Bank of Canada governor warns of growing risks to financial stability

Tiff Macklem says rapid growth of private credit and hedge fund trading in sovereign debt markets are raising red flagsYou can save this article by registering for free here. Or sign-in if you have an account.Bank of Canada governor Tiff Macklem said military actions in Iran have increased volatility in energy and financial markets, with uncertainty about the duration and fallout from the conflict contributing to greater risks to global economic growth.Subscribe now to read the latest news in your city and across Canada.Subscribe now to read the latest news in your city and across Canada.Create an account or sign in to continue with your reading experience.Create an account or sign in to continue with your reading experience.Adding to the risks — which are “tilted to the downside” — is the rapid growth of two activities outside, yet intersecting, with the heavily regulated banking and financial system: private credit and leveraged trading by hedge funds in sovereign debt markets.“Economic uncertainty is already high,” Macklem said in a speech on Wednesday at the Global Risk Institute in Toronto. “We cannot afford to add financial instability to the mix.” Get the latest headlines, breaking news and columns.By signing up you consent to receive the above newsletter from Postmedia Network Inc.A welcome email is on its way. If you don't see it, please check your junk folder.The next issue of Top Stories will soon be in your inbox.We encountered an issue signing you up. Please try againInterested in more newsletters? Browse here.Non-bank financial players have become central to how sovereign debt markets function, both globally and here at home, he said, adding that, in Canada, they account for up to 50 per cent of government bonds sold at market and are major players in the secondary market.This adds liquidity and efficiency in good times, but these leveraged sovereign debt purchases pose risks in times of stress.“The scale of these trades and speed at which they can unwind pose a systemic risk,” Macklem said. “Short-term funding strains could cause severe dislocations in sovereign debt markets — the backbone of our financial system, and the cross-border nature of markets means that stress that begins in one jurisdiction or sector can quickly move to another.”One scenario he worries about is a shock to markets that leads to a spike in global interest rate volatility, which causes these lenders to take haircuts on their investments or curtail funding.“Higher funding costs or reduced access can force the positions to be unwound. Leverage can build quietly and then unwind very quickly when conditions change,” he said.“If leveraged investors are forced to reduce their positions, they may need to sell sovereign bonds into already stressed markets. Prices fall. Liquidity deteriorates. And the stress feeds back on itself.”Macklem said the dash for cash at the start of the pandemic, the U.K. gilt crisis in 2022, and stress in the U.S. Treasury market last spring after President Donald Trump unleashed a torrent of tariffs around the world all shone a light on vulnerabilities in the sovereign debt market. More recently, he said, vulnerabilities have been exposed in the now trillion-dollar private credit market, which also raise concerns about potential contagion to the banking sector and core of the financial system. “Banks and insurers are linked to private credit through lending, sponsorship, warehousing and risk transfer,” he said. “That means weakness in private credit could spill back to the regulated sector, and because private credit is increasingly global, those spillovers could travel quickly across borders.”Though recent defaults appear to have been contained, they highlighted the risks in private credit and raised questions about the quality and transparency of underwriting, Macklem said. “The opacity of private credit means investors may not have enough information about the quality of loans held in their funds,” he said. “A spike in defaults could prompt them to try to exit their positions quickly. This could cause severe strains, including spillovers to public credit markets.”Macklem said systemic risks didn’t disappear after the global financial crisis in 2008, they just migrated — and global surveillance and regulatory frameworks haven’t kept up.“Our oversight was built for banking,” he said. “Non-bank players generally don’t have the same reporting requirements or level of monitoring. That gap poses a challenge for global standard-setters, national regulators and central banks.”Global organizations such as the Financial Stability Board are working to improve understanding and monitoring of private credit, Macklem said, adding that international cooperation across authorities and borders is required. “We need to understand the interconnections between private credit and banks,” he said, adding that surveillance should be enhanced so risks can be monitored as this market grows. “That includes tracking cross-border exposures, funding structures and the potential for correlated stress across institutions and jurisdictions.”• Email: bshecter@postmedia.comPostmedia is committed to maintaining a lively but civil forum for discussion. Please keep comments relevant and respectful. Comments may take up to an hour to appear on the site. You will receive an email if there is a reply to your comment, an update to a thread you follow or if a user you follow comments. 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