Stressed but not Helpless: Strategic Behaviour of Banks Under Adverse Market Conditions

Central banks and regulators around the world routinely assess the ability of banks to survive hypothetical stress scenarios by conducting bank stress tests. During a stress scenario—think of the financial crisis of 2008–09—we would expect banks to modify their risk exposure and react to actions their competitors take. However, standard stress-test tools do not capture bank behaviours even under extreme stress scenarios. Assumptions about bank behaviours may impact the analysis of bank resilience and regulation during a financial crisis.

Our new stress-testing tool challenges these assumptions. Banks under stress can strategically change their behaviour to maximize their value for shareholders. Using confidential Canadian supervisory data, we assess whether this value-maximizing behaviour can amplify a hypothetical stress scenario.

We show that during a crisis, banks comply with regulatory requirements by reducing their lending. This results in less financial support for businesses and consumers when they need it most. As such, a trade-off exists between banking stability and macroeconomic stability.