Canada’s top banking regulator has sat down with senior managers at the country’s largest financial institutions to scrutinize their exposure to private lending and alternative credit strategies tied to the fast-growing shadow banking sector.
A senior financial source who wasn’t authorized to speak about the meetings said regulatory concerns of a potential blow-up in the space were amplified recently by the failures of Silicon Valley Bank and Signature Bank in the United States and a growing chorus of voices warning about weakness in the commercial real estate sector.
The lightly regulated and unregulated lenders that employ alternative credit strategies include private equity, investment funds and hedge funds, and are now formally referred to by Canadian authorities including the Bank of Canada as “non-bank financial intermediaries.” Mortgage finance companies and mortgage investment corporations (MICs) are part of this classification, too.
The sector has been growing quickly, with players taking on many of the financial functions traditionally done by deposit-taking banks, such as direct lending to corporations and individuals as well as private securitizations, which involve collateralizing pools of consumer and business loans into marketable asset‑backed securities. There are some large players in the mix such as Blackstone Inc. and Brookfield Corp., but many smaller players as well.
The Bank of Canada hasn’t taken an in-depth look at the sector since 2020, when the central bank found it had already grown to $1.71 trillion by the end of 2019, up 17 per cent over two years. Globally, shadow banking has grown to exceed the share taken by traditional banking, though Canada’s large regulated financial institutions appear to have kept a lid on such explosive growth domestically.
Nevertheless, The Office of the Superintendent of Financial Institutions (OSFI) became concerned enough about connections between the two financial worlds in April of 2023 to include “transmission risk” from the non-bank financial intermediaries sector among the top risks to the financial system.
Among the things OSFI is understood to be scrutinizing is how the banks manage hedging involving financial instruments such as derivatives, which often involve counterparties outside the regulated banking system. The regulator is on the lookout for activities and transactions where leverage could be higher than expected in a downturn and where there is “hidden leverage embedded in their structure.”
“The growth and associated direct and indirect interconnectedness with the banking system has created a potential structural vulnerability,” OSFI warned, adding that blowups in the shadow banking segment “could amplify and transmit risk back to the financial system during market downturns.”
The regulator confirmed that talks with the big banks are underway to ensure they have adequate collateral and margin agreements in place in their dealings with hedge funds and other investment companies that have large derivative contracts with the banks.
“OSFI has been engaged with banks in the early part of the year on this topic,” said Elizabeth Roach, a communications advisor for the regulator.
The concerns are thought to have risen higher on the regulator’s radar due, at least in part, to a perception of growing valuation risk in privately held commercial real estate, particularly the office segment where publicly traded assets have declined by as much as 50 per cent as remote work leaves buildings with vacancies. Meanwhile, lending outside OSFI’s purview and without its checks and balances in the form of adequate capital against the risk is also understood to be a concern.
The re-regulation that followed the 2008 financial crisis led to banks abandoning some types of trading and lending that left them exposed to risk or required them to hold more capital, such as speculative investments and proprietary trading on their own accounts. The slack in lending was picked up by players including private equity and hedge funds as well as pension plans, which don’t face the same regulatory scrutiny.
With money to be made — it’s cheaper to issue debt privately than in the public markets — and a growing number of players joining the boom, private lending has become competitive. Market watchers say demand to make such loans exceeded the supply of highly creditworthy borrowers in recent years, increasing the willingness of lenders to take more risk for less return.
“There is an expression out there that ‘bad loans are made in good times’, and I am sure that this time it is no different … within the non-bank financial sector,” said a veteran financial executive, adding that hedge funds and private credit funds often use leverage through credit derivatives or just plain borrowing to boost returns. If their asset values fall suddenly, that creates problems that can be magnified by leverage and blow back on anyone they have derivative contracts with if they are unable to make good on their side of the bet.
“There will be losses incurred but (it) doesn’t necessarily lead to a systemic problem — that would only occur if there is interconnected relationships among financial institutions that creates a domino effect,” he said.
