Carney targets shadow banking. Should Canada?

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Calls to rein in shadow banking around the world are growing louder, but Canada is, once again, relatively immune from the global crackdown.

In a new Financial Times op-ed, Bank of England governor Mark Carney, who also heads the Financial Stability Board, argues that, while shadow banking can be "a sustainable source of market-based finance," it needs reforming.

Not here. Much like how Canada's financial institutions were praised during the financial crisis, the Canadian shadow banking sector is viewed as healthy.

While the term is loosely thrown around, shadow banking typically refers to financial activities – such as borrowing and lending – that take place outside the traditional banking sector. The topic is a hot one in countries such as China, because so-called wealth management firms offer investment products that allow people to deposit their money, and are promised returns far above those of regular deposit accounts. The investors' funds are then lent to high-risk borrowers such as real estate developers.

Shadow banks can also lend money, and even China's local governments have resorted to borrowing from them because the traditional banks have cut them off.

In Canada, shadow banking is most commonly associated with 2007's asset backed commercial paper crisis. Since then, however, it has rarely been talked about – for good reason.

"Overall, the Canadian shadow banking sector… is smaller relative to both the traditional banking sector and the Canadian economy than its U.S. counterpart," the Bank of Canada concluded in a 2013 study.

Using a very broad definition of shadow banking, the Bank of Canada found that Canadian shadow banking was roughly 40 per cent of nominal Canadian gross domestic product in 2012, while in the U.S. it amounted to 95 per cent of nominal 2011 GDP.

In a separate 2011 study, the Bank found that Canadian shadow banking liabilities had generally increased at the same pace as traditional banking practices since 1999; the U.S., meanwhile, saw its shadow banking liabilities climb to twice the size of traditional bank liabilities at peak of the crisis. Even afterwards, they still accounted for 25 per cent more than traditional bank liabilities.

Canada's shadow banking activities are also, in a sense, much safer than those in other countries. The central bank found that there has been a big shift in the composition of domestic shadow banking, such that government-insured mortgage securitization has become the biggest component – accounting for roughly 60 per cent of the activities. Private-label securitization, such as asset-backed commercial paper, accounts for 10 per cent of the total, followed by repurchase agreements at 10 per cent and money market funds at 5 per cent.

"The composition of the sector is also relatively conservative, with a large portion of activities conducted by or involving regulated entities and backed by an explicit government guarantee. This reduces the overall significance of shadow banking concerns," the Bank of Canada wrote.

Still, mortgage securitization isn't totally safe. "Although insured-mortgage securitization entails little shadow banking risk per se – given the explicit government backing – it may contribute to risks in the financial system more generally," the Bank of Canada wrote in 2013. Such securitization makes the financial system more complex, because mortgage lending can be funded through many avenues, not just bank deposits, and the ease of securitization can encourage leverage at lightly regulated financial institutions.

Instead of simply cutting off shadow banking, global regulators and central banks largely agree that the system can serve a purpose, so long as it is properly managed. "If properly constrained, [shadow banking] can thus lead to welfare-enhancing financial innovation," the Bank of Canada noted.

Canada isn't immune to risks from other countries' shadow banking sectors, however. Shadow banking-fuelled turmoil in China's financial sector would be felt in Canada, the central bank noted in its latest Financial System Review, largely because of its effect on demand for commodities.