How well can Canada’s big banks withstand a severe economic downturn? | Techy Kings

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identification

Do Canada’s big banks have enough capital to withstand a severe economic downturn? The COVID‑19 pandemic caused major disruptions to the Canadian economy. However, this health crisis did not turn into a financial crisis, for two main reasons. First, Canadian banks are well capitalized to weather the pandemic and continue to act as shock absorbers for the economy. Second, exceptional policy measures—fiscal, monetary, and prudential—reduced household and business insolvencies significantly, reducing the impact of shocks on the real economy and the financial system.

In this note, we assess whether the Canadian banking system has sufficient capital to withstand a severe and prolonged recession when the authorities do not provide a significant amount of policy support. Using our solvency stress test tool, we measure the impact of our risk scenarios on the capital positions of major banks in Canada. Although this represents a hypothetical scenario and the reality turns out to be different, this exercise is informative in understanding the potential weaknesses of the banking system. Importantly, we do not assess outcomes for individual institutions, but rather seek to understand the resilience of the banking system as a whole.

Similar to Gaa et al. (2019), we find that major banks will suffer significant financial losses in a severe scenario but will remain resilient and maintain capital levels well above regulatory minimums. The resilience of the Canadian banking system in this scenario can be explained by:

  • strong capital buffers and high loan-loss reserves into the scenario, which helps absorb additional loan losses. Canada’s largest bank’s capital buffer increased during the pandemic as earnings outpaced dividend payouts. In addition, banks built up high reserves in the first quarter of the pandemic as a precautionary measure, anticipating potential loan deterioration in the future.
  • sound underwriting and risk management practices, which limits the incidence and magnitude of bank loan defaults to households and businesses.
  • strong initial balance sheet households and businesses, allowing them to weather the effects of a simulated downturn.

Risk scenarios

To emphasize the solvency test 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 of such a severe recession is the economic downturn caused by the new wave of the epidemic. Our risk scenario begins with the emergence of a variant of COVID‑19 that spreads rapidly around the world and is resistant to existing vaccines. The narrative of this scenario is realistic: the Omicron variant is a reminder that the way the epidemic develops is still uncertain.

Given the data available at the start of the stress test analysis (around mid-2021), the risk scenario starts 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 variant of COVID‑19 emerges. Rather, it is hypothetical and assesses the resilience of the Canadian banking system to a severe and prolonged economic downturn. Therefore, we make strong assumptions about:

  • locking

    • Public authorities reimposed restrictions to slow the delivery of variants, reducing economic activity and increasing uncertainty about the economic outlook.

  • basic support

    • The government is gradually unwinding its support programs as previously planned and not introducing new fiscal transfers.
    • Macroprudential policy tools, such as adjusting the domestic stability buffer, remain unchanged.

  • scars

    • The crisis caused lasting consequences for the economy. For example, unemployed workers see their skills decline, and they struggle to re-enter the job market. Firms that go bankrupt disappear from the business landscape.

In that scenario, the sanctions triggered a severe and persistent recession that lasted six quarters. The initial impact was limited to industries sensitive to COVID‑19 but spread quickly to the wider economy. At the height of the crisis, Canada’s gross domestic product (GDP) contracted by 5.8% and the unemployment rate peaked at 13.5% (Table 1). Additionally, Canadian households saw their incomes decline and reduced their spending on residential investments. This resulted in a 29% correction in house prices nationally.

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