Patrick Augustin, an associate professor of Finance at the Desautels Faculty of Management at McGill University, said there are vulnerabilities in spite of greater capital and other regulatory requirements that were introduced in the aftermath of the global financial crisis. Even fully collateralized positions may be vulnerable.
“If there is a big price move on a particular day and your trades are levered, then you might get a pretty big ask for a margin call, and that effectively can lead to liquidations of positions,” said Augustin. “That can then migrate very quickly to fire sales and big drops in valuations (and) that itself might have ripple effects on the economy.”
Examples of such contagion were numerous during the financial crisis.
Augustin, who is also the Canada Research Chair in macrofinance and derivatives, said one of the most notorious was Goldman Sachs’ demand for collateral on derivative contracts underpinned by U.S. real estate, which pushed insurer AIG to the point it required a government bailout.
Goldman and AIG were deeply intertwined, as they had been since the mid-1990s, through multiple activities including stock lending, foreign exchange, fixed income, futures and mortgage trading.
Commercial real estate is considered a hot spot for such vulnerabilities these days because there can be a lag effect. Assets such as office, apartment and retail towers tend to get appraised annually rather than “marked to market” daily, meaning there could be a sudden, large margin call if the value is written down steeply.
If there is difficultly meeting the margin call when these new lower valuations are applied to derivative contracts, this could potentially cause problems not just for the counterparties but potentially to the clearing house managing the transaction between the parties if one can’t make good on their obligation.
Bryce Tingle, an associate professor in the University of Calgary’s faculty of law and director of the financial markets regulation program at the school of public policy, said a more recent default in the United States in 2021 provided a good example of the risks of “hidden leverage” that OSFI appears to be looking for within Canadian banks.
In March of that year, Archegos Capital Management ran into trouble with declining values in its portfolios and could not make good on margin calls from several derivatives counterparties, which led to estimated losses of about US$10 billion for some global banks. Those included Credit Suisse Group AG — which is now in the midst of being swallowed by UBS in a rescue overseen by the Swiss government — and Japan’s Nomura Holdings Inc.
Archegos, an investment firm known as a family office, had increased its exposure and leverage on equities by entering into derivatives transactions with the banks through financial instruments including total return swaps. These contracts would allow Archegos to receive the equivalent gain or loss on equity securities without tying up capital, allowing the fund to increase leverage. When the prices of the underlying stocks began to fall, that leverage triggered a spreading crisis.
Not only was Archegos unable to meet the banks’ margin calls on the derivatives, but some of the large, sophisticated banks had also bought the underlying stock as a hedge against losses on the contracts, dealing them a double blow.
“It turned out Archegos was buying so much of the same few stocks — very poorly diversified — that almost all the growth in the stocks came from this fund,” said Tingle. “And then of course, as soon as some of the stocks start going down, the only way for this fund to get money is to sell the stocks … driving the value of its entire portfolio down.”
Archegos is a case study for how “hidden leverage” can shake what appear on the surface to be solid bets, he said, and they point to the breadth and depth of due diligence OSFI is likely to be pressuring the Canadian banks to perform.
“All these banks took a massive haircut, which is very embarrassing for the banks, because obviously they hadn’t done their job,” said Tingle.
Deposit-taking banks, including those in Canada, rely on a variety of derivatives to hedge risks in their operations from interest rate changes to foreign exchange. They also use credit derivatives like total return swaps as protection against defaults in their loan portfolios. This is because many such loans are funded through deposits, which can be withdrawn by the depositor at any time.
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But Tingle said the structure of Canada’s banking system suggests that any hidden time bombs OSFI’s probe reveals would be relatively minor compared to past global catastrophes and would not reach the level of systemic risk unless it capsized one of the country’s big six banks.
“It’s been pretty stable business,” he said.
“And let’s face it … these guys have not had to work very hard to make a reasonable return. It’s not like the United States where they’re cutting each other’s throats for a basis point or two.”