A stable and efficient financial system is essential for sustaining economic growth and raising standards of living. In the Financial Stability Report, the Bank of Canada assesses the resilience of the Canadian financial system and identifies key risks that could undermine its stability.
This year, the Bank renamed its annual assessment of the stability of the Canadian financial system to the Financial Stability Report from the Financial System Review. This reflects a continuing evolution in how the Bank assesses risks to Canadian financial stability. In particular, the Report:
- takes more of a cross-sectoral perspective when assessing overall financial stability in Canada by accounting for interconnections among sectors in the financial system
- considers how financial system participants are building resilience against the risks to their sector and to the broader financial system
Analysis about the structure and efficiency of the financial system will continue to be covered on the Bank’s Financial System Hub.
Overall assessment
Key takeaways
- Canada’s financial system remains resilient. Over the past year, financial system participants—including households, businesses, banks and non-bank financial institutions—have continued to proactively adjust to higher interest rates.
- However, risks to financial stability remain. The Bank sees two key risks to stability, related to:
- Debt serviceability—Businesses and households continue to adjust to higher interest rates. Indicators of financial stress in both sectors were below historical averages through the COVID-19 pandemic but have been normalizing. Some indicators look to be increasing more sharply and warrant monitoring. Higher debt-servicing costs reduce financial flexibility for households and businesses and make them more vulnerable in the event of an economic downturn.
- Asset valuations—The valuations of some financial assets appear to have become stretched, which increases the risk of a sharp correction that can generate system-wide stress. The recent rise in leverage in the non-bank financial intermediation sector could amplify the effects of such a correction.
- The financial system is highly interconnected. Stress in one sector can spread to others.
- Participants should continue to be proactive, including planning for more adverse conditions or outcomes.
The global backdrop has generally improved over the past year, and investors’ appetite for risk has increased
Over the past 12 months, the global economic and financial environment has been marked by a further decline in inflation in advanced economies and a reduction in the risk of a major recession. However, geopolitical tensions have increased.
Financial system participants—including households, businesses, banks and non-bank financial institutions—have become increasingly focused on when and by how much central banks will reduce their policy interest rates. This has driven a renewed appetite for risk, which has pushed up the prices of a range of financial assets and driven down risk premiums and credit spreads in both Canada and the United States. Benchmark US and Canadian equity indexes reached all-time highs in 2024, and corporate credit spreads in both countries are now at or below levels seen on average since the 2008–09 global financial crisis.
Volatility and liquidity in bond markets have improved over the past 12 months, but volatility remains higher and liquidity remains lower than before central banks began increasing their policy rates. Markets have continued to function well. Trading volumes have remained relatively stable and the private sector has continued to absorb government debt, even as governments increased their issuance of debt and central banks continued their quantitative tightening programs.1 The issuance of corporate bonds has also been robust.
Despite some improvements in the global backdrop, uncertainty remains elevated. For example, inflationary pressures globally could be higher than expected, causing markets to further reassess the timing and the pace of the expected declines in policy interest rates by some central banks, as seen recently in the United States. Geopolitical tensions—in particular, the wars in the Middle East and Ukraine—persist and could escalate. These sources of uncertainty could reduce the global appetite for risk, leading to an abrupt repricing of assets and to stress in core funding markets.
Canada’s financial system has remained resilient
Over the past 12 months, financial system participants have taken steps to enhance their resilience in the face of higher interest rates.
- Households and businesses have reduced their demand for credit, and most have maintained higher levels of liquid assets built up during the pandemic.
- A growing number of borrowers with variable-rate, fixed-payment mortgages are making lump-sum payments or increasing the value of their regular payments ahead of renewal.
- Banks have increased their provisions for loan losses and maintained their large capital buffers.
- Some asset managers have strengthened their processes for managing liquidity risks.
- Some pension funds and insurance companies have reduced their exposure to commercial real estate or written down the value of assets in the office subsector, where vacancies are high.
These actions are reducing the risks to individual borrowers and lenders as well as to overall financial stability. In addition, financial sector authorities have enhanced their regulatory and supervisory activities around risky exposures. For instance, the Office of the Superintendent of Financial Institutions has provided stricter regulatory guidance for lenders with negatively amortizing mortgages as well as commercial real estate lending.2 It has also raised the level of the domestic stability buffer, a capital reserve that large banks can use in times of stress.3 Market participants believe that the likelihood of a shock occurring that could impair the Canadian financial system has declined. Participants also report having a high degree of confidence in the Canadian financial system’s resilience to a severe shock, should one occur.4
In sum, the financial system appears well positioned to manage the ongoing adjustments to elevated interest rates and the ongoing volatility in financial markets. Nevertheless, risks remain.
Risks to debt serviceability could affect the performance of lenders’ credit portfolios
Although most households are adapting to higher interest rates, some are showing increasing signs of financial stress. After hitting historical lows during the COVID‑19 pandemic, the share of borrowers without a mortgage who are behind on credit card and auto loan payments has come back up to more normal levels or has surpassed them.
