Global Risk Institute

Sheila JuddExecutive in Residence

Shadow BankingMay 16, 2017

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Presentation Purpose

• Share information/research findings on the topic, including GRI recommendations for industry oversight:

Sheila Judd, Executive in Residence, Global Risk Institute (GRI)

• Provide Bank of Canada view:

Toni Gravelle, Managing Director of the Financial Markets Department, Bank of Canada Guillaume Bédard-Pagé, Director, Financial Markets Department, Bank of Canada

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Presentation Overview

• Shadow Banking Definition(s)

• A US$36 Trillion (and growing) Global Sector

• Areas to Watch

• The Canadian Perspective

• Regulatory Considerations

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Main Points

• Shadow banks support economic growth and innovation, but their activities can pose heightened risks to the financial system, borrowers and investors

• Sector is large and diverse; it continues to grow and evolve

• Concentrations, funding mismatches and lack of transparency are key risk areas

• Introducing bank-like regulation to mitigate global systemic risk is complicated

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What is Shadow Banking?

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Shadow Banking Definitions

• No single definition, but all have common elements:

- Non-bank financial entities that are not deposit taking institutions- Prudential banking regulation does not apply

Financial Stability Board Definition:Credit intermediation involving entities and activities (fully or partly)

outside of the regular banking system

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Non-bank Credit Intermediation Activities

• Alternative lenders- Mortgage companies- Consumer loan companies - Auto lenders- Leasing companies

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Non-bank Credit Intermediation Activities

• FinTech

• US based P2P lender; “world’s largest”• Consumer and business loans• $26 B in cumulative loans• NYSE listed

• Canadian lender• Private (individual and corporate investors;

partnerships include CIBC, Equitable Bank, Power Financial)

• US based lender• Loans 84% US; 17% international• $19 B in cumulative loans• NYSE listed

• US based P2P lender• Private equity backed• $7 B in loans

• US based with loans in North America, Europe and Australia• $3 B in loans; small business focus• Private equity investors (including BNS, ING, Santander)

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Non-bank Credit Intermediation Activities

Alternative lenders, such as mortgage companies, consumer loan companies, auto lenders and leasing companies (Excludes pension funds and insurance companies)

Securities financing (repurchase agreements and securities lending)and other broker-dealer intermediation

(Excludes firms that are consolidated into regulated entities)

Credit-based investment funds, such as money market funds, mutual funds, exchange-traded funds and hedge funds(Excludes closed end funds)

Securitization activities

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Financial Stability Board Categorization

• Five economic functions that can give rise to systemic risk:

Economic Function Definition Typical entity types

EF1Management of collective investment vehicles with features that make them

susceptible to runs

Fixed income funds, mixed funds, credit hedge funds, real estate funds

EF2Loan provision that is dependent on short

term fundingFinance companies, leasing companies,

factoring companies, consumer credit companies

EF3Intermediation of market activities that is dependent on short-term funding or on

secured funding of client assets

Broker-dealers

EF4 Facilitation of credit creationCredit insurance companies, financial

guarantors, monolines

EF5Securitisation-based credit intermediation

and funding of financial entitiesSecuritisation vehicles

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Shadow Banking Has Benefits

• Supports economic growth + Increases credit availability + More sources of liquidity

• Diversifies financial system risks

• Fosters innovation

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Shadow Banking Has Benefits and Risks

• Supports economic growth + Increases credit availability + More sources of liquidity

• Diversifies financial system risks

… and Risks

- For consumers, investors and financial system

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Risks for Borrowers and Investors

• More sources of credit for already stretched consumers

• More investment products available to investors

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Systemic Risk Drivers

• Activities that pose systemic risk:

Solvency RiskUse of

Leverage

Maturity / Liquidity

Transformation Liquidity Risk

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What is “Maturity Transformation”?

• Using short term funding for long term assets

• Risk is whether funding will be available through duration of asset

Maturity = Short term funding for = Liquiditytransformation longer term assets risk

• Example: Using demand deposits and/or short term GICs as source of funding for mortgages

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What is “Liquidity Transformation”?

