And because the best levees can break down in a hurricane, we need strong crisis management that will mitigate the fallout from financial shocks without weakening the incentives for prevention of such breakdowns. One method that is increasingly being used to gauge the robustness of the financial system is the conduct of simulations to identify vulnerabilities to extreme shocks.
Such stress testing of the Canadian financial system was undertaken recently through the International Monetary Fund's Financial Sector Assessment Program. The Bank of Canada used its models to design a macroeconomic scenario involving a disorderly resolution of global imbalances and to assess the possible impact on corporate default probabilities by sector.