Financial System Review – 2021 – Bank of Canada

Financial system

  • The Canadian financial system has been resilient during the COVID-19 crisis, thanks to a well-capitalized banking sector and strong political support. Financial markets have quickly recovered from initial funding and market liquidity strains, and extraordinary liquidity support is no longer needed.
  • The COVID-19 crisis has highlighted the systemic implications of long-term trends. The potential demand for liquidity in bond markets is growing faster than the current structure of bond markets can provide in times of stress. The digitization of the economy creates new interconnections that increase the potential for system-wide disruption due to cyber incidents in financial institutions or financial market infrastructures.

COVID-19 caused exceptional uncertainty in the markets when it struck in March 2020, prompting financial market participants to look to hold liquidity. Fixed income markets came under extreme stress when many investors tried to sell their financial assets and few participants were ready to buy. This was true even for the safest securities: Government of Canada bonds and treasury bills. At the same time, households and businesses have become more cautious, drawing on their lines of credit, delaying loan repayments and building up liquid assets.

The Bank has intervened in a wide range of funding markets to ease liquidity pressures and improve the functioning of the market. The Bank increased the scope and amount of liquidity it provided to financial institutions. This has helped them meet the increased demand for credit from other participants in the financial system, including households and businesses. The Bank has also launched a series of asset purchase facilities to restore the functioning of the debt markets.

Financial markets are now functioning well and the Bank has gradually phased out crisis programs and facilities focused on market liquidity. These programs and facilities have had the desired effect. Market liquidity indicators have improved and the use of Bank facilities and programs has declined for some time. The Bank continues to monitor market conditions and stands ready to reactivate facilities if necessary.

Liquidity of the fixed income market

The capacity of the bond market structure to support the provision of liquidity under stress has not kept pace with the potential demand from the market liquidity asset management sector (Vulnerability 4). Beyond the scale of the COVID-19 shock, this structural trend partly explains the unprecedented speed, scale and scale of the interventions that were required to keep markets liquid in the spring of 2020. Given the potential As market demand for liquidity peaks, especially during times of stress, the implications of this long-term structural change will persist well beyond the pandemic.

The robust growth of the asset management industry over the past two decades means that more credit risk is intermediated and held outside the banking sector. Asset managers include institutions such as pension funds and insurance companies; they also include managers of mutual funds and exchange-traded funds who manage the pooled investments of private investors. By aiming to meet the investment objectives of their investors, asset managers help channel funds to borrowers and provide an attractive alternative to traditional banking services. The growth of the asset management industry, which grew from $ 2.4 trillion in assets under management in 2008 to $ 5.7 trillion in 2020, is due in part to:

  • lower interest rates
  • financial innovations
  • Demographic changes
  • stricter banking regulations after the global financial crisis

Read more on recent trends in asset management and other types of non-bank financial intermediation (NBFIs).

Asset managers rely on market liquidity to manage their risks. Banks have direct access to central bank money. On the other hand, to respond to complaints from their investors or counterparties, asset managers must either have liquidity or obtain liquidity by borrowing or selling securities in their portfolios. As a result, asset managers rely on market liquidity to quickly convert their securities into cash without drastically reducing their prices. As the asset management industry grows, this represents a potential increased demand for market liquidity.

In addition to the growth of the industry, the dependence of asset managers on market liquidity has increased with the evolution of their portfolios. In a low interest rate environment, asset managers gradually reoriented the composition of their portfolios towards less liquid assets. For example, pension funds are increasingly investing in less liquid assets such as real estate, infrastructure and private equity. Mutual funds increased their allocations to corporate bonds from more liquid government bonds, including those with lower credit quality. As asset managers diversify their portfolios to include riskier assets, the need to rebalance their portfolios in response to price changes can create additional liquidity needs. Additionally, to achieve higher returns, some asset managers have tended to leverage their investment portfolios through repo (repos) agreements and derivative markets. The prices of the securities they provide as collateral or underlying the derivatives they hold may expose them to liquidity risk. If these prices fall, as is often the case in a crisis, asset managers would be required to pay additional cash or other collateral to their counterparty as a margin, which could further increase their demand. liquidity.

Fixed income markets depend on banks for liquidity, but banks face risk management constraints. Transactions in fixed income securities are generally not made directly between investors. They are generally intermediated by bank brokers. The ability of a bank broker to buy securities, and therefore to support market liquidity, depends on the level of risk that the bank’s balance sheets can bear. Other businesses (notably credit) are in competition for the use of this balance sheet space and may have become more attractive than market making under Basel III.

There may be imbalances in the demand for and supply of liquidity needed to support intermediation, especially in times of stress. As the asset management industry grows and takes less liquid assets, it becomes increasingly likely that sudden spikes in demand for liquidity will collide with the ability of banks to act as intermediaries for fixed income transactions. The disruption of the fixed income markets in spring 2020 illustrates how the growing demand for market liquidity relative to the supply of intermediation can play out (Box 3).

Find out what the Bank is doing to address liquidity demand and supply imbalances in the fixed income market.

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