Although the so-called “shadow banking” system does represent a risk to financial stability, that risk appears to be low in the short term and, in the long term, it appears to become more significant in other developed markets than it will be in Canada, a new report from Toronto-Dominion Bank’s (TD) economics department suggests.
TD’s (TSX: TD) report explores the financial services firms collectively known as the “shadow banking” sector, which perform the same basic function as traditional banks but outside the regulatory framework. The TD report concludes that “shadow banking does pose a long-term risk to financial stability, but to different extents in different regions.”
In Canada, “the risk is comparatively small,” the TD report says. “If there is a risk, it likely lies in the National Housing Act mortgage-backed securities (MBS) market, which is tied to the broader issue around household debt.”
The TD report says that about 60% of the $700 billion Canadian shadow banking system is comprised of these securities. The rest is “unlikely” to represent a major risk.
“The markets for asset-backed securities, asset-backed commercial paper and money market mutual funds are small and have fallen significantly from their peaks in 2008. Repos and short-term paper have grown in size since the crisis, but these funding instruments are not, in themselves, risky,” the TD report says.
“On its own, shadow banking likely does not have the critical mass to pose a systemic concern in Canada,” the report adds. However, TD also observes that, in reality, the sector isn’t isolated as “broad-based securitization exposes numerous counterparties to the credit risk of originating banks’ mortgage portfolios.” This includes the banks, mortgage insurers and even the federal government, which backstops mortgage insurance and MBS guarantees, it notes.
“Should an unemployment rate or an interest rate shock hit the housing market and lead to a deleveraging episode, the risk is that all of these parties with exposure to the mortgage and MBS markets would be impacted negatively,” the TD report says. “That being said, the probability of a systemic event appears to be small.”
The more significant risks lie elsewhere, The TD report suggests, noting that “shadow banking represents a serious longer-term risk” in the U.S., U.K., and Europe.
“By design, shadow banking entities take advantage of gaps in regulatory oversight,” the TD report says. “In a changing regulatory environment that is focused mostly on the stability of the traditional banks, the concern is whether or not shadow banks will become as large as they once were through another unsustainable build-up of poor-quality assets that led to the 2008-09 financial crisis.”
Although regulators and policy-makers are seeking to address these concerns, it’s likely that the shadow banking industry will be one step ahead of the regulators, the report says.
“The most critical challenge associated with shadow banking is being able to predict how they evolve,” the TD report concludes. “The monitoring framework regulators are currently putting in place will hopefully stem some concern, but the risk is right there in the name: you cannot always see what is in the shadows.”