The increasing stress that borrowers face has not significantly impacted large banks, but some smaller mortgage lenders have seen a sharp uptick in credit arrears. Over the coming years, more borrowers will face pressure as they refinance existing mortgages at higher interest rates. Higher debt-servicing costs reduce financial flexibility for households and businesses and make them more vulnerable in the event of an economic downturn.
Valuation risks could lead to corrections in asset prices and to market strains
Price corrections could be large and abrupt if expectations around the path for interest rates change significantly or if the economic outlook deteriorates significantly. Valuation risks could also materialize if ongoing large increases in the issuance of government debt cause term premiums and bond yields to rise.
Stretched asset valuations may not properly reflect risks to the economic outlook and therefore increase the likelihood of a disorderly price correction. Asset managers could face losses, a sharp increase in liquidity needs from redemptions or margin calls, and forced deleveraging if investors abruptly reprice risky assets. A repricing could reverse recent investor flows into corporate bonds, prompting further redemptions. The recent increase in leverage through repurchase agreements (repos) by hedge funds and pension funds could amplify the liquidity needs of these funds arising from margin calls.
In this scenario, asset managers may contribute to strains on market liquidity if they unwind fixed-income positions to meet their liquidity needs. This could cause prices for these securities to decline further, reducing market liquidity and, in extreme cases, leading to fire sales and price spirals.5
Valuations remain under pressure in parts of the commercial real estate sector, particularly the office subsector where vacancies are high. Not all asset managers have fully reflected these reduced valuations on their balance sheets, meaning that further adjustments may be necessary in the future.
Interconnections in the financial system could transmit stress
The risks to the financial system related to debt serviceability and asset valuations are important to monitor because they could have a large impact on individual borrowers and lenders if they materialize. Links between participants could spread and amplify the impact of any shock, leading to system-wide stress.
Banks are well capitalized and have sufficient liquidity buffers, making them well positioned to continue supporting the economy, even through a period of stress.
However, stress in the global banking sector, like that seen in March 2023, could impact depositor and investor confidence. This could spark deposit outflows, even at healthy banks. Large Canadian banks could also be impacted by a disruption in global wholesale markets given their reliance on this source of funding. Funding pressures could lead banks to reduce lending and the provision of liquidity to markets.
A large-scale liquidity event could cause many financial system participants to simultaneously take actions to enhance their own resilience to stress. Such a situation could cause secondary effects, such as a fire sale of assets, that amplify and transmit stress through the system.
Participants need to continue planning for more adverse outcomes
The Bank works closely with federal and provincial financial authorities to monitor the health of Canada’s financial system. This collaboration is particularly important in areas where data gaps at an individual authority limit its ability to fully assess risks to the financial system.
While public authorities can intervene to preserve financial stability in periods of severe stress, banks and market participants should anticipate and plan for periods of stress and build adequate loss-absorption and liquidity buffers to ensure they remain resilient. In particular, market participants planning to raise cash through the sale of financial assets should consider that other market participants may also intend to sell the same type of assets to meet their liquidity needs during periods of stress.
Households and businesses should also continue to be proactive, planning for higher payments when mortgages and other debt renew at higher interest rates.
Banks can continue to support borrowers by reaching out well ahead of renewal dates and helping them plan for higher payments.
A stable and resilient financial system benefits all Canadians. Preserving financial stability requires the prudence and diligence of all financial system participants.
Households
Households are adjusting to the rise in debt-servicing costs.
Following sharp declines during the COVID‑19 pandemic, many indicators of financial stress have now returned to more normal levels.6 Signs of stress are concentrated primarily among households without a mortgage and survey data suggest that, of these households, renters are most affected. In contrast, indicators of stress among mortgage holders are largely unchanged, remaining at levels lower than their historical averages. Factors such as income growth, accumulated savings and reduced discretionary spending are supporting households’ ability to deal with higher debt payments.
Over the coming years, more mortgage holders will be renewing at higher interest rates. Based on market expectations for interest rates, payment increases will generally be larger for these mortgage holders than for borrowers who renewed over the past two years. Higher debt-servicing costs reduce financial flexibility for households and businesses and make them more vulnerable in the event of an economic downturn.
Signs of financial stress have risen primarily among households without a mortgage
The combination of higher inflation and higher interest rates continues to put pressure on household finances. Many indicators of financial stress, which had declined during the pandemic, are now close to pre-pandemic levels. Signs of increased financial stress appear mainly concentrated among renters.7, 8
The rates of arrears on credit cards and auto loans for households without a mortgage—which includes renters and outright homeowners—are back to pre-pandemic levels and continue to grow (Chart 1).9 In contrast, arrears on these products for households with a mortgage have remained low and stable.
Households have also increased their reliance on credit card debt. Research by Bank staff finds that households relying on credit cards to finance spending are more likely to experience financial stress in the future.10 In particular, borrowers without a mortgage who carry a credit card balance of at least 80% of their credit limit are significantly more likely to miss a future debt payment. Over the past 12 months, the share of these borrowers has continued to trend up (Chart 2, yellow line).
