Bank of Canada officials are closely monitoring the financial stability of the country’s financial system, particularly in light of increasing leverage and stretched asset valuations that could potentially pose a threat in the event of major price swings. However, they do not see an imminent repeat of the 2008 Financial Crisis.
The central bank’s annual report on stability highlighted a significant rise in leverage in Canadian bond and repo markets by hedge funds, driven by arbitrage strategies linked to interest rate cuts. Senior deputy governor Carolyn Rogers emphasized the importance of institutions running stress tests to ensure they have enough margin to withstand large price fluctuations.
The report also noted a 30% increase in leverage obtained by asset managers through borrowing in the repo market over the past year, with hedge funds and pension funds significantly increasing their repo leverage. While providing liquidity in futures and bond markets, the high degree of leverage can leave hedge funds vulnerable to sudden changes in prices and financing costs.
Rogers emphasized the interconnectedness of the financial system, noting that even a small bank failure in another country can shake confidence. She highlighted past instances where market dislocations impacted Canada, such as the UK pension system upheaval in 2022 and the “dash for cash” during the onset of the COVID-19 pandemic.
Overall, the Bank of Canada is urging caution and vigilance among financial institutions to prevent potential contagion and amplify manageable problems into unmanageable ones. Governor Tiff Macklem emphasized the importance of addressing vulnerabilities among banks, households, businesses, and non-bank financial institutions to maintain financial stability.