Risk-Taking in Nonbanks and Markets
28. The nonbank sector (excluding insurance) has grown considerably in recent years.
Pension funds and mutual funds dominate the institutional and retail asset management landscape,
respectively. Other investment funds and special purpose vehicles have a relatively small footprint
but are growing rapidly. Together, investment funds have been the main driver for the strong
growth of FSB-defined “nonbank financial intermediation”, which reached Can$2 trillion at
end-2017. Furthermore, captive financial institutions and money lenders are sizeable
(Can$3.3 trillion).
29. Risk-taking of institutional investors is rising, and valuations of certain asset classes
are stretched (Figures 11 and 12). Pension funds and other liability-driven institutional investors
have increasingly used complex derivatives and borrowing-based strategies (including short-term
repos), resulting in increased leverage and liquidity risk.
Pension funds have also increased their
exposures to illiquid asset classes such as real estate, private equity, and private credit, which
typically contain significant additional unreported leverage and contingent liquidity risk. Fixedincome and real estate asset valuations are stretched, while dependence on foreign investors for
non-government bond market funding has increased significantly. In the event of market stress,
rising liquidity and valuation risks could magnify losses and market volatility, while a retreat of
foreign investors could tighten financial conditions sharply.
30. Liquidity risk has increased at fixed income-focused mutual funds, potentially
resulting in large-scale redemptions during stress. Mutual funds covered by the stress tests have
increased their allocation to higher-duration and lower-rated non-government bonds. Large
redemptions (1st-percentile shock) would trigger fund outflows of 7 percent of assets under
management (AUM)
. The BOC framework, which incorporates the assumption that investor
redemptions are more sensitive to fund underperformance, suggests fund outflows of 18 percent of
AUM following a parallel increase in government bond yields by 100 basis points. A forced liquidation
of non-government bonds would amount to 5 percent of that market, resulting in a widening of
liquidity risk premium by 93 basis points, less than the stress level observed during the GFC.
0
5
10
15
20
25
30
35
40
0 5 10 15 20 25 30 35 40 45 50
Fund count
Historical outflows of individual funds (in percent of assets under
management (AUM); based on 1st-percentile experience)
Historical Fund Outflows and Scenario Redemption Shocks
Shock-A:
total outflows of 7 percent of AUM;
based on 1st-percentile shock
Shock-B:
total outflows of 18
percent of AUM;
based on modeling of
responses to fund
underperformance
0
2
4
6
8
10
Scenario-A
Scenario-B
Bond Sales to Meet Redemptions
(In percent of outstanding bonds o the same type)
Pro-rata sale pattern Waterfall sale pattern
14.4 37.7
Sources: Canadian authorities; Morningstar; and IMF staff estimates. Sources: Canadian authorities; Morningstar; and IMF staff estimates.
Note: Pro rata sale means that investment funds would maintain the same aset
allocation. Waterfall means that investment funds would first sell most liquid assets.
CANADA
INTERNATIONAL MONETARY FUND 21
Systemic Liquidity
31. System-wide liquidity conditions are stable, and money and public debt markets are
functioning well (Figure 13). System-wide liquidity is underpinned by the comprehensive BOC’s
framework for market operations and liquidity provision in normal times. The resilience of core
funding markets benefits from the predominance of secured transactions in money markets.
Liquidity in other public debt markets is also adequate, although spreads of provincial and
government-guaranteed (e.g., Canada Mortgage Bond) papers could widen considerably during
market stress. Foreign exchange markets are liquid. The authorities are working on a transition
towards an improved risk-free benchmark in line with IOSCO standards.
32. The BOC’s collateral framework needs improvement, particularly in light of greater
demand for collateral going forward. The BOC should improve its capacity to price collateral,
including the use of theoretical models, and update its valuation of banks’ loan portfolios more
frequently.
Theoretical valuation is crucial in situations where secondary market liquidity is low, as is
the case for some assets in normal times (e.g., NHA MBS) or more generally during market stress.
Furthermore, the planned modernization of the payment systems, with a move towards the realtime gross settlement (RTGS) platform, will likely result in a substantial increase in the demand for
collateral, warranting enhanced monitoring of collateral availability.
33. The resilience of foreign exchange markets is increasingly important given the
growing reliance on external, foreign-currency funding. Since end-2013, external debt liabilities
to GDP have increased by 37 percentage points, driven by banks (two-thirds) and other nongovernment entities (one-third). The latter reflects bond issuances by Canadian entities in
international markets. Banks have increasingly relied on external funding (Can$1.1 trillion at
end-2018), two-thirds of which are short-term. Although banks appear to have sufficient liquidity
buffers, including in foreign currency (paragraph 23), global financial market disruptions could still
affect their ability to fund their activities. Adequate liquidity in foreign exchange markets—
particularly for cross-currency swaps—becomes increasingly important so that banks and nonbanks
can continue to manage risks effectively.