More mortgage holders will be facing higher payments in the coming years
About half of all outstanding mortgages are held by borrowers who have yet to face higher rates because their payments were fixed for five years (with either a fixed or variable mortgage rate).11 Households that hold these mortgages will generally see a larger payment increase than those that have already renewed (Chart 3). The impact of the rise in debt-servicing costs will be partially offset for households whose income has grown over the intervening period.
As mentioned in previous Reports, the financial pressure will increase most for households that took out a mortgage in 2021 and early 2022 when house prices were close to their peak and mortgage rates were very low. These borrowers generally:
- have taken on large mortgages relative to their income
- have seen little increase (and potentially a decrease) in home equity
- will see larger increases in payments at renewal
Debt-servicing costs for new mortgages remain elevated
The share of income dedicated to mortgage payments—also called the mortgage debt service ratio— has been much larger for households that took on a mortgage after interest rates started rising in 2022 relative to households that took on a mortgage in prior years (Chart 4). As a result, at the end of 2023, over one-third of new mortgages had a mortgage debt service ratio greater than 25%, double the share of new mortgages with the same ratio in 2019. This growth has occurred despite households opting for smaller mortgages relative to their income and for longer amortization periods.12
Higher debt-servicing costs reduce a household’s financial flexibility, making them more financially vulnerable if their income declines or they face an unexpected material expense.
Most households retain some financial flexibility
The rise in house prices since the beginning of the pandemic has increased equity for most homeowners. In cases where mortgage holders run into financial stress, higher levels of home equity can act as a financial buffer, leaving room for borrowers to reduce their payments.
Similarly, access to liquid assets gives households some capacity to adjust to unexpected budget pressures. Survey data show that households—regardless of homeownership status—generally have more liquid assets as a share of their income than before the pandemic (Chart 5). That said, mortgage holders and renters hold fewer liquid assets as a share of their income compared with homeowners without a mortgage. In addition, the value of some of these assets could decline significantly during periods of stress when the funds are needed.13
Non-financial businesses
Higher interest rates can affect non-financial businesses both directly—by increasing financing costs—and indirectly—by slowing the economy. So far, the financial health of large non-financial businesses has remained broadly solid, thanks in part to their diversified sources of funding and their long-term financing. However, the number of insolvency filings—which are typically submitted by small businesses—has surged recently, suggesting that small businesses are facing more financial pressure.
Overall, non-financial businesses remain in good financial health
Demand for credit by non-financial businesses has softened considerably over the past 12 months, reflecting lower economic growth and higher interest rates. More generally, the ratio of total debt to assets among non-financial businesses picked up over 2023, primarily due to lower asset valuations, but remains below pre-pandemic levels (Chart 6). The liquidity position of non-financial businesses—measured by the ratio of total cash to debt—has deteriorated somewhat over the past 12 months but is still robust by historical standards.
Financial pressure is increasing for some businesses
The rise in financing costs over the past two years—either through bank or market sources of funding—and slowing economic growth have been challenging for many businesses. Since 2022, the debt-servicing costs of publicly listed businesses headquartered in Canada have risen sharply after having declined in the years before (Chart 7). While interest costs as a share of earnings remain below pre-pandemic levels, this share will likely keep rising in the coming years as existing debt is refinanced at higher interest rates.
An important factor temporarily protecting large businesses from the effects of higher interest rates is the financing structure of their existing debt. In Canada, most publicly listed businesses rely on issuing bonds as their primary source of debt financing, rather than relying on bank loans. Currently, about two-thirds of the bonds on their balance sheets have a remaining maturity of five years or more. For many firms, this means the cost to finance their existing debt will not increase for some time. Over the past 12 months, spreads between corporate and government bond yields have declined below their average level since the 2008–09 global financial crisis, which is also mitigating the increase in refinancing costs for large businesses.
Smaller businesses appear to be under more financial pressure than their larger counterparts. The number of businesses in Canada filing for insolvency, which had been unusually low during the pandemic, has surpassed pre-pandemic levels by a large margin (Box 1). A key reason for this rebound could be that the temporary government support programs put in place during the pandemic delayed the impacts of underlying financial pressures for some businesses and reduced the number of insolvency filings relative to pre-pandemic levels. The Bank will continue to closely monitor the level of business insolvencies and the risk they may pose for financial stability.
Box 1: A closer look at the sharp increase in the number of business insolvencies
Box 1: A closer look at the sharp increase in the number of business insolvencies
Business insolvencies have increased steadily since early 2022 and more sharply since the middle of 2023 (Chart 1‑A).14 As of March 2024, the number of businesses filing for insolvency was up significantly from a year earlier and was about double its average from before the COVID‑19 pandemic. The surge in insolvencies over the past 12 months has generally been:
- concentrated among small businesses15
- broad-based across industries
- driven by bankruptcy filings rather than insolvency proposals16
The run-up in business insolvencies since early 2022 likely reflects a combination of factors, including:
- higher borrowing costs
- slower economic activity
- phasing out of federal and provincial pandemic support programs
A rebound in business insolvencies from pandemic lows was to be expected. Some businesses may have been sustained throughout the pandemic by government support programs, and successive pandemic lockdowns disrupted the process for insolvency filing, particularly the use of bankruptcy courts, leading to a backlog of cases.
