Analyzing Default Risk and Liquidity Demand in Canada during the Financial Crisis

We use detailed data from the Canadian banking sector to evaluate the impact of the 2007 financial crisis. We document that unlike the Euro zone, which experienced a sharp and persistent increase in demand for liquidity supplied by the central bank immediately after the outbreak of the subprime crisis in the summer of 2007, the Canadian banking system experienced distress only for a limited time, for two months immediately following the collapse of Lehman Brothers in September 2008, and settled back to its usual state thereafter. We further use these data to evaluate bank-specific riskiness. We classify the risk measures based on whether the data necessary for their construction are publicly available, are available only to participants of the Large Value Transfer System (LVTS), which is a payment settlement mechanism specific to Canada, or are available only to the central bank. We show that the publicly available risk measures based on prices of credit default swap (CDS) contracts, while indicative of initial problems of the financial system as a whole, do not seem to correspond to the cross-sectional heterogeneity in the behavior banks face from their counterparties in the short-term lending markets. Participation, strategies in and reliance on special liquidity-supplying tools provided by the central bank thus seem to potentially be important additional indicators of distress.