Financial System Survey highlights—Spring 2021

The Bank of Canada conducts the Financial System Survey (FSS) twice a year to solicit the opinions of senior experts who specialize in risk management of the financial system. These experts provide their views on the risks to, and resilience of, the Canadian financial system as well as on emerging trends in financial products and practices. The survey results are a useful benchmark to compare Bank views and analytical work with outside opinions. Bank staff also use these results to identify new topics for research and analysis.

The spring survey, completed by 56 respondents, was conducted between February 22 and March 12, 2021. In addition to recurring questions, this survey included a set of questions on commercial real estate (CRE).

Highlights

• Respondents reported that, since the autumn 2020 survey, the risk of a shock that could impair the financial system has:
  • decreased in the short term, but
  • increased in the medium term
  Nevertheless, they remain confident in the financial system’s resilience.
• The top three risks to the Canadian financial system cited were:
• a fiscal or monetary policy mistake
• a cyber incident
• a rapid increase in inflation
• With respect to CRE, respondents believe that the retail, office and hotel subsectors face higher risks than the multi-family dwellings and industrial subsectors.
• Respondents reported the highest relative exposure to multi-family dwellings, followed by the office, industrial and retail subsectors. The CRE-related asset classes to which respondents have the highest relative exposure are:
• mortgage loans
• direct ownership of real estate assets
• Within one year of the survey, respondents plan to:
• marginally increase their exposures to the multi-family dwellings and industrial subsectors
• marginally decrease their exposures to the retail, office and hotel subsectors

Risks to the financial system

Overall perceptions of risk and confidence

Respondents believe that the likelihood of a shock that could impair the financial system has decreased slightly for the short term (less than one year) compared with six months ago (Chart 1). They attributed this improvement to:

• the effectiveness of monetary and fiscal policy support
• the rollout of COVID‑19 vaccines

Chart 1: Change in short-term risk of a shock that could impair the financial system

Chart 1: Change in short-term risk of a shock that could impair the financial system

Note: Respondents report how much risks have changed over the past six months. The change-in-risk index measures the average reported change, not the level of risk. Change-in-risk index weights: decreased materially: -2 points; decreased slightly: -1 point; remained unchanged: 0 points; increased slightly: 1 point; increased materially: 2 points. There was no Financial System Survey in spring 2020 due to the COVID‑19 pandemic.
Source: Bank of Canada Spring 2021 Financial System Survey

For the medium term (one to three years), the index is lower than in autumn 2020 because fewer respondents reported large increases in risk (Chart 2). Respondents who reported increases cited:

• uncertainty around monetary and fiscal policy support
• reduced flexibility for policy-makers to respond to future shocks
• concerns about inflation

Differences between types of respondents were notable:

• Banks believe that medium-term risks decreased.
• Asset managers reported that risks increased by more than the average across all respondents.

Chart 2: Change in medium-term risk of a shock that could impair the financial system

Chart 2: Change in medium-term risk of a shock that could impair the financial system

Note: Respondents report how much risks have changed over the past six months. The change-in-risk index measures the average reported change, not the level of risk. Change-in-risk index weights: decreased materially: -2 points; decreased slightly: -1 point; remained unchanged: 0 points; increased slightly: 1 point; increased materially: 2 points. There was no Financial System Survey in spring 2020 due to the COVID‑19 pandemic.
Source: Bank of Canada Spring 2021 Financial System Survey

Nevertheless, 96 percent of respondents are at least fairly confident that the Canadian financial system will remain resilient (Chart 3). Respondents frequently mentioned the effectiveness of monetary and fiscal policy support and improved market liquidity as their reason for remaining confident.

Chart 3: Confidence in the financial system's ability to withstand a severe impact

Chart 3: Confidence in the financial system's ability to withstand a severe impact

Note: Confidence index weights: not confident at all: 0 points; not very confident: 1 point; fairly confident: 2 points; very confident: 3 points: completely confident: 4 points. There was no Financial System Survey in spring 2020 due to the COVID‑19 pandemic.
Source: Bank of Canada Spring 2021 Financial System Survey

Most important risks

Respondents ranked the three risks that, if realized, would most harm the functioning of the Canadian financial system (Chart 4). They also ranked the three risks that would have the greatest impact on their organization’s activities (Chart 5). Risks to an organization’s activities are important when assessing system-wide risks because disruptions or difficulties at one organization can spread rapidly to others in Canada’s closely interconnected financial system.

New ranking methodology

In previous reports, we simply aggregated the total number of mentions for each risk, regardless of their ranking. In this report, we introduce a risk index, which accounts for the ranking attributed to each risk.1 This approach better reflects respondents’ views of different risks. In Chart 4 and Chart 5, we recalculate all historical risks using the new methodology.

The top three risks to the financial system cited in the spring 2021 survey were:

1. a fiscal or monetary policy mistake
2. a cyber incident
3. a rapid increase in inflation

According to the risk index—a weighted measure of how frequently risks are ranked by participants—these top three risks increased the most compared with the autumn 2020 survey. COVID‑19 and rising defaults in the household and corporate sectors fell out of the top three and now rank fourth and sixth, respectively.