To better understand the rise in business insolvencies in relation to pandemic lows, we examine 19 industries in Canada (each represented by a bubble in Chart 1‑B). We compare the cumulative deviations of insolvency filings from their pre-pandemic average (from 2016 to 2019) over two periods:17
- from early 2020 to the end of 2022 (period of below-average number of insolvencies)—shown on the horizontal axis in Chart 1‑B
- from the end of 2022 onward (period of above-average number of business insolvencies)—shown on the vertical axis in Chart 1‑B
The size of each bubble in Chart 1‑B is proportional to the size of the industry. The concentration of bubbles around the diagonal 45-degree line suggests that, for many industries, the cumulative rise since the end of 2022 is similar in size to the cumulative decline from 2020 to 2022. In addition, some of the industries that saw the largest initial declines, such as retail trade and accommodation and food services, have also experienced the largest rebounds. This reinforces the idea that government support programs likely played a role in limiting insolvencies from 2020 to 2022. While higher interest rates and slowing demand have contributed to stress among businesses, the rebound in the number of insolvencies above its pre-pandemic average appears to be mainly the result of a catch-up effect in the overall number of insolvencies since 2020.
Banks
Canadian banks remain resilient. Overall, credit performance remains strong, and capital and liquidity buffers remain above regulatory minimums. Increased provisions for loan losses are impacting profitability but also enhancing banks’ resilience. Funding costs have increased, but deposit retention has remained strong and access to wholesale markets continues to be robust. The Bank will continue to monitor indicators of borrower stress and how that stress may impact the credit quality of banks’ assets.
Funding for banks remains accessible, but costs have increased
Ongoing access to stable sources of funding affects the stability of individual banks, the banking sector as a whole and the ability of banks to support the economy.
Banks rely on two main sources of funding:
- deposits of households and businesses
- funds obtained through wholesale capital markets, both domestically and internationally
While bank deposits in the United States have declined over the past 12 months, those in Canada have continued to grow, but at a higher cost for banks. As interest rates have risen, depositors have migrated to higher-yielding products such as term deposits. This translates to higher funding costs for banks. Banks generally pass these higher costs on to customers in the form of higher interest rates on loans, maintaining interest rate margins.
Large banks also rely on domestic and international wholesale markets for additional funding. This exposes large banks to strains in global fixed-income markets that could impact their access to funding during periods of stress. Large Canadian banks continue to maintain access to wholesale markets, although at a high cost. The total cost of wholesale funding for large banks has remained high, driven by yields for Government of Canada bonds.
However, bank credit spreads have declined sharply over the past year and are back to pre-pandemic levels (Chart 8). This reduction has occurred against the backdrop of diminishing concerns from investors about the health of the global banking sector following the stress episode seen in March 2023. Since late 2023, investors have increased their appetite for corporate debt, suggesting greater ease of access to markets for banks.
Loan impairments at large banks remain low
Overall, the credit performance of bank assets generally remains strong. Among large banks, impairments on loans to households (including mortgages and consumer loans) are low by historical standards, despite a recent increase (Chart 9).
The share of mortgages in arrears has risen more for small and medium-sized banks (Chart 10). The difference in mortgage arrears at smaller lenders likely reflects differences in the borrower profiles and in the timing of mortgage renewals. Some small and medium-sized banks specialize in mortgage lending to higher-risk borrowers and typically issue more mortgages at shorter terms than other lenders.18 As a result of these shorter terms, nearly all borrowers who took out mortgages at small lenders have already renewed at higher rates. In contrast, about half of the mortgages at large banks have yet to be renewed.
The recent rise in business insolvencies discussed in Box 1 does not represent a significant source of concern for the credit performance of banks. Businesses filing for insolvency have typically been small and represent a small share of the total business loan portfolio of banks.19
The credit performance of loans to the commercial real estate sector—particularly the office subsector—continues to face pressure. For most Canadian banks, exposures to the office subsector are generally minimal. The Bank is closely watching developments in this area (Box 2).
Banks are managing their balance sheets more cautiously
Banks have increased loan-loss provisions, which serve as an early line of defence to absorb credit losses. Allowances for loan losses at large banks—the cumulated stock of provisions expressed as a percentage of loan balances—were 20% higher in the first quarter of 2024 than before the pandemic. Smaller lenders are also improving their resilience by increasing loan-loss provisions.
Large banks continue to maintain ample buffers to meet unexpected liquidity needs and absorb unexpected losses. As of the first quarter of 2024, the average common equity Tier 1 capital ratio of large banks was 13.4%, about 2 percentage points higher than just before the start of the pandemic.20 The average liquidity coverage ratio of large banks was 135% in the first quarter of 2024, up from 132% prior to the pandemic.21
Box 2: Exposures to commercial real estate in the Canadian financial system
Box 2: Exposures to commercial real estate in the Canadian financial system
Parts of the commercial real estate (CRE) sector, particularly the office subsector, are under pressure. This reflects both cyclical and structural factors, such as higher borrowing costs and weaker demand for office space. Weaker demand has pushed the national vacancy rate up to about 20% for offices located in the downtown areas of major cities.22 The industrial and retail subsectors have been performing relatively better, as illustrated by how market pricing of real estate investment trusts has evolved since 2020 (Chart 2‑A).
