Senior deputy governor Carolyn Rogers says greater leverage not an issue but, however could possibly be if there’s a sprint for money
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Financial institution of Canada officers are monitoring pockets of accelerating leverage and “stretched” asset valuations that would pose a menace to monetary stability within the occasion of main value swings, however see no indicators {that a} repeat of the 2008 Monetary Disaster is imminent.
The central financial institution’s annual report on stability throughout Canada’s monetary system, launched Thursday, flagged a steep improve in using leverage in Canadian bond and repo markets by hedge funds, which seemed to be pushed by arbitrage methods tied to the timing and quantum of rate of interest cuts.
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“We pointed it out … not necessarily with the intention of saying you should stop doing it because there’s some value in having a good futures market, you create liquidity in normal times,” senior deputy governor Carolyn Rogers stated in interview. “But the action that we would hope would come out of us featuring it and talking about it is that these institutions run stress tests and make sure that their margins are big enough to account for large swings in price.”
The central financial institution’s Monetary Stability Report stated leverage obtained by asset managers by borrowing within the repo market elevated by round 30 per cent prior to now 12 months. The rise was largely pushed by hedge funds and pension funds growing their repo leverage by about 75 per cent and 14 per cent, respectively. For hedge funds, the spike seems to be associated to relative-value buying and selling methods, together with more and more common cash-futures foundation trades within the Authorities of Canada bond market.
Whereas offering liquidity in each futures and bond markets, “the large degree of leverage employed can leave hedge funds vulnerable to changes in the price difference between the underlying securities as well as to sudden changes in the availability and cost of repo financing,” the report stated.
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Rogers famous that banks, pensions, hedge funds and funding sellers concerned in Canada’s monetary system have totally different regulators, however the Financial institution of Canada can look throughout all markets for indicators of danger and contagion.
“We try to take a cross-sectoral look and think about things that might fall between the cracks,” Rogers stated.
Even a failure of a small financial institution overseas can shake confidence
Financial institution of Canada senior deputy governor Carolyn Rogers
The problems flagged within the report aren’t an issue now, she stated, however might simply grow to be one if there was a sudden rush to acquire extra liquidity from banks to unwind positions or meet margin calls at a time once they have been loath to increase it.
“You have to hope that whatever is causing them to need that liquidity is not also causing the banks to want to hang on to their liquidity,” she stated. “If there was a big rush for liquidity and that demand for liquidity outstripped the supply … that starts to show up in asset prices.”
If belongings have to be offered to satisfy liquidity wants, there could be massive swings in value, resulting in knock-on results. Different establishments holding these belongings might face margin calls and likewise must liquidate.
“Then you get this kind of spiral,” she stated.
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Current examples of even refined customers of leverage getting caught up in market dislocations embody the upheaval in the UK pension system in 2022, which was brought on by a steep improve in sovereign yields on the identical time that the British pound was dropping sharply. The Financial institution of Canada additionally cited a “dash for cash” when COVID-19 was declared a worldwide pandemic in March of 2020, which led to dislocations throughout markets.
Rogers stated additionally it is noteworthy that the influence of regional financial institution failures in the US within the spring of 2023 have been felt at Canada’s banks for a time.
“To the extent that there was contagion here in Canada, that showed up on the global wholesale funding markets, you saw the credit-risk spread,” she stated, including that whereas that is not a priority, it illustrates the interconnectedness of the monetary system. “One of the things about the banking sector is even a failure of a small bank in another country can shake confidence,” she stated.
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After Thursday’s report was launched, Financial institution of Canada governor Tiff Macklem additionally spoke about potential contagion at a information convention, the place he mentioned what the central financial institution views as pockets of vulnerability amongst banks, households, companies and non-bank monetary establishments corresponding to pensions, insurance coverage firms and hedge funds.
“If one thing goes wrong, obviously it’s not good for those people, but it doesn’t reflect financial stability,” he stated. “It’s when there’s a few failures and you get the interconnections between the system. The contagion that is created starts to amplify the problem and a manageable problem becomes an unmanageable problem.”
• E mail: bshecter@postmedia.com
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