Why regulation of 'shadow banking' must be tightened

Robust growth in Canada’s “shadow banking” could increase insecurity in the financial system and the sector's ability to dilute the effects of an economic crisis, like it did in 2007-08.

This stark warning was issued by C.D. Howe Institute in a report that analysed the effects an expanded non-bank financial intermediation (NBFI) sector has on the financial system and economy. 

In Water in the Wine? Monetary Policy and the Impact of Non-bank Financial Intermediaries, authors Jeremy Kronick and Wendy Wu recommended a tightening of the regulation of NBFIs to level the playing field with the banks. They also urged key regulators – the BoC, OSFI, Department of Finance and the provincial securities regulators – to make NBFIs “front and centre” of discussions next time they meet.

Broadly, NBFIs can include investment funds, private lenders like mortgage finance companies, non-bank investment dealers and companies that offer private-label securitization. Essentially, bank-like credit intermediation activities taking place outside the traditional banking system

While Canada was lauded for surviving the Great Recession “relatively unscathed”, the study, which was released today, said this was in part down to the resilience of a smaller-sized NBFI sector, especially when compared to the United States.

Twelve years later, NBFI assets in Canada have grown substantially – 30% between 2015 and 2017 alone, according to the Bank of Canada’s Guillaume Bédard-Pagé in 2019 – and have nearly doubled since 2006. At the end of 2017, it represented $1.5 trillion, about 10% of total financial assets and 34% of total assets of all deposit-taking institutions.

A bigger and more important NBFI sector has multiple effects on the financial system and on the economy, the report said.

“On the one hand, intermediaries in the sector, or NBFIs, provide alternatives for both depositors and borrowers that improve the functioning of the economy by increasing competition. On the other hand, they also might increase vulnerabilities, since they are often not as closely regulated, and deposit insurance does not cover their liabilities.”

Critically, the Institute found that as NBFI deposit growth increases in importance, this can dilute the effectiveness of monetary policy, possibly as a result of depositors shifting between NBFIs and traditional banks. It also found that contractionary monetary policy causes an increase in business credit growth for NBFIs and a fall in chartered bank business loan growth.

“Although the overall effect on business credit growth is the desired decrease,” the report warned, “the increase in NBFI business loans both decreases monetary policy effectiveness and results in a riskier composition.

“We [also] find the insignificant effect on overall mortgage credit growth following a contractionary monetary policy shock appears to be driven by a shift of credit from traditional banks to NBFIs, and could be a concern from a financial stability perspective.”

The analysis indicated that both the traditional monetary policy tool of overnight rate tightening and the more recent addition of tightening mortgage underwriting standards – such as the recent B-20 guidelines - might have the unintended side effect of actually increasing financial instability.

So what can be done? To combat this, the report recommended limiting the migration of loans between traditional banks and NBFIs by tightening the regulation of NBFIs to level the playing field with traditional banks.

“We argue that NBFIs – or shadow banks, in now outdated language – should be brought out of the shadows. At the very least, the systemically important NBFIs should face similar capital requirements and underwriting standards to those of traditional banks.”