Various financial entities—both banks and non-banks—are active in the CRE sector, either providing lending or taking ownership stakes in real estate properties (Table 2‑A). Given ongoing pressures in the CRE sector, these entities face risks linked to credit or valuation losses, particularly in cases where this sector accounts for a large share of their overall assets.
| Most common exposures (associated financial risk) | Exposure to the CRE sector | Exposure to the office CRE subsector | ||||
|---|---|---|---|---|---|---|
| Loans (credit risk) |
Ownership stakes (valuation risk) | Share of loans | Share of assets | Share of loans | Share of assets | |
| Large banks | ● | 10% | 5% | 1.3% | 0.6% | |
| Small and medium-sized banks | ● | 20% | 16% | 1.5% | 1.2% | |
| Large insurance companies | ● | ● | 12% | 2.8% | ||
| Large pension funds | ● | 15% | 2.5% | |||
Note: CRE is commercial real estate. The share of loans for large insurance companies is not available and the share of loans for large pension funds is not applicable.
Sources: Financial statements of Canadian banks, large insurance companies and pension funds; regulatory filings of Canadian banks; and Bank of Canada calculations
Last observations: large banks, 2024Q1; small and medium-sized banks, December 2023; large insurance companies and pension funds, respective year-end dates
For banks, exposures to the CRE sector come largely in the form of loans, including commercial mortgages and loans to real estate developers, builders and real estate investment trusts. In Canada, the CRE sector accounts for 10% of the total loan book of large banks and 20% of that of small and medium-sized banks, although with significant variation among smaller lenders.
In the United States, the loan exposure of small and medium-sized banks to the CRE sector (36%) is, on average, more than twice as large as that of their Canadian counterparts (16%). For most Canadian banks, exposures to the office subsector are generally minimal—in the range of 1% to 2% of loans—with only a few small lenders having exposure above 5% of total loans.
Among non-bank financial intermediaries, substantial data gaps limit the ability to fully assess CRE exposures. However, Statistics Canada reports that roughly half of non-residential mortgages in Canada are held by institutions other than banks and credit unions.
Canada's largest life insurance companies hold about 12% of their total invested assets in the global CRE sector, and 70% of that is held in commercial mortgages. Large public pension funds hold a slightly higher fraction of their assets in the CRE sector (15%), but their exposure is more heavily weighted toward ownership stakes than loans. About 90% of pension funds’ exposure to CRE reflects ownership stakes compared with 30% for insurance companies. Both types of entities hold only about 3% of their total invested assets in the office subsector. The ownership stakes of pension funds are mostly high-quality office properties in large city centres, which have seen more modest declines in value than office properties of lower quality.
Canadian pension funds and insurance companies are generally well equipped to absorb losses:
- They have both the diversity of holdings required to help offset impacts on their earnings and the long investment horizons necessary to absorb losses.
- They are structurally less exposed to funding and redemption risks.
- There is typically less leverage in Canadian CRE relative to CRE in the United States.
In recent months, some asset managers, including pension funds and insurance companies, have written down their exposures to the CRE sector as part of periodic asset revaluations. The extent of these revaluations has likely lagged behind the declines in market valuations shown in Chart 2‑A. This could reflect long-term valuation assumptions that investors such as pension funds and insurance companies make or a higher-quality asset base. It could also suggest that further adjustments may be necessary in the future, particularly in the office subsector.
There are two key takeaways about risks to the Canadian financial sector from commercial real estate:
- First, because many Canadian financial entities participate in the CRE sector, the risk is not concentrated in any one area of the financial system.
- Second, given their diversified loan and asset portfolios, the largest entities in the system appear to have generally limited exposures to CRE.
Risks in this area are expected to continue to evolve, and the Bank of Canada will continue to monitor this area closely.
Non-bank financial intermediaries
In Canada, a significant amount of bank-like activity occurs outside the traditional banking sector and involves non-bank financial intermediaries (NBFIs), such as non-bank lenders and asset managers (e.g., pension funds, insurance companies and fund managers). NBFIs—in particular asset managers—face liquidity risks resulting from portfolio rebalancing needs, investor redemptions and increases in margin requirements for derivative positions. They rely on core funding markets to manage these risks.23
Asset managers’ leverage has grown over the past 12 months, led by an increase in hedge fund repo borrowings. Asset managers often take on leverage, through both repos and derivatives, to increase their return to investors and to manage risks.24 This leverage can increase the vulnerability of asset managers in periods of volatility to liquidity needs arising from, for example, a withdrawal of funding or margin calls. Asset managers, particularly those who rely on short-term loans like repos, face the risk that they will not be able to replace maturing debt with new debt. This is known as refinancing (or rollover) risk. A rapid unwinding of repo borrowings can also have negative spillover effects on the broader repo and fixed-income markets.
