Non-Bank Financial Intermediation in Canada: An Update

Bank-like activities and entities located outside the perimeter of banking regulation have often been called “shadow banking.” A more accurate, though less interesting, name is non-bank financial intermediation (NBFI). The Bank of Canada monitors NBFI, particularly entities and activities that involve a significant amount of maturity, liquidity and credit transformation—a potential source of systemic risk.

Despite the “shadowy” reputation implied by its nickname, NBFI provides a valuable alternative to traditional banking. It fosters innovation, enhances competition, caters to underserved market segments and promotes financial system efficiency. However, non-bank financial entities are usually not subject to the prudential supervision and capital requirements that apply to traditional deposit-taking financial institutions.

The most recent global financial crisis showed that systemic risk can build up where it is difficult to observe and when firms have opportunities to capitalize on loopholes in the regulatory system. Misaligned incentives and complex financial instruments encouraged credit growth outside the regulatory system and contributed to a build up of risk that led to the global financial crisis. Canada was not immune. Parts of our asset-backed commercial paper market, which invested in complex credit derivatives, froze during the summer of 2007.

Since the crisis, authorities around the world, including staff at the Bank of Canada, have been gathering information and collecting data to improve their maps of the financial system terrain outside the regulatory perimeter. To capture how the financial system is evolving and where risk may be shifting, they must repeat this exercise regularly, especially with the important changes taking place in response to regulatory reforms.

New work by Bank staff shows that the NBFI landscape has expanded considerably since the crisis. Canadian NBFI totalled close to $1.5 trillion at the end of 2017, having risen steadily since 2006 (Chart 1). Although overall NBFI assets have grown substantially over the past 10 years, that growth has not kept pace with traditional deposit-taking institutions, such as banks and credit unions (Chart 2). Of course, size alone cannot capture the importance of potential financial vulnerabilities.

Sources: DBRS, Markit, Morningstar, Ontario Securities Commission, Statistics Canada and Bank of Canada calculations

Sources: DBRS, Markit, Morningstar, Ontario Securities Commission, Statistics Canada and Bank of Canada calculations

The composition of NBFI has changed over the past decade. The asset-backed commercial paper market is much smaller, and the associated vulnerabilities have been reduced. In contrast, investment funds and the borrowing and lending of securities have grown significantly, which could affect how market liquidity will behave under future stress. In addition, private lenders have increasingly provided alternative lending options to borrowers who do not qualify for mortgages from banks. As alternative lenders get larger, they may increase the use of new or alternative funding sources for mortgages. This could include further development of private-label Canadian residential mortgage-backed securities or increased direct placements of mortgages with institutional investors.

The Bank of Canada will continue to monitor these and other developments in Canadian NBFI for signs of credit activity increasing and of risk shifting to the shadows.