the operational risk category. Across the two categories, based on our risk index, cyber incidents ranked as the top risk in the 2023 FSS and were also the top risk for banks.3 Among other sources of cyber risks, respondents mentioned concerns about the impact to their organizations from potential cyber attacks and the reliance on third-party service providers. Some respondents mentioned the 2022 Rogers Communications outage as an example of how issues at third-party service providers could affect their organizations. Respondents are managing the risk of a cyber incident by:
- investing in cyber security
- training employees
- reviewing and auditing third-party service providers
- updating business continuity plans
- Domestic macroeconomic risks. Lasting inflation and the risk of a recession were the most frequently mentioned domestic macroeconomic risks. Respondents were particularly concerned about the implications that high inflation and a potential recession could have for households and businesses. Respondents are managing domestic macroeconomic risks by:
- increasing their monitoring of liquidity risks
- conducting scenario analysis
- reducing their risk exposures
The top three risks in the 2023 FSS are relevant for the broader financial system and are in line with past discussions in the Bank’s Financial System Review. For instance:
- Russia’s invasion of Ukraine is a recent example of geopolitical risk. In addition to its immeasurable humanitarian impact, the invasion initially led to:
- a repricing of risk assets in some financial markets
- increased risks to global financial stability through heightened uncertainty
- inflationary pressures from rising commodity prices and from disruptions to supply chains
- A successful cyber attack on a major financial institution, financial market infrastructure or other critical infrastructure could have broader implications given the highly interconnected nature of the financial system.
- Unexpected persistence of or further increases in inflation could lead to tighter monetary policy, which could result in a repricing of risk assets.
Respondents also reported new developments that their organizations have started monitoring within the past year. These included:
- environmental social governance (ESG):
- Respondents are managing compliance and reputational risks related to ESG. They are also exploring opportunities for ESG investments based on their clients’ interests.
- the US debt ceiling impasse:
- This could have a significant impact on asset valuations and market volatility.
- discontinuation of Canadian Real Return Bond issuance:
- Respondents are looking into alternative methods for managing inflation risk in their portfolios.
Margining practices for non-centrally cleared derivatives
We used the 2023 FSS to improve our understanding of market participants’ margining practices for non-centrally cleared derivatives. Margin requirements can reduce the spread of losses from the default of a counterparty. But large and sudden increases in margin requirements could lead to strains on fixed-income market liquidity.4 Specifically, in times of crisis, many market participants may sell fixed-income assets to raise cash to pledge as margin. Banks may be unwilling to fully absorb these assets on their balance sheets given their increased risk aversion amid heightened volatility and uncertainty in markets. In such scenarios, when the demand for liquidity exceeds the supply, fixed-income market liquidity could deteriorate significantly. This could be seen at the onset of the COVID-19 crisis in March 2020 and from the turmoil in the UK gilt market in September 2022.5
In the 2023 FSS, we asked market participants about:
- the types of collateral they can pledge as margin for non-centrally cleared derivatives
- the scenarios they use in stress tests of their ability to meet large increases in margin requirements
- how they intend to meet large increases in margin requirements
Prevalence of non-centrally cleared derivatives
Overall, 67% of respondents use non-centrally cleared derivatives (Chart 4). The most common types of non-centrally cleared derivatives used are:
- foreign exchange derivatives (e.g., cross-currency swaps, foreign exchange forwards and foreign exchange options)
- interest rate derivatives (e.g., interest rate swaps, bond forwards and interest rate options)
- equity derivatives (e.g., total return swaps)6
Most respondents who use non-centrally cleared derivatives indicated that these derivatives are an important part of their business. Respondents mentioned that they use non-centrally cleared derivatives because:
- they can be customized to manage specific risks
- for some markets, centrally cleared derivatives do not exist or are less liquid than comparable non-centrally cleared derivatives
A greater share of respondents’ non-centrally cleared derivatives agreements require variation margin than initial margin (Chart 5).7 These results align with regulatory rules for margin requirements for non-centrally cleared derivatives agreements established by the Office of the Superintendent of Financial Institutions (OSFI). These rules apply to federally regulated financial institutions, including banks.8 Due to the over-the-counter structure of non-centrally cleared derivatives markets, other market participants are indirectly subject to these rules given that their counterparties are banks. Specifically, OSFI’s rules indicate the following:
- Public sector entities and multilateral development banks are exempt from both initial and variation margin requirements.
- Counterparties of physically settled foreign exchange forwards and swaps are exempt from initial and variation margin requirements.
- Entities whose total notional exposure of non-centrally cleared derivatives is below different thresholds are exempt from pledging initial margin and, in some cases, variation margin as well.
- Agreements between a Canadian bank and its affiliates are exempt from requiring both initial and variation margin.
Eligible collateral for margin
For non-centrally cleared derivatives agreements that require margin, respondents are typically able to pledge both cash and securities (Chart 6). Across respondents’ non-centrally cleared derivatives agreements, the collateral that is eligible for initial margin has some notable differences from that eligible for variation margin:
- Cash is less prevalent for initial margin. Respondents mentioned legal uncertainties around which creditors have legal ownership over cash in the event of a counterparty default as the main reason for their preference to receive securities as initial margin.9
- Corporate bonds and public equities are less prevalent for variation margin. Some respondents told us that the inability to rehypothecate initial margin was the main reason counterparties preferred to pledge riskier eligible securities.10
The ability of market participants to pledge a mix of cash and different securities as margin can increase the resilience of market liquidity in instances of large and sudden increases in margin requirements. When market participants must pledge cash as margin, they may have to sell assets or raise cash in funding markets to meet margin calls, which could strain market liquidity.
