Canada

Financial Institutions Are Buying Riskier Assets Due To Moral Hazard: Bank of Canada

Canadian financial institutions increasingly see the financial system as risk-free. That might be a risk itself. The Bank of Canada (BoC) completed its biannual Financial System Survey (FSS) this week. It found institutions are buying “riskier” assets to make up for low interest rates. Risk managers see the risk as low, believing the financial system can now handle any shock. This has the BoC quietly pondering if this means the system has reached the point of moral hazard.

Low Rates Are Crushing The Financial System

Canada’s “prolonged” period of low interest rates has crushed profits at institutions. The survey found 54.6% of respondents believe low rates have worsened their ability to profit. Before you go all, “yeah, screw Bay Street!” It’s worth looking at who is getting crushed.

The BoC said the negative impacts are seen at insurers, pensions, and banks. Since these are primarily consumer services, their loss is your loss. They pass on their lack of returns with higher rates, higher contributions, and more fees. Something to think about when getting your next insurance quote.

How Low Interest Rates Impacted Canadian Institutional Investors

The effect of low interest rates on the investment goals of Canadian institutional investors.

Source: Bank of Canada.

A minority of institutions saw no impact from low interest rates, and some even saw a benefit. Low rates made no difference at 1 in 5 institutions (18.2%), while just over a quarter (27.3%) saw an improvement. Those who saw an improvement were largely asset managers, who saw the value of assets surge. On the upside, private money is making out like a bandit in this situation.

Low Interest Rates and Why They’re Here

Let’s back the truck up — what’s the deal with low interest rates? In periods where the economy is seeing low growth, the central bank will lower rates. They do this as an incentive for people to borrow their future income and boost today’s economy. Rates keep falling until inflation hits the desired goal. If risk drives interest rates up and they want more inflation, the central bank suppresses it. This produces an environment where it’s better to be a borrower than it is to be a lender.

Consumers think it’s a no-brainer to borrow but at the same time your lenders, pensions, and insurers can’t make money. If their fixed income streams are low, they need to seek areas with higher returns to balance the losses. This leads to buying riskier assets — anything from private equity to grandma’s house.

The full impact on society isn’t understood, due to the narrow focus of all players involved. Central banks argue cheap money improves the affordability of debt, making housing cheaper. That’s not exactly true if you’re now competing with a hedge fund for the same house, is it?

Canadian Institutions Are Leveraging Up On Risk

Shocking no one, that’s exactly what the BoC has found institutions are doing. “Over the past decade, asset managers, pension funds and insurers have engaged in a search for yield, reducing their exposure to safer assets and increasing exposure to riskier assets. These respondents have also increased their use of leverage and the maturity of their assets.” 

In other words, institutions see fixed income and lending to be less attractive. Why would you lend money if the central bank limits your return and provides liquidity? This ensures you can’t make much (incentive destruction) and inflates assets. More institutions are now using the cheap money themselves to buy assets directly. If they can’t buy them directly, they often find indirect exposure

Institutions Are Confident In The System… Now It’s A Moral Hazard

On the upside, the BoC found institutions are very confident in the financial system. Perhaps a little too confident. Those who believe the financial system can handle any shock hit 60%, a new high for the survey. Another 37% are fairly confident in the system’s ability to mitigate risk. Only 3% of institutions feel “not very confident” — almost a rounding error.

Not one respondent answered, “not at all confident.” Not even one wacky person in the back thinks the levies can break and cause a flood? That’s a bit of a problem since risk only happens when no one believes it’s possible.

After withstanding the kind of shock they just witnessed, how could they not be confident? The system became virtually consequence-free overnight, with taxpayers mitigating any issue created by overexposure to risk assets. It now seems almost silly to not have greater exposure to higher returning but risky assets, no?

That appears to be the takeaway. “Overall, most respondents stated that they are more exposed to risky assets, yet they believe that their level of risk has not changed significantly,” said the BoC.

Adding, “Combined with their high level of confidence in the financial system, attributed in part to the pandemic response of authorities, this may suggest moral hazard.” 

To recap, the Financial Crisis resulted in a prolonged low rate environment. This forced institutions to buy riskier assets to make up for the lack of returns. The current recession hit and taxpayers more than picked up the tab for any mistakes. Investors now believe the financial system will distribute any shock across taxpayers. Exposure to heightened risk no longer even impacts their risk profile significantly.

Probably nothing.

3 Comments

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  • Christopher Barclay 1 week ago

    Precisely, what could go wrong? It’s just a few dollars from taxpayers per year that will be perpetually paid every time they screw up. Voters love this idea because they think they’re the ones winning.

  • Van YIMBY 1 week ago

    Low rates are a heist. People aren’t smart enough to understand the low rates come at the devaluation of their labor.

  • Rob triple B 1 week ago

    Most assets including real estate are inflated due to low interest rates. It’s a shell game and sooner or later this Ponzi scheme will hit the brick wall and finally have the market determine value of assets.

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