Financial System Survey highlights—2024

The Bank of Canada conducts the Financial System Survey (FSS) annually to solicit the opinions of senior experts in risk management.1 These experts provide their views on the risks to, and the resilience of, the Canadian financial system as well as on new developments they are monitoring. The survey results are a useful benchmark for comparing Bank views and analytical work with outside opinions. Bank staff also use these results to identify new topics for research and analysis.

The 2024 FSS, completed by 60 respondents, took place between February 20 and March 8, 2024 (Chart 1). In addition to recurring questions, this survey included a set of questions on potential risks posed by different hypothetical paths for interest rates. The insights gained from FSS respondents on this special topic can help support the Bank’s ongoing assessments of the stability of the Canadian financial system. The questions revolved around learning about:

• how market participants have adjusted to higher interest rates and the associated risks since monetary policy tightening began
• which policy-rate path scenarios would negatively impact different participants
• how financial markets and participants might react if these policy rate path scenarios were to occur

Highlights

• Respondents believe the risk of a shock that could impair the Canadian financial system has decreased since the 2023 survey. Those who believe in the low likelihood of a shock cited normalizing inflation levels and reduced expectations for a hard landing for the economy. Respondents’ confidence in the resilience of the Canadian financial system increased slightly and is at its highest since the first FSS in 2018. The reasons cited for this include:
  • the well-capitalized banking sector
  • the well-regulated financial system
  • the resilience of the Canadian financial system to past episodes of turmoil
• Cyber incidents remained the top risk that organizations face. Geopolitical risks and risks associated with a slowdown in the global economy were the second most important risks, while market liquidity risks ranked third.
• Many respondents reported that they have not made significant changes to their asset allocation since the start of monetary policy tightening in 2022. Those who have made changes generally increased their exposure to cash and equivalents and to fixed-income securities. The rationale for these adjustments differed across respondents but included attractive returns on fixed-income securities, the desire to reduce portfolio risk and the need to maintain asset-liability matching. Some who did not adjust their asset allocation indicated they adopt a long-term view when setting their asset allocation.
• The majority of respondents reported that the most detrimental policy-rate path for their organization would be a higher-than-expected scenario. If broad market expectations were to shift to this scenario, respondents expect a repricing of risk assets in the near term. This would include an increase in credit spreads and a decline in private and public asset valuations.
• Some respondents indicated they would adjust their asset allocation if their expectations shifted to the higher-than-expected scenario. They generally intend to:
  • increase exposure to cash and equivalents and government securities
  • reduce exposure to credit, real estate assets, public equities and other asset classes
• In asset classes where many respondents intend to transact in the same direction, the expected flows may amplify price changes because other market participants may demand greater price concessions to take the other side of these trades. This could result in strains in those markets and could increase losses further for some market participants.

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 decreased in both the short (less than one year) and medium (one to three years) terms since the 2023 survey (Chart 2). Respondents who believe the likelihood of a shock was low mentioned:

• normalizing of inflation levels
• reduced expectations for a hard landing for the economy

Respondents who believe that a shock was more likely mentioned concerns about:  

• geopolitical tensions
• the upcoming US presidential election
• the impact of elevated interest rates on the economy
• residential and commercial real estate
• uncertainty around future inflation levels
• unintended consequences from broader adoption of and advancements in artificial intelligence (AI)

Respondents’ perceptions of a decrease in the likelihood of a shock were accompanied by continued confidence in the resilience of the Canadian financial system. Confidence increased slightly, reaching its highest level since the first FSS in 2018 (Chart 3). Reasons cited for this ongoing confidence were similar to those from past surveys, such as:

• the well-capitalized banking sector
• the well-regulated financial system
• the resilience of the Canadian financial system to past episodes of turmoil

Some respondents continued to expect that regulators, central banks and governments would intervene if a large shock were to occur. Others raised concerns about the ability of central banks and governments to respond to future shocks given already-large central bank balance sheets and fiscal deficits.

Most important risks

Respondents ranked the three risks that would have the most severe impact on their organization if they were to occur over the next three years. They also assigned each of these risks to a broader category. Chart 4 shows the top risk categories in the order of their risk index, calculated by combining the ranking of each risk category weighted by its frequency among responses.

The following are details on the top three risks:

1. External risks. These predominantly involve the risk of a cyber incident impacting operations or data security. Banks cited external risks as the top risk to their organization. Respondents are managing the risk of cyber incidents by:
• investing in cyber security
• putting policies and controls in place to ensure business continuity
• training employees on malware, phishing and best practices
• using external cyber security providers to monitor systems

In the context of cyber incidents, some respondents stated that their reliance on third-party service providers can limit their organization’s ability to manage exposure to cyber risks.

