effect on the real economy. that, in brief, is our framework. now, let ’ s look at high household debt, a key vulnerability we analyzed in the december issue of the fsr. 6 key vulnerability : household indebtedness canada was spared some of the most serious negative consequences of the global financial crisis because of our strong financial regulatory and supervisory framework and the effectiveness of our policy response. this response included a reduction in the policy interest rate by the bank of canada to support aggregate demand and help achieve our inflation target. 7 as a result of these policies, the canadian economy recovered relatively quickly, supported by solid growth in household spending that was funded by household income growth and borrowing. 8 the buildup of household debt, however, has increased the vulnerability of the economy and the financial system to adverse shocks to incomes and interest rates. 9 with high indebtedness or elevated leverage – an important indicator of vulnerability in the financial system – the household sector is less resilient. during times of stress, people with higher debt will typically cut back on their spending disproportionately more than those with less or no debt. this means that high household indebtedness can amplify the impact of a shock. in more extreme cases, adverse shocks could lead to an increase in household defaults, which would mean losses for banks, other lenders and mortgage insurers. in the worst case, if the losses were extensive and spillovers were large, the increase in stress could potentially deplete the capital buffers built into the financial system to absorb losses, impairing its functioning, with large negative effects on economic activity. market infrastructures, which are the systems that facilitate the clearing, settlement and recording of payments, securities and derivatives or other financial transactions among participating entities. vulnerabilities in these different sectors are measured along various dimensions, such as the degree of leverage, complexity, and liquidity and maturity transformation, as well as the behaviour of asset prices. while these elements are part of the normal functioning of the financial system, they may make the system vulnerable if they become excessive. in addition, we review the external exposures of the sectors and their degree of interconnectedness across the canadian financial system. for example, the interbank market is an important source of funding, but it could rapidly transmit funding problems through the system in the event of a financial shock. g. cateau, t. roberts and j. zhou, “ ind

the mispricing of assets. in contrast, risks are events or outcomes that could threaten the ability of the financial system to perform its core functions. risks materialize when trigger events – which are adverse shocks such as the recent dramatic drop in oil prices – interact with vulnerabilities. to illustrate the difference between a vulnerability and a risk, imagine a bridge with fractures in its concrete supports. that ’ s the vulnerability. the risk is that the bridge could collapse if a trigger event, such as an earthquake, shook its foundations. focusing explicitly on vulnerabilities in the canadian financial system allows us to highlight where the fragilities lie and how they are evolving. we identify a range of vulnerabilities and consider them in relation to a wide variety of financial institutions, markets, end - users and payment systems ( table 1 ). 5 we share our assessments of systemic vulnerabilities and risks with our federal regulatory partners on the senior advisory committee ( sac ). the sac is chaired by the deputy minister of finance and includes the bank of canada, the office of the superintendent of financial institutions, the canada deposit insurance corporation and the financial consumer agency of canada. our work contributes to the committee ’ s discussions of systemic vulnerabilities and potential remedial policy actions. see “ enhanced risk - assessment framework, ” bank of canada financial system review ( june 2014 ) : 1 – 2 ; and i. christensen, g. kumar, c. meh and l. zorn, “ assessing vulnerabilities in the canadian financial system, ” bank of canada financial system review ( june 2015 ) : 37 – 46. the sectors we examine include the following : ( i ) financial institutions ( including large and small banks ), credit unions, trust companies, life insurance companies, and pension funds ; ( ii ) financial and property markets and non - bank financial intermediation ; ( iii ) the end - users of financial system services such as households, governments and non - financial corporations ; and ( iv ) payment clearing and settlement systems and financial bis central bankers ’ speeches the second step is developing a risk scenario for each of the most serious vulnerabilities, including a list of possible triggers. a risk scenario describes how a trigger event will interact with a vulnerability to affect the financial system. third, we assess the probability of each risk occurring and the impact if it did. the rating of risks summarizes our judgment on their importance to the financial system and their likely