The International Monetary Fund Country Report on Canada (2008) has been released. Here are some highlights:
Canadian banks appear to be sound and resilient. The stress tests indicate that the five largest banks would be capable of weathering a shock about one-third larger than the 1990–91 recession, involving a contraction of the North American economy, an increase in interest rate risk premia, and lower commodity prices. This resiliency may in part reflect the fact that the Canadian banks are national in scope and thus able to benefit from regional and sectoral diversification.
There’s more detail available on this. Credit risk is the major risk factor; market risk and liquidity risk were determined to be less important risk factors.
Until recently, most Canadian liquidity protection could only be drawn in the event of a GMD, whereas conduits in Europe and the United States enjoy virtually unconditional “global-style” liquidity protection.12 This may have been, in part, an unintended consequence of OSFI’s Regulation B-5, which exempted only GMD-conditional liquidity support from bank regulatory capital requirements. For unconditional facilities up to one year, OSFI and the United States used national discretion (consistent with Basel rules) to apply a 10 percent credit conversion factor (CCF), whereas most European countries applied a zero CCF. Basel II will apply a zero CCF to GMD-conditional support, and 20 percent to unconditional facilities with maturities up to one year.
Note: The required regulatory capital on a liquidity facility is calculated on the product of the CCF and the highest risk weight assigned to any of the underlying individual exposures covered by the facility.
I hadn’t known that about the European banks’ zero CCF on unconditional liquidity support! No wonder they’re in so much trouble! The Fed Policy, and its change to match stricter Canadian standards, has been previously discussed.
The situation in the ABCP market is still evolving and continues to pose a risk to investor confidence. Stress tests performed by OSFI indicate that if banks were to put the assets in their sponsored conduits on their balance sheets, this would leave them with capital above the regulatory targets. While the problems in the third-party conduits may result in losses to some of the parties involved, it is not clear that the stability of the broader financial system will be materially affected. There is, however, the risk that continuing problems in the ABCP and money markets could lead to a wider loss of confidence. The precise form such an event would take is of course difficult to predict, as are its possible consequences.
Note: However, these stress tests do not seem to consider an interruption of financing, a decline in asset prices, or the cost of holding “bridge loans” that would have otherwise been financed in the money markets.
…which leaves one wondering just what was modeled by the OSFI stress tests!
The banking system also appears to remain fairly stable in terms of marketbased measures. The two-year probability of default of a single Canadian bank implied by Moody’s KMV data has increased to about 7 percent in mid-December, compared with 2 percent before the market turbulence began in August 2007, and remains well below the 14 percent seen in the United States. A banking stability index (BSI) defined in terms of the joint probability of default of the largest banks in the system has also increased commensurately.
I’m surprised that this paragraph didn’t draw more headlines! KMV is a Merton-style structural model of defaults – as such, if may be expected to overestimate default probability at times when the equity cowboys are panicky.