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Framework for assessing financial stability

The role of the Bank of Canada in supporting financial stability

Financial stability and macroeconomic stability are interdependent. A stable and resilient financial system can provide critical services necessary to support the economy, both in normal times and during periods of stress. Financial stability reduces the need for authorities to intervene when stress occurs. It also helps efficiently transmit monetary policy to the economy to achieve low and stable inflation.

The Bank of Canada is one of several federal and provincial entities that support Canada’s financial stability. In that regard, the Bank:

  • conducts and publishes research and analysis on financial stability
  • provides liquidity to the financial system in times of stress
  • oversees and acts as the resolution authority for financial market infrastructures that are designated as systemically important

Asset prices and the financial health of households, businesses and financial intermediaries can fluctuate, sometimes significantly. This does not usually impair the ability of the financial system to provide access to funds and critical financial services. However, some pre-existing conditions—such as high levels of leverage or the mispricing of risk—can amplify shocks and spread them throughout the financial system, threatening financial stability. This is especially the case when these conditions involve a systemically important financial entity or a core funding market.

Participants in the financial system are also highly interconnected. Stress affecting one participant could spread to other participants:

  • directly through balance sheet exposures
  • indirectly through:
    • common exposures and similarities in business models and risk management practices
    • confidence effects

Enhancing the resilience of individual sectors of the financial system and systemically important entities is therefore crucial to safeguarding financial stability.

Assessing financial stability

In fulfilling its mandate to foster a stable and efficient financial system, the Bank continuously monitors key sectors of the system, including:

  • Households and businesses—As the ultimate providers and users of funds in the financial system, significant changes in their financial health can have important implications for financial and macroeconomic stability. Their actions can lead to funding and credit risks for financial institutions.
  • Banks and other deposit-taking institutions (such as credit unions)—Banks channel funds from savers to borrowers and serve as intermediaries in fixed-income markets by buying and selling securities. If banks and other deposit-taking institutions provide fewer loans or market services, there can be serious consequences for the financial system and the economy.
  • Non-bank financial intermediaries (NBFIs)—NBFIs (such as asset managers and non-bank lenders) offer a valuable alternative to banks in providing funding to the economy. Asset managers are the largest component of NBFIs and depend on core funding markets to meet their cash needs. Their actions, when combined, can affect the functioning of core funding markets.

Well-functioning financial markets—where investors, issuers and intermediaries buy and sell financial instruments—are also critical to maintaining financial stability. Assets are priced efficiently when financial markets function well, reducing the risk of sudden price corrections. Financial markets that function well also allow governments and businesses to secure funding when needed, with less uncertainty. The Bank closely monitors financial markets and assesses risks to their stability, notably with respect to market liquidity.

Financial stress in any of these sectors is a source of concern. But in its assessment of financial stability, the Bank focuses on feedback mechanisms and interconnections between these sectors that can lead to system-wide stress, which may require authorities to intervene.

Communicating about financial stability

The Bank communicates regularly about financial stability issues. Once a year, the Bank provides its overall assessment of the state of financial stability in Canada in the Financial Stability Report. The Report aims to raise awareness of risks to financial stability in key sectors and the broader system. Members of the Bank’s Governing Council also provide updates on the risks to financial stability through public speeches.

The Financial Stability Report does not provide an assessment of resilience among financial market infrastructures and payment service providers. Given the Bank’s oversight and supervisory mandates for these entities, they are discussed in annual reports available on the Bank’s website.

The Financial Stability Report is mainly focused on risks to the financial system that evolve with the strength of the broader economy. The Report may include analyses of how structural changes, such as technological advances (including cyber risks and cryptoassets) or climate change, could lead to system-wide stress. Such risks tend to be independent of economic and financial cycles. Analysis of these issues, as well as of the structure and efficiency of the financial system, are regularly published on the Bank’s Financial System Hub.

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