2. International economic and political risks. These involve mainly geopolitical tensions and the risk that an escalation in geopolitical tensions or other developments could lead to a slowdown in the global economy. Pension funds and insurers ranked international economic and political risks as their top risk. The most frequently cited geopolitical tensions were the potential for:
   • an escalation of Russia’s war in Ukraine
   • an escalation of the war in the Middle East
   • an increase in tensions between the United States and China

Some respondents also raised concerns around the upcoming US presidential election and uncertainty around its potential impacts on geopolitical risks. Respondents are managing these risks by using stress tests to assess their potential impact. Some respondents were also re-evaluating their asset allocation in other countries.

3. Market liquidity risks. Worsened market liquidity and the potential for severely challenged funding and market liquidity in a crisis were frequently cited risks in this category. Respondents are managing market liquidity risks by:
   • reducing holdings of some illiquid assets
   • maintaining access to multiple sources of liquidity, including markets and lenders

New developments

Respondents also reported new developments that their organization has started monitoring within the past 12 months and shared how these may impact risks to their organization. The most frequently reported new developments were:

• generative AI:
  • Respondents pointed to productivity benefits that broader adoption of generative AI could bring to their organizations. But they also raised concerns around increased exposure to cyber threats.
  • The rapid adoption of generative AI could introduce new unknown risks if appropriate governance and regulation do not keep pace with it.
• changes in market structure:
  • The transition of the standard settlement cycle—from two days (T + 2) to one day (T + 1) after the date of the trade—presents a new operational risk.
  • The disappearance of the bankers’ acceptances (BA) market and the trade-offs involved in substituting different securities for BAs have associated risks.2
• climate risks:
  • Some respondents mentioned the wildfires that occurred in Canada in the summer of 2023.

Potential risks from different hypothetical interest-rate paths

We used the 2024 FSS to better understand potential risks from the different paths that interest rates might take. Insights gained from the survey will support the Bank’s ongoing assessments of the stability of the Canadian financial system. We asked how market participants adjusted their strategies to respond to higher policy rates and bond yields since monetary policy tightening began in 2022.

In addition, we provided market participants with different scenarios for policy rate paths—higher-than-expected, lower-than-expected and as expected—and asked them to tell us:

• which path would have the most severe negative impact on their organization
• how financial markets would react if broad market expectations shifted to the most severe scenario
• how they would adjust their asset allocation and risk management strategies if their expectations were to shift to the most severe scenario

Adjustments to higher interest rates and bond yields

Many respondents reported not having changed their asset allocation significantly in response to higher bond yields and policy rates since the start of the monetary policy hiking cycle in 2022. However, across respondents, the survey revealed:

• small changes of increased exposure to cash and equivalents and fixed-income securities
• decreased exposure to public equities, commercial real estate and some other asset classes (Chart 5)

Respondents may have interpreted the question in different ways. Some may have considered their changes in exposure in terms of the dollar amount they allocate to each asset class, while others may have reported changes in the share of their total portfolio allocated to each asset class. As a result, some decreases in exposure may reflect asset sales, while others may reflect increased exposure at a slower rate compared with other asset classes.

Some notable differences emerged across types of respondents:

• A higher proportion of investment fund managers (e.g., mutual funds, hedge funds and alternative asset managers) increased their exposure to cash and equivalents and government securities compared with other types of respondents.
• A higher proportion of banks and broker-dealers increased their exposure to residential real estate than other respondents. More banks and broker-dealers also reported reducing their leverage compared with other types of respondents.
• A higher proportion of pension funds and insurers decreased their exposure to commercial real estate and public equity compared with others.

Respondents reported various motivations for adjusting cash and equivalents and fixed-income assets, including more attractive returns, the desire to increase liquidity buffers as a precaution against risks and the desire to maintain asset-liability matching. Some respondents also noted that, given changes in market sentiment, they have adjusted their asset allocation several times since monetary policy tightening began in 2022. Some of those who reported they did not change their asset allocation indicated that their allocation reflects a long-term horizon and that they typically do not adjust it in response to short-term movements in financial markets.

In addition to the changes reported, some respondents mentioned they intend to reduce their exposure to credit because of tight credit spreads. Most respondents did not make any changes to their risk management strategies to deal with higher interest rates, stating that their existing strategies were effective. However, some did report changes, including the following:

• Investment fund managers increased their liquidity buffers and increased downside protection in some markets.
• Banks tightened lending standards and increased monitoring of credit risks.
• Pension funds and insurers increased monitoring of various financial risks, including through additional stress tests.