Chart 4: Top risks to the financial system

Chart 4: Top risks to the financial system

Note: Risk index weights: 1st choice: 3 points; 2nd choice: 2 points; 3rd choice: 1 point. There was no Financial System Survey in spring 2020 due to the COVID‑19 pandemic.
Source: Bank of Canada Spring 2021 Financial System Survey

The top three risks to an organization’s own activities cited in the spring 2021 survey are:

1. a cyber incident—which had the highest risk index for banks, insurers and financial market infrastructures
2. drops in residential/commercial property prices
3. a reduction in market liquidity—which had the highest risk index for asset managers and pension funds

Chart 5: Top risks to your organization

Chart 5: Top risks to your organization

Note: Risk index weights: 1st choice: 3 points; 2nd choice: 2 points; 3rd choice: 1 point. There was no Financial System Survey in spring 2020 due to the COVID‑19 pandemic.
Source: Bank of Canada Spring 2021 Financial System Survey

Commercial real estate

We used the spring 2021 FSS to develop our understanding of the risks facing the CRE sector. We asked participants about their:

• perception of each subsector’s susceptibility to a sharp valuation adjustment in the short term
• level of concern about knock-on effects on the wider financial system

The survey also explores factors that will continue to affect the CRE sector once the economy has recovered.

To help build an understanding of system-wide risks, we asked respondents how they:

• are exposed to the CRE sector
• intend to change their exposures within one year of the survey

Risks to the commercial real estate sector

For the purpose of the questions on CRE, we defined short-term risks as those that currently threaten the CRE sector. Long-term risks are those risks that may continue after the recovery from the COVID‑19 pandemic.

Respondents think that the retail, office and hotel subsectors are somewhat likely to experience a sharp valuation adjustment in the short term (Chart 6). In contrast, they believe a sharp adjustment for the multi-family dwellings and industrial subsectors is rather unlikely. This may reflect the uneven effects of the pandemic on these different subsectors.

Chart 6: Likeliness of a sharp valuation adjustment in the short term

Chart 6: Likeliness of a sharp valuation adjustment in the short term

Note: The risk index is constructed with the following weights: extremely likely: 4 points; moderately likely: 3 points; somewhat likely: 2 points; slightly likely: 1 point; not at all likely: 0 points.
Source: Bank of Canada Spring 2021 Financial System Survey

While some subsectors have elevated risks of a sharp valuation adjustment, most respondents are not very concerned that it would have knock-on effects on the wider financial system (Chart 7). Banks commented that they are concerned about an adjustment leading to defaults and loan losses.

Chart 7: Concern that a sharp valuation adjustment will have knock-on effects

Chart 7: Concern that a sharp valuation adjustment will have knock-on effects

Note: The risk index is constructed with the following weights: extremely concerned: 4 points; moderately concerned: 3 points; somewhat concerned: 2 points; slightly concerned: 1 point; not at all concerned: 0 points.
Source: Bank of Canada Spring 2021 Financial System Survey

Respondents are concerned about the same CRE subsectors (retail, office and hotel) over the long term (Chart 8).

Chart 8: Long-term concern over CRE subsectors

Chart 8: Long-term concern over CRE subsectors

Note: The risk index is constructed with the following weights: extremely concerned: 4 points; moderately concerned: 3 points; somewhat concerned: 2 points; slightly concerned: 1 point; not at all concerned: 0 points. CRE stands for commercial real estate.
Source: Bank of Canada Spring 2021 Financial System Survey

Respondents indicated that the main drivers for these long-term concerns (Chart 9) are:

1. a broad economic downturn
2. changes to consumer behaviour
3. remote work and remote learning

Chart 9: Greatest long-term risks to CRE

Chart 9: Greatest long-term risks to CRE

Note: Order of factors based on a weighted index (1st choice: 3 points; 2nd choice: 2 points; 3rd choice: 1 point). CRE stands for commercial real estate.
Source: Bank of Canada Spring 2021 Financial System Survey

Exposure to the commercial real estate sector

Respondents reported their exposures to each CRE subsector in qualitative terms (i.e., significantly, moderately, somewhat, slightly or not at all exposed). This makes it impossible to compare exposures in absolute terms, but it provides insights about the importance of CRE exposures for different participants.

Respondents reported the highest relative exposure to multi-family dwellings—with 39 percent of respondents indicating that they are significantly or moderately exposed—followed by the office, industrial and retail subsectors. All respondents reported little to no exposures to the hotel subsector (Figure 1). Subsector exposures varied considerably by the type of respondent, with banks and pension funds reporting higher relative exposures:

• Pension funds are exposed to most CRE segments, with the highest exposures to the office subsector (70 percent are significantly or moderately exposed).
• Banks’ highest exposures are to the multi-family dwellings subsector (75 percent are significantly or moderately exposed).

Figure 1: CRE exposure to subsectors

Figure 1: CRE exposure to subsectors