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Canada’s shadow banking system (i.e. financial activity that creates credit but is not subject to full oversight by a regulator) has ballooned by about 50 per cent since before the onset of the U.S. financial crisis in 2005, to about $730-billion, equivalent to about 40 per cent of annual GDP, at the end of 2012. T (Kevin Van Paassen/The Globe and)
Canada’s shadow banking system (i.e. financial activity that creates credit but is not subject to full oversight by a regulator) has ballooned by about 50 per cent since before the onset of the U.S. financial crisis in 2005, to about $730-billion, equivalent to about 40 per cent of annual GDP, at the end of 2012. T (Kevin Van Paassen/The Globe and)

Shadow banking enters the spotlight; will an economic shadow follow? Add to ...

The shadow banking system in Canada is under increasing scrutiny by regulators, according to the latest Bank of Canada Financial System Review (FSR), and that may not be a good thing for Canada’s economic outlook.

The report suggests that Canadian regulators are worried enough about some types of shadow banking to warrant enhanced study, and possibly further regulation. If so, the implication for the economy is less credit availability, and yet another headwind for GDP growth in an economy already hampered by persistent weak demand from external trading partners and an overvalued currency.

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Many startling facts jumped off the pages of this review. Canada’s shadow banking system (i.e. financial activity that creates credit but is not subject to full oversight by a regulator) has ballooned by about 50 per cent since before the onset of the U.S. financial crisis in 2005, to about $730-billion, equivalent to about 40 per cent of annual GDP, at the end of 2012. The largest component of shadow banking is government-insured mortgage securitization at almost 60 per cent, followed by banker’s acceptances and commercial paper at 15 per cent, private securitization and repurchase agreements (repos) at 10 per cent each, and finally money market funds at 5 per cent.

Mortgage securitization is also responsible for the vast majority of the growth in shadow banking in recent years. Government-insured mortgage securitization, through National Housing Act mortgage-backed securities (NHA MBS) and Canada mortgage bonds (CMB) combined, account for virtually all of the increase since 2005.

However, the surge in mortgage securitization activity was not limited to government-insured products. Asset-backed commercial paper (ABCP) and asset-backed securities (ABS), which account for 10 per cent of shadow banking, show a substantial rise in bank and non-bank lenders who are funding mortgages through the ABCP market. Mortgages and home-equity lines of credit now represent more than 50 per cent of the assets in the ABCP pools.

There have been several regulatory changes that the Bank of Canada believes will lessen the risks in the ABCP sector, including the recent adoption of more transparent international accounting standards in the form of Basel III, which mandates tighter capital and liquidity standards for securitized products, and the federal government’s recent prohibition on using government-backed securities in private-securitization products. Nonetheless, this activity was highlighted by the central bank as an area requiring much closer surveillance by regulators.

The repo market is the other area the Bank of Canada flagged for enhanced scrutiny. While this market is relatively small at just 10 per cent of shadow banking, it is an important funding market for Canadian chartered banks. As such, any disruption in the market could lead to a severe contraction of liquidity in the financial system. The most important risk the Bank of Canada highlights is the unusual rise in repo activity by some Canadian pension funds in order to “implement leveraged investment strategies.” It is this area of repo activity the BoC and other regulators intend to watch much more closely going forward.

But one aspect of shadow banking this report lacks is a discussion of its impact on economic growth, if enhanced oversight and/or regulation slows the growth of credit or causes credit creation to actually contract. Research suggests a contraction in shadow banking can have notable negative impacts on economic growth. A 2012 study by economists at the International Monetary Fund found that on average, GDP growth decreases by 0.4 percentage points for every 1 per cent decline in private credit.

In all, the Bank of Canada went to considerable lengths to downplay the significance of shadow banking in Canada, and the risks to the financial system it represents, highlighting the explicit sovereign guarantee of most insured mortgages and multi-pronged efforts to regulate activity.

However, some of the metrics cited were somewhat disingenuous. In particular, the report notes that Canada’s shadow banking sector is relatively small at 40 per cent of GDP, versus 95 per cent in the United States. While correct, what is omitted is that Canada’s shadow banking sector is quite large in comparison with many other countries. The 2012 Financial Stability Board review of shadow banking in 20 major national economies plus the euro area noted that average activity was 25 per cent of GDP – a full 15 per cent smaller than Canada boasts.

The Bank of Canada also suggested that risks from shadow banking are mitigated because a good deal activity is conducted by regulated financial institutions. In the run-up to the 2008 financial crisis, the United States also believed that much of shadow banking was being overseen by their patchwork of federal and state regulators.

The U.S. found out the hard way that it is the quality, not the quantity, of oversight that prevents a financial crisis. Let’s hope Canada’s regulators have received this message as well.

Sheryl King is an independent macroeconomic strategist with more than 20 years experience in the international financial industry and central banking.

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