In contrast, risk associated with liquidity mismatch faced by bond and money market mutual funds is broadly unchanged over 2023. Mutual funds face liquidity risks when they offer daily redemptions to investors but invest in assets, such as corporate bonds, that are relatively less liquid than other mutual fund assets. If a fund faces redemptions that exceed its available liquidity—the cash and safe assets it sets aside to meet regular and unanticipated liquidity needs—the fund may have to sell assets from its portfolio. If many asset managers try to sell similar assets over a short period of time to raise liquidity, it can amplify price movements.
Hedge funds and pension funds have significantly increased their use of repo leverage
Leverage obtained by asset managers through borrowing in the repo market increased by around 30% in the past 12 months.25 This increase was driven largely by hedge funds and pension funds increasing their repo leverage by approximately 75% and 14%, respectively.26 Pension funds are the largest non-bank participants in Canadian repo markets, with over $90 billion in total borrowing outstanding. These pension funds face relatively less refinancing risk than hedge funds. About half of pension fund repo leverage has a maturity greater than one month, while about 70% of hedge fund repo exposure is under one week because hedge funds tend to rely more heavily on overnight and short-term repos. Some individual repo positions held by hedge funds are also very large and highly concentrated—for example, in a single Government of Canada bond.
The largest pension funds and insurance companies are typically sophisticated users of leverage that manage their liquidity risk and use liquidity coverage ratios to monitor planned and potential outflows.27 Nonetheless, even sophisticated users can run into difficulties during periods of market stress, as seen in the October 2022 UK pension fund experience and during the March 2020 “dash for cash.”28
Discussions with market participants and analysis of trading data indicate that one of the drivers behind the increase in hedge fund leverage is relative-value strategies. An example is the increasingly popular cash-futures basis trade in the Government of Canada bond market (see Box 3). These trades can provide market liquidity in both futures and bond markets. However, 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.
Liquidity mismatch in the mutual fund sector is broadly unchanged
The liquidity mismatch in the mutual fund sector remained roughly the same over the past 12 months. Bond fund assets grew 4.3% in 2023, while liquid holdings, composed of cash and government treasury bills and bonds, grew from 9.2% to 10.2%, as these funds reduced their share of assets in corporate bonds. Money market funds grew significantly in 2023, with assets increasing 51% to $78 billion, primarily as a result of investor inflows. Despite this growth, money market funds remain a relatively small segment of the mutual fund sector.29 The liquidity of these funds has improved over time as the share of their assets held in cash or Government of Canada treasury bills has grown from 30.0% to 37.6%.
Many non-bank financial intermediaries are holding more liquidity
In discussions with Bank of Canada staff, asset managers report putting a greater focus on monitoring and managing liquidity risk, including increasing liquidity buffers. In the Bank’s 2024 Financial System Survey (FSS), more than half of asset managers reported that they have shifted more of their investments toward cash equivalents and government bonds since the start of monetary policy tightening in 2022 (Chart 11).30
These increased liquidity buffers should improve the ability of asset managers to absorb liquidity shocks. Asset managers should bear in mind, however, that other market participants may have liquidity buffers made up of similar assets that they also intend to sell during periods of stress. The aggregate impact of these sales during periods of stress may lead to fire-sale dynamics, transmitting stress through the financial system.
Box 3: Cash-futures basis trade
Box 3: Cash-futures basis trade
The basis trade, a relative-value strategy that has been a feature of the US Treasury market in recent years, is becoming more popular in Canada. This type of trading strategy uses a mix of long and short positions to capitalize on price differences between bonds and bond futures.
Market participants typically use a high degree of leverage—or borrowed funds—to increase profits for these trades. For example, when bond futures contracts are relatively more expensive than the underlying bond, an entity could profit from a cash-futures basis trade by selling bond futures, buying the underlying bond, and borrowing cash in repurchase agreement (repo) markets using the bond as collateral to finance the position.
Basis trades can improve market efficiency by reducing the cost of buying bond futures and supplying futures market liquidity to those who prefer holding long futures instead of bonds.31 These trades can also pose risk in times of stress—both to those making the trades and to financial markets more generally—due to many factors.
- The pricing discrepancies tend to be quite small, so to increase the profitability of the trades, financial firms (usually large, foreign-domiciled hedge funds) often use a large degree of leverage, which they typically obtain in the repo market. Indeed, the increase in the basis trade has been cited as one of the contributing factors for the surge in demand for repo funding seen earlier this year in Canada.32 High repo leverage, particularly when it is obtained through overnight or short-term repo maturities, can amplify sudden price movements in the underlying bond market.
- Maintaining these trades could become costly if repo rates were to spike suddenly, or if higher bond market volatility were to result in larger margin calls. The unwinding of these trades as a result of these shocks could lead to abrupt sales of fixed-income assets and, possibly, to strains on market liquidity. The more leveraged a hedge fund is, the more vulnerable it is to such shocks, and the greater the risk it poses to the overall system. This was evident in the US Treasury bond market in March 2020, when pandemic-related market stress caused many hedge funds to unwind their sizable cash-futures basis trade positions. This unwinding resulted in a large volume of US Treasury bonds being sold and contributed to the severe hampering of what is normally considered the most liquid bond market in the world. The one-way selling negatively affected market participants around the world that rely on the liquidity and stability of US Treasuries.33 As the International Monetary Fund recently noted, the aggressive use of repo leverage can also leave these trades vulnerable to other shocks, including upside inflationary surprises that could lower the value of bonds.34
The cash-futures basis trade is estimated to have grown steadily in Canada (Chart 3‑A), with exchange-for-physical transactions reaching $51 billion by the end of April 2024.35 This represents about 8% of the total trading volume of Government of Canada bonds (Chart 3‑B).36, 37 Of the total volume, 45% is in 2-year futures contracts, and the remainder is split somewhat evenly between the 5- and 10-year futures contracts.
