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From Stress to Strategy: How Banks Balance the Scales

Author

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  • Ruben Hipp
  • Javier Ojea-Ferreiro

Abstract

This paper introduces a partial equilibrium stress-testing model in which heterogeneous banks optimize portfolios subject to regulatory constraints, with endogenous price effects and managerial buffers arising from a Nash equilibrium. Applied to Canada's Big Six banks, the framework is used to illustrate three applications. First, it identifies a sharp nonlinearity: aggregate credit provision is stable if banks sit comfortably above the regulatory minimum but contracts abruptly when close or below. Second, a counterfactual increase in the Domestic Stability Buffer from 3% to 3.5% reduces aggregate lending by approximately 1.2%, an effect comparable in magnitude to a 25 basis point increase in the policy rate. Third, reverse stress testing recovers the macro-financial environments consistent with systemic stress without conditioning on any prior narrative. Two of three identified stress clusters feature above-trend GDP growth: one driven by a house price correction, and one by Canadian dollar appreciation alongside rising oil prices. Both represent vulnerabilities that conventional scenario design would systematically miss.

Suggested Citation

  • Ruben Hipp & Javier Ojea-Ferreiro, 2026. "From Stress to Strategy: How Banks Balance the Scales," Staff Working Papers 26-26, Bank of Canada.
  • Handle: RePEc:bca:bocawp:26-26
    DOI: 10.34989/swp-2026-26
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    References listed on IDEAS

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    JEL classification:

    • C - Mathematical and Quantitative Methods
    • C6 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling
    • C63 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Computational Techniques
    • C7 - Mathematical and Quantitative Methods - - Game Theory and Bargaining Theory
    • C73 - Mathematical and Quantitative Methods - - Game Theory and Bargaining Theory - - - Stochastic and Dynamic Games; Evolutionary Games
    • G - Financial Economics
    • G2 - Financial Economics - - Financial Institutions and Services
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G3 - Financial Economics - - Corporate Finance and Governance
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
    • H - Public Economics
    • H1 - Public Economics - - Structure and Scope of Government
    • H12 - Public Economics - - Structure and Scope of Government - - - Crisis Management

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