What role will shadow banking play in the coronavirus crisis?

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Dollar sign, chalk board © Valentine Azhgirevich /123RF Stock PhotosSince the last financial crisis in 2008-09, the shadow banking sector in Canada has been growing at a rapid pace, which can pose challenges in the current coronavirus crisis, according to a report by DBRS Morningstar.

Shadow banking refers to non-bank financial institutions that provide credit and related financial intermediation that aren’t prudentially regulated.

A pension fund wouldn’t fall under the definition of a shadow bank according to the Financial Stability Board, says Maria-Gabriella Khoury, senior-vice president of North American financial institutions at DBRS Morningstar and the author of the report. She notes other investment managers, like those that manage mutual funds or exchange-traded funds, would be considered shadow banks.

In Canada, shadow banking assets are up by 12 per cent annually, on average, since 2010, reaching $1.5 trillion in 2018. This is more than double their level of $0.6 trillion in 2010, the report said. “This pace is faster than the growth of shadow banking globally. Such global assets are now $51 trillion. Moreover, the growth of shadow banking in Canada is also faster than that of its banks, whose domestic assets were $3 trillion in 2018, having increased at only seven per cent annually, on average, from $1.9 trillion in 2010.”

In particular, the Morningstar report pointed to the increase in fixed income funds, money market funds, mixed funds and hedge funds driving the growth in the shadow banking sector. And these can pose financial stability risks because of funding mismatches and leverage and credit risks.

Khoury says a large shadow banking sector can have downsides in times of crisis, like the one currently caused by the coronavirus pandemic.

“The main downside in a crisis like today, for example, [is] you’ll have redemptions. A lot of people will seek liquidity, would rather keep whatever little money they have in cash, so it’s that increase in redemptions that could put pressure on the funds themselves as they try to come up with cash. They could start selling their positions, which would put pressure on bond prices, for example. It just has a ripple effect that will go [through] the entire industry.”

As well, a shadow bank has less capacity to respond to an increase in redemption calls than a bank does, she says, noting regulated entities like banks can go to the Bank of Canada for liquidity, whereas non-regulated asset managers don’t have the same recourse. “The mechanism is not available to them directly, so it could cause pressure on their liquidity.”

And consumer awareness about this phenomenon is important, she notes. “Because your average retail investor does not understand if they’re buying funds from this independent asset manager that’s not backed by a bank, that if all the other retail investors want to withdraw their money, this fund could go under.”

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