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Is the banking crisis over?

Although it’s been more than six weeks since a lender failed on either side of the Atlantic, it’s too early for the all-clear signal – including here in Canada.

Sure, the Canadian banking system has remained resilient in the face of global turmoil. But the International Monetary Fund is suggesting that federal and provincial regulators are still not paying enough attention to risks lurking in darker corners of our country’s financial system.

Spoiler alert: The problem isn’t Canada’s Big Six banks, which remain well-capitalized and profitable despite gathering economic headwinds. Rather, the IMF is pointing to the perils posed by “shadow banks.”

Also known as “non-bank financial institutions” (hardcore regulatory nerds say the NBFI abbreviation stands for “non-bank financial intermediaries” instead, so take your pick), they include a wide array of financial players such as hedge funds, crypto lenders, payday lenders, pension funds, insurers, fintechs and investment funds.

Shadow banks provide market competition for borrowers. But there is growing concern about the sector’s stability during times of economic stress.

The shadow-banking sector, which has experienced massive growth over the last 15 years, accounted for almost half of all global financial assets or a whopping US$486.6-trillion in 2021, according to the Financial Stability Board, an international body.

Here in Canada, the sector was worth roughly $1.71-trillion at the end of 2019, according to a separate report published by the Bank of Canada.

Despite their collective heft, shadow banks still receive insufficient scrutiny by financial regulators even though many engage in riskier lending than chartered banks. In fact, some players aren’t regulated at all.

That’s why the IMF, which published a report about Canada this week, is urging domestic regulators to take a closer look at shadow-banking risks.

“In the case of non-bank financial institutions (NBFIs), more routine and compulsory top-down stress tests performed by federal and provincial regulators would complement exercises currently performed by the institutions themselves,” reads the IMF’s statement.

“Supervisors may also need additional powers to compel provision of information from pension funds and asset managers, as the current voluntary approach to assessing market liquidity risks from these institutions may have limits.”

Oh snap! Even the IMF is calling out Canada’s penchant for secrecy.

Thankfully, the transmission of risks from shadow banks is already on the radar of Canada’s banking regulator, the Office of the Superintendent of Financial Institutions.

OSFI, as it is known for short, flagged the issue in its annual risk outlook, stressing that it is examining how federally regulated financial institutions are exposed, both directly and indirectly, to non-bank financial players.

“Growth and uncertainty in unregulated non-bank financial intermediation may increase the likelihood of risk transmission to the broader financial system during periods of volatility and market decline,” OSFI stated in its risk report.

“Unrestrained money issuance, along with alternative credit strategies and structures within the NBFI sector, were key contributors to the global financial crisis in 2008-2009,” it later added.

But mitigating this risk isn’t solely OSFI’s responsibility, which is why the IMF also stressed that “co-ordination between federal and provincial supervisors could be further strengthened.”

Although information sharing between regulators might seem obvious, privacy legislation often hampers that process, the IMF said. But so do regulatory turf wars.

Canada, though, isn’t alone in its struggle to gauge risks posed by shadow banks. Not only are the risks harder to spot, but some players lack a backstop, such as capital reserves, despite their growth.

In fact, there are mounting concerns in a number of countries about the shadow-banking sector’s stability.

On Tuesday, European Central Bank supervisor Andrea Enria warned that risks would intensify over the coming months as interest rates climb higher.

The Bank of England, meanwhile, began stress testing shadow banks as part of its first financial-system-wide exercise. Britain, of course, got a serious taste of trouble last fall when liability-driven investment funds melted down (owing to then-prime minister Liz Truss’s mini-budget bungle) and caused a pension crisis.

South of the border, meanwhile, Gary Gensler, chair of the U.S. Securities and Exchange Commission, is also calling for better oversight of hedge funds and other shadow banking players.

There is good reason to worry.

One study published by the Bank of International Settlements earlier this year found that non-banks curtail their syndicated credit significantly more than banks during crisis periods.

Although history is littered with examples of shadow banks that have run into trouble (think hedge fund Long-Term Capital Management in 1998 or asset manager Archegos Capital Management in 2021), the bulk of regulatory reforms since the global financial crisis have largely focused on major banks.

It’s not enough to require federally regulated banks to hold more capital if risks are also accumulating in the alternative lending space, which is the bailiwick of the provinces.

Instead of hiding behind Canadian federalism, financial regulators across the country must heed the IMF’s call and take co-ordinated action on this issue. Stress testing shadow banks is a matter of common sense.

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