Introduction
Do large banks in Canada have enough capital to withstand a severe economic downturn? The COVID‑19 pandemic caused a large disruption to the Canadian economy. However, this health crisis has not turned into a financial crisis, for two main reasons. First, Canadian banks were well capitalized going into the pandemic and continued to act as a shock absorber for the economy. Second, extraordinary policy measures—fiscal, monetary and prudential—significantly reduced household and business insolvencies, softening the impact of the shock on the real economy and the financial system.
In this note, we assess whether the Canadian banking system has enough capital to withstand a severe and prolonged recession when authorities do not provide a large amount of policy support. Using our solvency stress-testing tool, we measure the effect of our risk scenario on the capital positions of major banks in Canada.1 Although this represents a hypothetical scenario and reality turned out differently, the exercise is informative in understanding potential vulnerabilities of the banking system. Importantly, we are not evaluating outcomes for individual institutions, but rather seeking to understand the resilience of the banking system as a whole.
Similar to Gaa et al. (2019), we find major banks would incur significant financial losses in such a severe scenario but would remain resilient and maintain levels of capital well above the regulatory minimum. The resilience of the Canadian banking system in this scenario can be explained by:
- strong capital buffers and high loan-loss reserves going into the scenario, which help absorb additional loan losses. The capital buffers of Canada’s largest banks increased during the pandemic as earnings outpaced the distribution of dividends. In addition, the banks built up high reserves in the first quarters of the pandemic as a precaution, anticipating potential future loan impairments.
- sound underwriting and risk management practices, which limit the occurrence and magnitude of defaults on bank loans to households and businesses.
- strong initial balance sheets of households and businesses, allowing them to weather the effects of the simulated downturn.
The risk scenario
To stress test the solvency of major banks in Canada, we design a global risk scenario in which economic activity contracts sharply over an extended period. Among the possible triggers for such a severe downturn is an economic setback caused by a new wave of the pandemic.2 Our risk scenario begins with the emergence of a COVID‑19 variant spreading rapidly around the world and resistant to existing vaccines. The narrative of this scenario is realistic: the Omicron variant is a reminder that how the pandemic evolves remains uncertain.
Given the data available at the start of the stress-testing analysis (around mid-2021), the risk scenario begins in the first quarter of 2021 and lasts for three years. This scenario should not be seen as a projection of events if a new COVID‑19 variant emerges. Rather, it is hypothetical and assesses the resilience of the Canadian banking system to a severe and prolonged economic recession. Therefore, we make strong assumptions regarding:
- lockdowns
- Public authorities reimpose lockdowns to slow the transmission of the variant, reducing economic activity and adding uncertainty about the economic outlook.
- policy support
- Governments gradually unwind their support programs as previously planned and do not introduce new fiscal transfers.
- Macroprudential policy tools, such as adjusting the domestic stability buffer, remain unchanged.
- scarring
- The crisis causes long-lasting consequences for the economy. For instance, unemployed workers see their skills depreciate, and they struggle to re-enter the job market. Firms that become insolvent disappear from the business landscape.
In the scenario, the lockdowns trigger a severe and persistent recession that lasts six quarters. The initial impact is limited to industries sensitive to COVID‑19 but quickly spreads to the broader economy. At the height of the crisis, Canada’s gross domestic product (GDP) contracts by 5.8% and the unemployment rate reaches a peak of 13.5% (Table1). Also, Canadian households see their incomes decline and reduce their spending on residential investment. This results in a 29% correction of house prices at the national level.
