The rapid growth of the non-bank financial intermediation sector, formerly called shadow banking, appears to dilute monetary policy effectiveness in Canada and poses a risk to financial stability, according to a new report from the C.D. Howe Institute.
In Water in the Wine? Monetary Policy and the Impact of Non-bank Financial Intermediaries, authors Jeremy Kronick and Wendy Wu note while non-bank financial intermediaries (NBFIs) provide alternatives for both depositors and borrowers that improve the functioning of the economy by increasing competition, they are not as closely regulated as traditional financial institutions and deposit insurance does not cover their liabilities.
The assets of institutions involved in non-bank financial intermediation have continued to grow in Canada since the global financial crisis. A recent report puts the value of Canada's NBFI sector at the end of 2017 at $1.5 trillion – about 10 percent of total financial assets and 34 percent of total assets of all deposit-taking institutions. Broadly speaking, categories of NBFIs include investment funds, private lenders like mortgage finance companies, non-bank investment dealers, companies that offer private-label securitization like asset-backed securities, and more.
The authors find the growth of the sector has been a drag on the effectiveness of monetary policy, which could, in part, be caused by depositors shifting between these intermediaries and traditional banks, an effect exacerbated as the sector grows.
The report further finds contractionary monetary policy causes an increase in business growth for NBFIs and a fall in chartered bank business growth. Although the overall effect on business credit growth is the desired decrease, the increase in NBFI business loans both decreases monetary policy effectiveness and creates concerns regarding risk composition.
In addition, the insignificant effect on overall mortgage credit growth following a contractionary monetary policy shock appears to be driven by a shift in credit from traditional banks to NBFIs, and could be a concern from a financial stability perspective.
"Overall, these results highlight the significance of a growing NFBI sector for monetary policy and financial stability," said Kronick. "Our findings suggest that both the traditional monetary policy tool of the overnight rate and tightening mortgage underwriting standards through macroprudential policy might have the unintended side effect of increasing financial instability."
The report recommends levelling the playing field between traditional banks and NBFIs by limiting the migration of loans between the two types of financial institutions, and by tightening regulation of NBFIs and imposing underwriting standards similar to those that apply to traditional banks.
Jeremy Kronick is Associate Director, Research, at the C.D. Howe Institute.
Wendy Wu is Associate Professor, Department of Economics, at Wilfrid Laurier University.