The Bank of Canada finds pockets of vulnerability in the financial system

Article content

Bank of Canada officials are monitoring pockets of rising leverage and “stretched” asset valuations that could pose a threat to financial stability in the event of large price swings, but see no signs of a repeat of the 2008 financial crisis. be imminent.

The central bank's annual report on the stability of Canada's financial system, released Thursday, noted a sharp increase in the use of leverage in Canadian bond and repo markets by hedge funds, which appeared to be driven by of arbitration linked to the moment and amount of interest. rate cuts.

Article content

Article content

“We point it out … not necessarily with the intention of saying you should stop doing it because there is some value in having a good futures market, it creates liquidity in normal times,” Lt. Gov. Carolyn Rogers said in an interview. “But the action we hope will come from us presenting it and talking about it is for these institutions to stress test and make sure their margins are large enough to account for large swings in prices.”

The central bank's Financial Stability Report said leverage obtained by asset managers through lending in the repo market increased by around 30 percent in the past 12 months. The increase was largely due to hedge funds and pension funds increasing their repo leverage by about 75 percent and 14 percent, respectively. In the case of hedge funds, the rise appears to be related to relative value trading strategies, including the increasingly popular cash futures-based trades in the Government of Canada bond market.

While it provides liquidity in both the futures and bond markets, “the high degree of leverage employed can leave hedge funds vulnerable to changes in the price spread between the underlying securities, as well as sudden changes in the availability and the cost of repo financing,” the report says. saying.

Article content

Article content

Rogers noted that banks, pensions, hedge funds and investment dealers involved in Canada's financial system have different regulators, but the Bank of Canada can look across all markets for signs of risk and contagion.

“We try to take a cross-sector view and think about things that might go unnoticed,” Rogers said.

Even the failure of a small bank in another country can shake confidence.

Carolyn Rogers, Senior Deputy Governor of the Bank of Canada

The problems highlighted in the report are not a problem now, he said, but could easily become one if there was a sudden rush to obtain additional liquidity from banks to unwind positions or meet margin requirements at a time when they were reluctant to extend it.

“You have to hope that whatever is causing them to need that liquidity is not also causing the banks to want to preserve their liquidity,” he said. “If there was a large rush of liquidity and that demand for liquidity exceeded supply… that starts to be reflected in asset prices.”

If assets need to be sold to meet liquidity needs, large price swings can occur, causing knock-on effects. Other institutions that hold those assets may face margin calls and also have to liquidate.

“Then this kind of spiral occurs,” he said.

Article content

Recent examples of even sophisticated users of leverage getting caught up in market distortions include the turmoil in the UK pension system in 2022, which was caused by a sharp rise in sovereign yields at the same time as sterling fell sharply. . The Bank of Canada also cited a “race for cash” when COVID-19 was declared a global pandemic in March 2020, causing dislocations in markets.

Rogers said it is also noteworthy that the impact of the regional bank failures in the United States in the spring of 2023 was felt in Canada's banks for a time.

“To the extent that there was contagion here in Canada, which manifested itself in the global wholesale financing markets, you saw the credit risk spread,” he said, adding that while this is no longer a concern, it illustrates the interconnectedness of the situation. Finance system. “One of the things about the banking sector is that even the failure of a small bank in another country can affect confidence,” she said.

Article content

Following the release of Thursday's report, Bank of Canada Governor Tiff Macklem also spoke about potential contagion at a news conference, where she discussed what the central bank sees as pockets of vulnerability among banks, households, companies and non-banking financial institutions, such as pensions. insurance companies and hedge funds.

“If something goes wrong, it's obviously not good for those people, but it doesn't reflect financial stability,” he said. “It is when there are some failures and the interconnections between the system are damaged. The contagion that is created begins to amplify the problem and a manageable problem becomes an unmanageable problem.”

• Email: bshecter@postmedia.com

Bookmark our website and support our journalism: Don't miss out on the business news you need – add Financialpost.com to your favorites and subscribe to our newsletters here.

Article content