From Stress to Strategy: How Banks Balance the Scales

This paper introduces a partial equilibrium stress-testing model in which heterogeneous banks optimize portfolios subject to regulatory constraints, with endogenous price effects and managerial buffers arising from a Nash equilibrium. Applied to Canada's Big Six banks, the framework is used to illustrate three applications. First, it identifies a sharp nonlinearity: aggregate credit provision is stable if banks sit comfortably above the regulatory minimum but contracts abruptly when close or below. Second, a counterfactual increase in the Domestic Stability Buffer from 3% to 3.5% reduces aggregate lending by approximately 1.2%, an effect comparable in magnitude to a 25 basis point increase in the policy rate. Third, reverse stress testing recovers the macro-financial environments consistent with systemic stress without conditioning on any prior narrative. Two of three identified stress clusters feature above-trend GDP growth: one driven by a house price correction, and one by Canadian dollar appreciation alongside rising oil prices. Both represent vulnerabilities that conventional scenario design would systematically miss.