Housing Finance
34. Housing finance is broadly resilient, but pockets of vulnerabilities exist (Figures
14 and 15). Mortgage finance is dominated by D-SIFIs and supported by the government via
mortgage insurance, securitization guarantees, and other policies. With a market share of about
70 percent, D-SIFIs focus on prime borrowers, and their lending is backed by their strong balance
sheets. The smaller (uninsured) non-prime lending segment is largely served by smaller banks and
prudentially unregulated lenders, which are comparatively less resilient. Some of these lenders rely
on less stable, higher-cost funding such as brokered deposits or redeemable equity, and their
lending is concentrated in regions with large housing market imbalances. Market concerns about
the business model of non-prime lending were manifested by the liquidity crisis at a mid-sized
deposit-taking institution in 2017.
CANADA
22 INTERNATIONAL MONETARY FUND
35. The cost of prime mortgage financing is low and little differentiated, with credit risk
being underpriced in some segments. Various government policies aiming at ensuring housing
affordability contribute to low mortgage financing costs.5 Capital charges for uninsured mortgage
lending are low and do not fully reflect through-the-cycle credit risk. The long period of benign
macrofinancial conditions contributes to lenders’ assessment of risk in their lending as extremely
low, justifying minimal capital and mostly uniform pricing offered to borrowers. For insured
mortgages, costs faced by riskier borrowers are compressed by mortgage insurers’ practice of
insuring loans that fund insurance premiums (up to 4 percent of principal).6 Consequently,
borrowing costs for riskier borrowers are near risk-free levels, increasing debt accumulation among
such borrowers and intensifying aggressive lending competition. Credit spreads of prime mortgage
lending have narrowed in recent years, undermining the impact of macroprudential policy
tightening.
36. Aspects of Canada’s mortgage finance may amplify procyclical effects of falling house
prices during severe downturns. Core lenders focus on low-risk mortgage lending. In response to
deteriorating household debt-servicing capacity, they may constrain new lending or renewals of
maturing mortgages (typically, 5-years contractual maturity and 25-years amortization period),
potentially adding pressures on the housing market. Alternatively, a sudden adoption of risk-based
pricing to accommodate financially weak borrowers might amplify household debt-servicing fragility
(paragraph 22). Furthermore, lenders’ ability to restructure loans by extending the amortization
schedule could be constrained given the fact that remaining amortization of mortgages mostly
exceeds 20 years. Rising losses and tighter funding conditions at weaker lenders might impair the
flow of credit to non-prime borrowers who could similarly face refinancing pressure due to their
shorter-maturity mortgages (typically, 1–2 years).
Interconnectedness
37. Various parts of the financial system are directly exposed to the housing market
and/or linked through housing finance. Total residential and nonresidential mortgage credit
amounted to Can$1.8 trillion, or 81 percent of GDP, at end-2018. Mortgage credit is provided by
banks (69 percent) and other financial institutions; households are the main borrowers (81 percent),
followed by corporates. Life insurers and pension funds have increased their investment in
commercial real estate,
while financial institutions hold around Can$180 billion in NHA MBS. The
government’s central role in housing finance fortifies the financial-sovereign nexus. In the adverse
scenario, the government would need to pay out claims and/or provide capital or other support up
to Can$15 billion related to mortgage insurance.
38. Increased intra-system and cross-border interconnectedness appears to generate
larger spillover effects (Figures 16 and 17). The banking, insurance and asset management
sectors have significantly expanded their cross-border activities and overseas operations over the
5 For example, NHA MBS, though not being traded actively, are Level-1 high-quality liquid assets.
6 These loans are provided by the lenders on the same terms as the mortgages.
CANADA
INTERNATIONAL MONETARY FUND 23
past decade.
Canada also mainly relies on international central counterparties (CCPs). Canada’s
international banking and portfolio investment linkages are predominantly with the United States.
The financial system’s growing internationalization while yielding risk diversification makes Canada
more exposed to macrofinancial developments abroad. Market-based analysis suggests rising
inward and outward spillovers through stock and bond markets.7
Meanwhile, cross-sectoral
exposures have risen, mainly through the use of repos and derivatives (also relevant for the crossborder dimension), increasing complexity and interconnectedness within the financial system. While
unsecured interbank credit is relatively small, banks and pension funds are actively trading in the
repo market. Distress at one of the D-SIBs would likely generate strong contagion to the rest of the
financial system.
