Bank of Canada officials are monitoring pockets of increasing leverage and “stretched” asset valuations that could pose a threat to financial stability in the event of major price swings, but see no signs that a repeat of the 2008 Financial Crisis is imminent.

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Bank of Canada warns bets tied to timing of rate cuts are boosting leverage in some markets Back to video

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The central bank’s annual report on stability across Canada’s financial system, released Thursday, flagged a steep increase in the use of leverage in Canadian bond and repo markets by hedge funds, which appeared to be driven by arbitrage strategies tied to the timing and quantum of interest rate cuts.

“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 said 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 bank’s Financial Stability Report said leverage obtained by asset managers through borrowing in the repo market increased by around 30 per cent in the past 12 months. The increase was largely driven by hedge funds and pension funds increasing their repo leverage by about 75 per cent and 14 per cent, respectively. For hedge funds, the spike appears to be related to relative-value trading strategies, including increasingly popular cash-futures basis trades in the Government of Canada bond market.

While providing liquidity in both 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 said.

Rogers noted that banks, pensions, hedge funds and investment dealers involved in Canada’s financial system have different regulators, but the Bank of Canada can look across all markets for signs of risk and contagion.

“We try to take a cross-sectoral look and think about things that might fall between the cracks,” Rogers said. 

Even a failure of a small bank in another country can shake confidence

Bank of Canada senior deputy governor Carolyn Rogers

The issues flagged in the report aren’t a problem now, she said, but could easily develop into one if there was a sudden rush to obtain additional liquidity from banks to unwind positions or meet margin calls at a time when they were loath to extend 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 said. “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 assets must be sold to meet liquidity needs, there can be large swings in price, leading to knock-on effects. Other institutions holding those assets may face margin calls and also need to liquidate.

“Then you get this kind of spiral,” she said.

Recent examples of even sophisticated users of leverage getting caught up in market dislocations include the upheaval in the United Kingdom pension system in 2022, which was caused by a steep increase in sovereign yields at the same time that the British pound was dropping sharply. The Bank of Canada also cited a “dash for cash” when COVID-19 was declared a global pandemic in March of 2020, which led to dislocations across markets.

Rogers said it is also noteworthy that the impact of regional bank failures in the United States in the spring of 2023 were 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 said, adding that while this is no longer a concern, it illustrates the interconnectedness of the financial system. “One of the things about the banking sector is even a failure of a small bank in another country can shake confidence,” she said.

After Thursday’s report was released, Bank of Canada governor Tiff Macklem also spoke about potential contagion at a news conference, where he discussed what the central bank views as pockets of vulnerability among banks, households, businesses and non-bank financial institutions such as pensions, insurance companies and hedge funds.

“If one thing goes wrong, obviously it’s not good for those people, but it doesn’t reflect financial stability,” he said. “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.”

• Email: bshecter@postmedia.com

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