Managing the risks of large increases in margin requirements
Of respondents who use non-centrally cleared derivatives, 80% stress test their ability to meet large increases in margin requirements. The 2008–09 global financial crisis and the more recent COVID-19 crisis are historical scenarios that they commonly use for stress tests. Hypothetical scenarios for stress testing that respondents cited included:
- a crisis in Canada that resembles the turmoil in the UK gilt market in September 2022, where long-term UK gilt yields rose by 150 basis points within six days
- an escalation in geopolitical conflicts after Russia’s invasion of Ukraine
In these stress-test scenarios, respondents typically test their ability to meet increases in margin requirements over a one-month period.
In addition to stress tests, respondents also manage risks related to increases in margin requirements by:
- regularly monitoring collateral inventories
- establishing contingent liquidity plans
- diversifying counterparties for funding
- diversifying available funding instruments
Respondents reported that they would meet increases in margin requirements primarily by pledging assets and cash on hand. We anticipate that market participants would be more likely to use a range of funding sources if increases in margin requirements were greater than those produced from their stress tests. The Bank has a particular interest in such scenarios because market participants’ actions could have greater implications for market liquidity. If increases in margin requirements were larger than those produced from stress tests, respondents would tend to act similarly but would also sell assets and raise cash through securities financing markets and lines of credit to a greater degree (Chart 7).
For increases in margin requirements that are smaller than those anticipated from stress tests:
- Insurers, pension funds and asset managers would mostly pledge asset holdings.
- Banks would mostly pledge asset holdings and cash on hand, but they would also use securities financing markets, rehypothecate margin received and raise cash through other sources (e.g., debt issuance).
Some respondents mentioned they prefer to pledge assets rather than cash because this allows them to maintain their portfolios’ asset allocation. Respondents who intended to pledge cash said the reason was operational simplicity.
For increases in margin requirements that were larger than those anticipated from stress tests:
- Asset managers would make greater use of asset sales to raise cash.
- Banks would increase their use of all funding sources.
- Insurers and pension funds would make greater use of assets sales, securities financing markets and lines of credit.
In follow-up discussions, we learned that some respondents consider liquidity needs for meeting an increase in margin requirements as part of their overall liquidity risk framework. As part of these frameworks, respondents consider how best to meet their combined liquidity needs, including for increases in margin requirements, using a variety of different funding sources. However, respondents highlighted that they would typically sell assets to raise cash only as a last resort. Broadly, respondents consider the following to evaluate decisions around the use of different funding sources:
- the availability of eligible assets
- relative costs incurred among different funding sources
- haircuts applied to asset classes
- 1. To learn about the mechanics of quantitative tightening, see D. Bolduc, B. Howell and G. Johnson, “How does the Bank of Canada’s balance sheet impact the banking system?” Bank of Canada Staff Analytical Note No. 2022-12.[←]
- 2. See T. Gravelle, “The Bank of Canada’s market liquidity programs: Lessons from pandemic,” speech at the National Bank Financial Services Conference, Montréal, Quebec, March 29, 2023.[←]
- 3. We will clarify which risk category respondents should use to report cyber incidents in the next FSS.[←]
- 4. For details on how margin prevents spillover effects from the default of a counterparty, see N. Chande, S. Lavoie and T. Thorn, “Margining for Non-Centrally Cleared Over-the-Counter Derivatives,” Bank of Canada Financial System Review (December 2013): 45–51.[←]
- 5. To learn more about the market turmoil at the onset of the COVID-19 crisis, see J.-S. Fontaine, C. Garriott, J. Johal, J. Lee and A. Uthemann, “COVID-19 Crisis: Lessons Learned for Future Policy Research,” Bank of Canada Staff Discussion Paper No. 2021-2. To learn more about the turmoil in the UK gilt market, see A. Hauser, “Looking through a glass onion: lessons from the 2022 LDI intervention” (speech at the Global Markets’ Workshop on Market Dysfunction, the University of Chicago Booth School of Business, March 3, 2023).[←]
- 6. For a more granular breakdown of the types of non-centrally cleared derivatives used in Canada, see M. Mueller and A. Usche, “Toward More Resilient Markets: Over-the-Counter Derivatives Reform in Canada,” Bank of Canada Financial System Review (December 2016): 52–65; and P. McGuire, “Triennial Central Bank Survey of foreign exchange and Over-the-counter derivatives markets in 2022,” Bank of International Settlements (October 27, 2022).[←]
- 7. For definitions of initial and variation margin, see N. Chande, S. Lavoie. and T. Thorn, “Margining for Non-Centrally Cleared Over-the-Counter Derivatives,” Bank of Canada Financial System Review (December 2013): 45–51.[←]
- 8. For details on the scope of coverage for margin requirements for Canadian banks, see Office of the Superintendent of Financial Institutions, “Margin Requirements for Non-Centrally Cleared Derivatives” (April 2020).[←]
- 9. For a discussion on the legal ownership of cash in financial transactions, see A. Ricchetti, and M. Sagan, “Cash is King—Taking Control over Cash Collateral,” McMillan Financial Services Bulletin (January 18, 2022).[←]
- 10. For rules on initial and variation margin requirements that apply to Canadian banks, see Office of the Superintendent of Financial Institutions, “Margin Requirements for Non-Centrally Cleared Derivatives” (April 2020).[←]