• Using liquid assets to finance less liquid assets

• Example: Money market funds that purchase assets with limited liquidity, but offer investors the ability to redeem their investments on short notice

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Why the Difference in Regulation?• Banks are subject to a “social contract”

• Banks benefit from government-backed deposit insurance and funding backstops; in exchange, banks must abide by government regulations

- Prevent panics that result in runs on deposits - Protect depositors and taxpayers

- Provide back-up funding source in event of - Provide stability to the financialmarket disruption system

• Shadow banks are not subject to the same social contract: they exist outside of the realm of banking regulation that protects depositors and taxpayers

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Why is Shadow Banking a Concern?

• Shadow banks operate like banks, with liquidity and solvency risks• Despite the significant financial reforms post the financial crisis, shadow banks are not

subject to liquidity, leverage or capital rules that apply to banks• Most observers agree that shadow banking activities caused the 2007-2009 financial

crisis• Failure in shadow banking could pose risks for financial stability

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International Monetary Fund Assessment

“Future risk levels will be influenced by, among other things, the degree to which liquidity mismatches deepen thereby increasing run risks, the extent to which entities use leverage, the extent to which concentrations increase, and whether the level of transparency of risk improves allowing for investors to assess risks properly.”

International Monetary Fund Global Financial Stability Report, October 2014

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Shadow Banking Size and Trends

Shadow Banking Banking

US$36 T (end of 2014) US$135 T

Up 10.1% year over year Up 6.4% year over year

Average growth of 6.3% from 2011-2014

Average growth of 5.6% from 2011-2014

About ¼ the size of banking; growing faster

Source: FSB’s Global Shadow Banking Monitoring Report, November 2015

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Primary Drivers of Shadow Banking Growth

• Regulation- Tighter rules and more constraints for banks than non-banks

• Low interest rates; ample liquidity- Search for yield by investors - Search for yield by asset managers has spurred some managers to begin lending

• Technology - New technologies and demand for technology based solutions- New firms are not burdened by legacy technology / infrastructure- Easier to bring borrowers and investors together

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Shadow Banking Around the Globe

Share of Shadow Banking Assets, End of 2014

CA = Canada CN = ChinaDE = GermanyEMEs ex CN = Argentina, Brazil, Chile, India, Indonesia, Mexico, Russia, Turkey, Saudi Arabia, South AfricaFR = FranceIE = Ireland JP = JapanKR = KoreaNL = NetherlandsUK = United KingdomUS = United States

Source: FSB’s Global Shadow Banking Monitoring Report, November 2015

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Shadow Banking Around the Globe (2015)

Share of Shadow Banking Assets, End of 2015, excluding China

CA = Canada DE = GermanyEMEs = Argentina, Brazil, Chile, India, Indonesia, Mexico, Russia, Saudi Arabia, South Africa, TurkeyFR = FranceIE = Ireland IT = ItalyKY = Cayman IslandsJP = JapanKR = KoreaNL = NetherlandsUK = United KingdomUS = United States

Source: FSB’s Global Shadow Banking Monitoring Report, May 2017

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Largest Shadow Banking Sectors

Shadow Banking Percentage of GDP, Top 10, End of 2014

Source: FSB’s Global Shadow Banking Monitoring Report, November 2015, Supplemental Data File

% of GDPIreland 1,190

United Kingdom 147Switzerland 90

United States 82Netherlands 74

Germany 73France 71Japan 60

Canada 58Korea 48

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Growth of Largest Shadow Banking Sectors

Shadow Banking Growth vs. GDP Growth, 2011-2015, %

Source: FSB’s Global Shadow Banking Monitoring Report, May 2017, Supplemental Data File

SB Growth GDP GrowthIreland 12.9 10.2

United Kingdom 11.3 2.9Switzerland 7.8 1.1

United States 0.7 3.8Netherlands 4.9 1.3

Germany 11.3 2.9France -1.2 1.4Japan 8.0 1.9

Canada 9.8 2.9Korea 12.7 4.1

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Areas to Watch for Heightened Systemic Risks• Countries with the largest share of global shadow banking assets that also have large shadow banking

sectors relative to their economy • Countries experiencing significant growth in shadow banking

Largest Contributors to Systemic Risk

Share of Global Shadow Banking Assets

Relative Size of Shadow Banking

Sector to GDP

Country 2014 RankChange

from 2010

SB Assets as % of

GDP

Rank

USA 40% 1 Down 2% 82 4UK 11% 2 Down 23% 147 2

China 8% 3 Up 400% 26 13Ireland 8% 4 Up 14% 1,190 1

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Shadow Banking Activities - Breakdown

