Financial Stability Report—2026—In focus
The war in the Middle East has pushed up oil prices, putting pressure on inflation. In a situation where geopolitical tensions trigger a severe tightening in financial conditions, the resilience of the financial system could be tested.
This section assesses how a persistent oil market disruption, combined with a sharp tightening in financial conditions, could affect the Canadian economy and the resilience of the financial system.
The stress‑test scenario is constructed by taking the illustrative scenario in the April 2026 Monetary Policy Report and adding a severe increase in financial stress.1
The stress‑test scenario assumes:
- Crude oil prices remain around US$100 a barrel for at least three years, and supply bottlenecks persist.
- Cost pressures are passed through to a broad set of goods and services, leading to higher prices.
- Financial market stress across asset classes in both Canada and the United States spikes quickly and remains elevated for several months. It then gradually dissipates, in line with historical stress events such as the 2008–09 global financial crisis.2
- Because inflation is high and persistent, monetary policy remains tight.
As a result, economic activity deteriorates, unemployment rises and housing prices fall. This leads to significant challenges for Canadian households and businesses. Canada’s major banks face a material increase in credit losses but remain resilient.
Financial stress amid high inflation could test resilience
As financial pressures increase in the stress‑test scenario, the Canadian economy becomes more sensitive to financial shocks, and economic conditions deteriorate further.3 This reflects past episodes of heightened financial stress, which have led to severe recessions, high unemployment and large declines in housing prices.
Financial stress also pushes up risk and term premiums, resulting in higher borrowing costs for households and businesses. At the same time, weakening equity prices reduce household wealth. This puts households and businesses under strain, which could lead financial institutions to reduce their lending.
As a result, in the stress‑test scenario, the real economy softens broadly: gross domestic product declines by about 1%, unemployment rises to around 10%, and housing prices fall by about 25%.
Households and businesses would face significant stress
In the stress‑test scenario, as unemployment rises and housing prices fall, households and businesses come under significant stress. Rates of mortgage arrears increase and reach a multi‑decade high (Chart 15). Businesses face increased costs and a decline in demand, which pushes corporate default rates close to levels seen during the global financial crisis (Chart 16).
Despite the heightened economic and financial stress faced by households and businesses in the stress‑test scenario, Canada’s major banks remain resilient. Credit losses rise to slightly more than 1% of loan balances. These losses are greater than those experienced during the global financial crisis but not as significant as those experienced during the recessions of the late 1980s and early 1990s. Credit losses deplete allowances and a portion of pre‑provision net revenue but are not large enough to reduce bank regulatory capital.
While major banks remain in sound financial condition in this stress‑test scenario, they could slow their lending because of loan losses.
Liquidity stress could be amplified
The stress‑test scenario does not explicitly model the effects of liquidity spirals. However, these could develop if defensive actions by market participants during periods of stress reinforce one another and further reduce market liquidity.
For example, businesses could draw on credit lines, banks could increase liquidity buffers, and investors could sell assets to raise cash. While these actions might be prudent individually, together they could put additional pressure on core funding markets.
In the extreme, this could lead to market dysfunction and make the actual impacts more severe for Canada’s banks and the broader financial system than the stress‑test scenario suggests.
Endnotes
- 1. See Bank of Canada, “In focus: The war in the Middle East—Transmission channels and risks to inflation,” Monetary Policy Report (April 2026).[←]
- 2. Systemic financial stress occurs when sharp corrections take place simultaneously across several major markets: equity markets, government debt, foreign exchange rates, money markets, the banking system, corporate bonds and the housing market. For more details, see T. Duprey, “Canadian Financial Stress and Macroeconomic Conditions,” Bank of Canada Staff Discussion Paper No. 2020‑4 (June 2020) or the Bank of Canada’s Financial Stability Indicators dashboard.[←]
- 3. This scenario uses the Bank of Canada’s Risk Amplification Macro Model (RAMM), a nonlinear model that can be used to simulate the amplification of shocks that may occur during episodes of heightened financial stress. For more details on RAMM, see K. Tuzcuoglu, “Risk Amplification Macro Model (RAMM),” Bank of Canada Technical Report No. 123 (January 2023).[←]