New model reveals sharp nonlinearity in bank credit provision
A new Bank of Canada staff working paper introduces a strategic stress-testing framework for Canada's Big Six banks. Published in July 2026, the study demonstrates how capital buffer proximity and strategic portfolio adjustments amplify adverse financial conditions.
Modeling the strategic balance sheet
The paper introduces the Banks' Strategy Model, a structural partial equilibrium framework analyzing Canada's Big Six banks, which hold over 93 percent of total banking assets.
Unlike conventional top-down stress-testing models that assume fixed balance sheets, this framework incorporates endogenous managerial buffers using smooth log-barriers.
Banks optimize jointly over assets and liabilities while accounting for price pressure from aggregate trading, cleared by a Nash equilibrium each period.
This design allows the model to capture how strategic portfolio responses propagate and amplify adverse financial conditions over multi-year horizons.
Uncovering hidden systemic vulnerabilities
Applied to simulate macroeconomic scenarios, the framework uncovers critical insights for macroprudential policy.
First, aggregate credit provision contracts abruptly when the minimum CET1 ratio drops below 50 basis points above the regulatory minimum.
Second, raising the Domestic Stability Buffer from 3 percent to 3.5 percent reduces lending by 1.2 percent, an effect equivalent to a 25 basis point policy rate hike.
Finally, reverse stress testing identifies vulnerability clusters, including house price corrections and Dutch disease dynamics, that conventional recessionary models miss.
Beyond static stress tests
This framework successfully bridges a critical gap in macroprudential stress testing by replacing rigid rules with realistic bank behavior.
However, the reliance on partial equilibrium mechanics may understate broader macroeconomic feedback loops during acute systemic crises.
For policymakers, it provides an indispensable tool to evaluate structural trade-offs between bank resilience and credit availability.