FundsFundsFunds

Non-bank Lenders

Broker-dealers

SecuritizationCredit Insurers

Funds Non-bankLenders

Broker-dealers

Credit Insurers

Securit-ization

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Canadian Perspective

• Sector size: $1.1 Trillion

- About half the size of Canada’s traditional banking sector

- 2.9% of global total shadow banking sector

Source: Bank of Canada Financial Stability Report December 2016

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Bank of Canada – Stability Risk Assessment

“Based on available information we judge that the shadow banking sector does not pose large vulnerabilities for the Canadian financial system at this time, mainly because of the limited degree of liquidity and maturity mismatch as well as the low leverage in most parts of the sector. The relatively small size of individual sub-sectors currently also limits the potential for systemic stress.”

Bank of Canada, Financial System Review, December 2016

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Canada’s Evolving Mortgage Market

• Growing non-bank segment- Mortgage finance companies (MFCs)- Mortgage investment corporations (MICs) - Private investors

• MFCs are non-bank financial institutions that underwrite and administer mortgages sourced through brokers

- Funding mainly through securitization or direct sales to third parties, primarily Canada’s Big Six banks - Not directly subject to prudential banking regulation, but access to mortgage insurance and

securitization requires adherence to OSFI mortgage rules

• MICs and other private investors typically deal in uninsured mortgages that are not available through traditional channels

- Non-prime loans, second mortgages, very short-term mortgages - Investors in MICs take on greater risk and receive higher returns

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Growth in Mortgage Finance Companies

• 12.5% market share (end 2015); up from 6.6% at end of 2007

• 4 main MFCs; other smaller players as well

• Growth driven by:

- Demand

- Increased availability of mortgage insurance and access to securitization (in turn due to policies to promote competition)

- IT advances (web-based platforms, extensive automation of processes)

- Greater internet use by borrowers looking to compare mortgage products and rates

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MFCs and Systemic Risk

• MFCs are contributing to an increase in financial system vulnerabilities- Riskier assets

- Lower levels of capital and contingent liquidity

- More concentrated funding sources

“If a large MFC were to fail or become unable to fund new loans, it would be disruptive for the mortgage market, possibly magnifying the impact of a downturn.”

Bank of Canada, December 2016 Financial System Review

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Regulation

• A myriad of banking regulations has been implemented post the 2007-2009 financial crisis; riskiest activities of shadow banking have been addressed

• Specific to shadow banking, the Financial Stability Board:

- Implemented sector monitoring in 2010 that has increased reporting and facilitated improved understanding of sector activities and risks

- Implemented a Policy Framework in 2013, with guiding principles and an implementation “toolkit” for national regulators

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FSB Policy Framework (August 2013)

• Regulatory measures should be:

- Focused, targeting the externalities and risks that shadow banking creates

- Proportionate to the risks to the financial system

- Forward looking and adaptable to emerging risks and innovations

- Designed and implemented in an effective manner, balancing the need for international consistency against the need to take account of jurisdictional differences

- Regularly assessed and reviewed following implementation and improved as necessary

• May 2016 Implementation Assessment: still at early stages

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Regulatory Challenges

• Lack of consistency in how nations define and measure shadow banking

• Difficulties in obtaining robust reporting

• Differences in breadth and scale of activities (and risks being taken) across jurisdictions

• Continuing evolution of the sector

• Positive contributions of shadow banking activities:- Fills in gaps in traditional bank offerings- Driver of innovation- Diversifies financial system risks across more players

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Regulatory Considerations

• Are guiding principles enough?

• Should shadow banks be subject to banking regulation?

• What controls could be implemented to mitigate risks associated with unchecked growth and innovation?

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GRI Recommendations

• Systemic risks:- National regulators should introduce a minimum liquidity requirement for systemically

important shadow banks

• Risk transparency:

- Regulators should require simple and transparent risk disclosures for borrowers and investors

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Main Points - Recap

• Shadow banks support economic growth and innovation, but their activities can pose heightened risks to the financial system, borrowers and investors

• Sector is large and diverse; it continues to grow and evolve

• Concentrations, funding mismatches and lack of transparency are key risk areas

• Introducing bank-like regulation to mitigate global systemic risk is complicated