The growth of the basis trade in Canada has mirrored the growth of the Government of Canada bond futures market, including the reintroduction of 2- and 5-year futures contracts a few years ago. This has resulted in relatively steady shares of total futures trading volumes.
Overall, the basis trade serves an important function in linking Canadian government bond and futures markets. The influx of active participants such as hedge funds has allowed liquidity to improve in the futures market in normal times, but it could also worsen financial stress if events should trigger a sudden unwinding of leveraged trades.38
Endnotes
- 1. The upward pressure seen periodically in Canadian repo markets over the past 12 months is largely due to an increase in borrowing to finance investment positions rather than due to quantitative tightening. See B. Plong and N. Maru, “What has been putting upward pressure on CORRA?” Bank of Canada Staff Analytical Note No. 2024-4 (March 2024).[←]
- 2. See Office of the Superintendent of Financial Institutions, “2024 Capital Adequacy Requirements (CAR) – Letter (2023)” (letter to banks and trust and loan companies, October 20, 2023), and Office of the Superintendent of Financial Institutions, “Commercial Real Estate Risk Management” (regulatory notice, September 29, 2023).[←]
- 3. For more information, see Office of the Superintendent of Financial Institutions, “OSFI Reinforces Resilience of Canada’s Financial System: Sets Domestic Stability Buffer at 3.5%” (press release, June 20, 2023).[←]
- 4. For more details, please see the results of the 2024 Financial System Survey.[←]
- 5. For instance, many asset managers responding to the Bank’s Financial System Survey indicated that they would rebalance their portfolios toward safer assets if interest rates were to be higher than expected. Such behaviour could contribute to unusually large price movements and, in extreme cases, fire-sale dynamics.[←]
- 6. For more information, see the “Indicators of financial vulnerabilities” page on the Bank’s website.[←]
- 7. Separating out renters from outright homeowners in the TransUnion data is not possible. Both groups are categorized as households without a mortgage.[←]
- 8. The survey results show that renters were more likely than homeowners to report having their financial situation worsen in 2023 and being at risk of missing a debt payment in the next three months. See N. Bédard and P. Sabourin, “Measuring household financial stress in Canada using consumer surveys,” Bank of Canada Staff Analytical Note No. 2024-5 (April 2024).[←]
- 9. To protect the privacy of Canadians, TransUnion did not provide any personal information to the Bank. The TransUnion dataset was anonymized, meaning it does not include information that identifies individual Canadians, such as names, social insurance numbers or addresses.[←]
- 10. See J. Xiao, “The reliance of Canadians on credit card debt as a predictor of financial stress,” Bank of Canada Staff Analytical Note (forthcoming).[←]
- 11. See M. teNyenhuis and A. Su, “The impact of higher interest rates on mortgage payments,” Bank of Canada Staff Analytical Note No. 2023-19 (December 2023).[←]
- 12. For instance, 12% of new mortgages had a loan-to-income ratio above 450% at the end of 2023, a historical low. Also, 47% of new mortgages had an amortization period longer than 25 years, up from 34% in 2019.[←]
- 13. This definition of liquid assets includes some financial instruments that can be converted to cash, such as equities and mutual funds, and whose value may fluctuate. This definition also includes guaranteed investment certificates, which could be subject to early withdrawal penalties.[←]
- 14. The data behind this analysis are published by the Office of the Superintendent of Bankruptcy under the Bankruptcy and Insolvency Act. See Office of the Superintendent of Bankruptcy, “Insolvency and CCAA Statistics in Canada” (modified May 3, 2024).[←]
- 15. Businesses filing for insolvency are typically small. Insolvency data reveal that the median liabilities held by businesses at the time of filing were close to $210,000 in 2023. Note that summary statistics calculated using the publicly available dataset from the Office of the Superintendent of Bankruptcy must be interpreted with some caution. This is because data on liabilities reflect what is reported as part of the filing by insolvency trustees, which need to report only $1,000 in liabilities to start the insolvency process. Since 2013, submissions that reported the minimum liabilities represented under 4% of all business insolvency filings. Also, data on liabilities are totalled by the first three digits of postal codes in the dataset.[←]
- 16. Insolvency proposals allow businesses to continue operating while restructuring their debt. In contrast, under bankruptcy filings, businesses stop operating and their assets are liquidated.[←]
- 17. The construction industry is somewhat of an outlier to this analysis and is excluded from Chart 1‑B for ease of illustration. Business insolvencies in construction during the pandemic were significantly below the industry’s 2016–19 average. A rebound above the construction industry’s pre-pandemic average has occurred, but only from mid-2023 onward. Because of this, the cumulative rebound is small compared with the cumulative deviations below average that were registered during the pandemic.[←]
