From Stress to Strategy: How Banks Balance the Scales

Ruben Hipp and Javier Ojea-Ferreiro
Authors registered in the RePEc Author Service: Javier Ojea Ferreiro

Staff Working Papers from Bank of Canada

Abstract: 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.

Keywords: Financial system; Financial institutions and intermediation; Financial stability and systemic risk; Models and tools; Economic models (search for similar items in EconPapers)
JEL-codes: C C6 C63 C7 C73 G G2 G21 G3 G32 H H1 H12 (search for similar items in EconPapers)
Pages: 42 pages
Date: 2026-07
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