Respondents listed some limitations associated with managing risks stemming from higher interest rates, which included:

• poor liquidity in bond markets
• worsening liquidity for private assets
• higher financing costs
• uncertainty around private asset valuations

The most detrimental scenarios for the policy rate path

Of respondents, 80% believe that a scenario with higher-than-expected rates would result in the most severe negative impact for their organization (Chart 6). Some respondents believe this scenario could arise due to higher inflation, stagflation or a monetary policy error. Some believe that this scenario could lead to:

• a repricing of risk assets
• higher debt-servicing costs and associated credit risks
• deteriorated market liquidity
• a recession
• an increase in unemployment

Only 7% of respondents believe that a lower-than-expected rate path scenario would be the most severe for their organization. These respondents cited reasons including:

• lower yields on fixed-income investments
• impacts on the valuations of their assets and liabilities

Eleven percent of respondents believe that neither scenario would negatively affect their organization. These respondents primarily included clearing houses, exchanges and other financial market infrastructures that may have less direct exposure to risk assets, as well as investment fund managers who strive to be market neutral through active risk management and hedging.

Only 2% of respondents indicated that policy rates following their current expectations would be the most severe scenario for them.

Impact of the higher-than-expected policy rate scenario

We focus on the impact of the scenario of the higher-than-expected policy rate path, given that the large majority of respondents selected it as the most detrimental. Respondents generally expected a repricing of risk assets in the near term if broad market expectations were to shift to the higher-than-expected scenario (Chart 7). In this scenario, respondents broadly agreed that:

• bond yields would increase
• investment-grade and high-yield credit spreads would widen
• private debt valuations would decline
• publicly traded and private equity valuations would decline
• residential and commercial real estate prices would decline

If respondents’ expectations for the path for policy rates shift to the higher-than-expected scenario, their intended adjustments to asset allocation would resemble a flight-to-safety (Chart 8). Broadly, this trend includes decreasing exposure to investment-grade and high-yield credit, real estate assets, public equities and other asset classes while increasing exposure to cash and equivalents and government securities. However, across all asset classes, some respondents intend to adjust their exposure in the opposite direction, and many respondents do not plan to adjust their exposure at all. The survey also reveals some differences across types of respondents:

• A higher proportion of investment fund managers intend to increase their exposure to cash and equivalents compared with other types of respondents. A higher proportion also intend to reduce their exposure to corporate credit, private debt and infrastructure asset classes.
• Banks and broker-dealers reported intended changes similar to those of investment fund managers. But a higher proportion of them intend to reduce their exposure to real estate compared with the other respondents. More banks and broker-dealers also plan to decrease exposure to private debt and equity compared with others.
• Pension funds and insurers intend to trade in the opposite direction of others in some asset classes. For example, more pension funds intend to increase exposure to private debt, and more insurers intend to increase exposure to investment grade credit compared with the other types of respondents.

In this scenario­—where financial markets experience a repricing—some market participants may experience losses on some of their positions. Losses could be accompanied by liquidity risks; for instance, some investment fund managers indicated they may face an increase in redemption requests. At a high level, respondents’ ability to meet increased demands for liquidity may be improved by prior adjustments they made toward relatively liquid securities (such as cash and equivalents and Government of Canada and other federally guaranteed bonds) since monetary policy hiking began in 2022.

However, if liquidity risks are especially large, some market participants may have to sell additional securities to meet their liquidity needs. In some markets—such as for Government of Canada and other federally guaranteed bonds—some respondents indicated they intend to increase exposure if their expectations shift to the most detrimental scenario. These flows in opposing directions—those needing to sell securities and those intending to buy—could promote two-sided trading. This could limit pressures on market liquidity in some asset classes.3

In other asset classes—such as high-yield credit or public equities—the intended exposure changes that respondents reported are largely in one direction. For these markets, other market participants may demand greater price concessions to take the other side of these trades, which could exacerbate market movements. This could result in strains in some markets and further increase losses for some market participants.

These results reinforce the need to adopt a system-wide lens when thinking about and planning for stress scenarios. Market participants should consider what other participants may do and whether market liquidity would be sufficient in certain markets to accommodate not only their own but all participants’ intended actions.

In a 2023 speech, Deputy Governor Toni Gravelle reminded market participants that in cases of insufficient liquidity, the Bank would offer extraordinary liquidity only in extreme market-wide situations—where the entire financial system faces funding strains.4

Impact of the lower-than-expected policy-rate scenario

The 7% of respondents who considered the scenario of lower-than-expected policy rates as the most detrimental were concerned primarily about lower returns on their future fixed-income investments. These respondents expected Government of Canada bond yields to decline if broad market expectations were to shift to this scenario. However, they had mixed responses for their expected changes in other financial market variables. These respondents may have considered a longer horizon than other respondents. This could explain why they perceived lower returns on fixed-income investments despite the potential initial appreciation of fixed-income valuations.

Endnotes