- 18. The shorter terms of mortgages issued by smaller and alternative lenders reflect the fact that high-risk borrowers usually aim to improve their credit score and transition to a prime lender at a lower mortgage rate.[←]
- 19. For large banks in Canada, business lending comprises about 40% of total lending, of which loans to small businesses tend to make up a relatively small share. Among the two large banks that publish information on their business loan portfolio by firm size, loans to small and medium-sized businesses account for about 8.5% of total business loans. The liabilities of insolvent businesses (as declared at the time of filing) totaled about $11.4 billion in 2023. On the extreme assumption that all of these liabilities were owed in the form of bank loans, this would have represented only about 0.7% of all outstanding bank loans to incorporated businesses.[←]
- 20. The common equity Tier 1 ratio is a measure of a bank’s capacity to absorb losses. It measures a bank’s equity, including certain regulatory adjustments, to its overall risk-weighted assets. This measure weights the value of assets for their perceived riskiness.[←]
- 21. The liquidity coverage ratio measures a bank’s ability to continue to meet its obligations during a short period of acute funding stress. It is defined as the total amount of liquid assets to its net cash outflows, adjusted for assumed stressed flow rates.[←]
- 22. See CBRE, “Canada Office Figures Q4 2023,” Executive summary (January 9, 2024).[←]
- 23. An asset is considered to be liquid if it can be traded at low cost in large quantities in a short period of time without a significant impact on its price. For more details, see S. Gungor and J. Yang, “Has Liquidity in Canadian Government Bond Markets Deteriorated?” Bank of Canada Staff Analytical Note No. 2017-10 (August 2017).[←]
- 24. For example, pension funds and life insurance companies make use of derivatives to hedge risk related to foreign exchange and interest rates.[←]
- 25. Data are as at May 1, 2023.[←]
- 26. Estimates are based on transaction data reported to the Canadian Investment Regulatory Organization (CIRO) through the Market Trade Reporting System 2.0. Therefore, the estimates reflect only transactions where at least one counterparty is a CIRO-registered dealer. Only Canadian-dollar repo transactions with known maturity dates are included. These data may not fully reflect the positions of firms. For example, firms may also transact with non-CIRO-registered dealers.[←]
- 27. For details on pension funds, see G. Bédard-Pagé, D. Bolduc-Zuluaga, A. Demers, J.-P. Dion, M. Pandey, L. Berger-Soucy and A. Walton, “COVID‑19 crisis: Liquidity management at Canada’s largest public pension funds,” Bank of Canada Staff Analytical Note No. 2021-11 (May 2021). For life insurance companies, see P. Aldridge, S. Gignac, R. Vala and A. Walton, “Liquidity risks at Canadian life insurance companies,” Bank of Canada Staff Analytical Note No. 2024-7 (April 2024).[←]
- 28. See J.-S. Fontaine, C. Garriott, J. Johal, J. Lee and A. Uthemann, “COVID‑19 Crisis: Lessons Learned for Future Policy Research,” Bank of Canada Staff Discussion Paper No. 2021-2 (February 2021).[←]
- 29. Money market funds comprised 2.6% of total Canadian mutual fund assets at the end of 2023.[←]
- 30. The FSS also showed that a large number of firms had not significantly changed their asset composition, while some had increased their exposure to less liquid assets. For more details, see Bank of Canada, Financial System Survey highlights—2024 (May 2024).[←]
- 31. See J. Sandhu and R. Vala, “Do hedge funds support liquidity in the Government of Canada bond market?” Bank of Canada Staff Analytical Note No. 2023-11 (August 2023).[←]
- 32. See B. Plong and N. Maru, “What has been putting upward pressure on CORRA?” Bank of Canada Staff Analytical Note No. 2024-4 (March 2024).[←]
- 33. The US Securities and Exchange Commission has subsequently required firms providing significant liquidity in the US Treasury market to register as dealers.[←]
- 34. See International Monetary Fund, “Global Financial Stability Report – The Last Mile: Financial Vulnerabilities and Risks” (April 2024).[←]
- 35. The Montréal Exchange offers market participants the ability to simultaneously take offsetting positions in fixed-income instruments and bond futures through exchange-for-physical transactions. Fixed-income instruments must have a risk profile similar to Government of Canada bonds that underly bond futures. For more details, see Montréal Exchange, “Exchange for Physical (EFPs).”[←]
- 36. See A. Uthemann and R. Vala, “How big is cash-futures basis trading in Canada’s government bond market?” Bank of Canada Staff Analytical Note (forthcoming).[←]
- 37. See J. Glicoes, B. Iorio, P. Monin and L. Petrasek, “Quantifying Treasury Cash-Futures Basis Trades,” FEDS Notes, Board of Governors of the Federal Reserve System (March 8, 2024). Glicoes et al. estimate, using a different methodology than presented in this Report, that in the United States, positions in the basis trade ranged from US$317 billion to US$991 billion at the end of January 2024.[←]
- 38. See Sandhu and Vala (2023).[←]