Financial System Review—2020

The impact of COVID‑19 on the Canadian financial system

Browse previous versions of the Financial System Review.

Summary

COVID‑19 is an unprecedented shock for the Canadian economy. Households, businesses and governments need a well-functioning financial system to manage the effects of the pandemic and support a robust recovery. In this Financial System Review, we identify the effects on financial stability and explain how recent actions by the Bank of Canada and other policy-makers help Canadians through a very challenging time.

Uncertainty has led to widespread financial stress

COVID‑19 is a severe health threat, and the necessary measures taken to contain its spread have cut economic activity. Canada is also grappling with the plunge in global oil prices, which hit while many businesses in the energy sector were still recovering from the 2014–16 oil price shock.

Early on, uncertainty about just how bad things could get created shock waves in financial markets, leading to a widespread flight to cash and difficulty selling assets. Policy actions are working to:

• restore market functioning
• ensure that financial institutions have adequate liquidity
• give Canadian households and businesses access to the credit they need

Putting a floor under the economy

Since the onset of the pandemic, the Bank has established and expanded a range of facilities and purchase programs to address problems with market functioning and confidence. They are showing signs of succeeding:

• Access to liquidity has greatly improved in key financial markets that had been showing signs of significant stress.
• Many of the programs are now being used less than they were at inception.

Weathering the effects of containment measures

COVID‑19 has hit many households and businesses hard, especially those that are highly indebted or have low cash buffers. Strong and targeted policy responses by governments, regulators and the Bank are supporting the Canadian financial system. During this period, emergency measures that provide basic incomes to households and help businesses access credit are crucial.

For its part, the Bank has taken action by:

• lowering the policy rate to 0.25 percent
• supporting the flow of credit to households and businesses
• strengthening the transmission of monetary policy so that lower policy rates can be passed through to borrowers

We will continue to assess the impacts of these measures and can adjust the scale of these programs as market conditions change.

Policies are helping the financial system absorb the shock

The financial system provides the credit, liquidity, and payment and settlement services necessary to address the economic impacts of COVID‑19 and facilitate the recovery. Canada’s key financial institutions are strong enough to deal with these challenging conditions, including operational disruptions.

Canada’s six largest banks have strong capital and liquidity buffers, diversified assets and the protection of a robust mortgage insurance system. Bank staff analyzed two scenarios. The first shows that an aggressive policy response has helped put the banks in a good position to manage the consequences of the shock. The second shows that without these policies, banks would be faring much worse, with important negative effects on the availability of credit to households and businesses.

Many paths to the recovery are possible, as illustrated in the April Monetary Policy Report. Policy support will need to be flexible and adapt as the situation evolves.

The Financial System Review is a product of the Governing Council of the Bank of Canada: Stephen S. Poloz, Carolyn A. Wilkins, Timothy Lane, Lawrence Schembri, Paul Beaudry and Toni Gravelle.

Introduction

COVID‑19 is a severe health threat and a challenge to the economic well-being of Canadians. This Financial System Review (FSR) provides an in-depth analysis of the impacts of the pandemic and related containment measures on the Canadian financial system and considers the resulting implications for economic activity. Households, businesses and governments need a well-functioning financial system to manage the effects of the COVID‑19 and support a robust recovery. The economic costs of the pandemic would be magnified if the financial system were not up to the task.

The pandemic affects both the capacity of firms to supply goods and services and the ability of consumers to make purchases. The global nature of supply chains makes production highly interconnected across countries, and disruptions in one country can quickly result in shortages in others.

Demand effects are rooted in income losses and uncertainty about just how bad things could get. Households and businesses are limiting their activities and spending because of mandatory physical distancing and fear of catching the virus. The initial impact of the pandemic was greatest in the travel, entertainment and food services sectors but has since become more broad-based. Businesses are also delaying investment decisions, and households are increasing their precautionary savings. Foreign demand, commodity prices and terms of trade have declined.

COVID‑19 affects the financial system through many complex and interrelated channels. Figure 1 provides a stylized overview. Some impacts are amplified by financial vulnerabilities that the Bank of Canada has previously identified, such as high indebtedness for households and businesses.

The fall in incomes and asset values and the rise in uncertainty about their future paths make lending to households and businesses riskier for banks and non-bank financial intermediaries. These conditions also lead investors to try to sell assets in financial markets. But the abrupt and widespread flight to cash makes selling assets difficult. If left unchecked, this decline in market liquidity could limit access to credit for households and businesses. This could hinder their ability to smooth the impact of the shock on spending and investment.

Strong policies have put a floor under the economy and laid a strong foundation for its recovery.1 Concerted policy actions by the Bank and other authorities have helped restore market functioning, and liquidity conditions have improved significantly. Government support for households and firms is directly mitigating income losses. Lower policy interest rates are underpinning demand and helping to achieve the inflation target. Enhanced regulatory flexibility is providing financial institutions with greater scope to continue lending. Coordination between authorities has been essential to creating mutually reinforcing policies. These policies can adjust to the pandemic’s impact on the economy.

This FSR has a different structure than is typical, focusing on the impact of COVID‑19.2 The next section sets the stage by describing the reaction of global financial markets to the evolution of the COVID‑19 outbreak into a pandemic. The following section reviews how Canadian authorities responded to the resulting impaired market liquidity. The effects on credit provision are then discussed, followed by an analysis of the impact of the drop in household and business incomes. The FSR concludes with an assessment of the resilience of the financial system, including a look at the banking system in the more pessimistic scenario discussed in the April Monetary Policy Report.

The analysis in the FSR benefited from the collaboration of the new Systemic Risk Surveillance Committee (Box 1).

Global economic uncertainty has caused widespread stress

• The global economic outlook has deteriorated with unprecedented speed and severity, causing an abrupt tightening in financial conditions. Central bank and government policy responses have helped offset some of this tightening and restore market functioning.

Concern about the economic impact of COVID‑19 overtook global financial markets as it became clear that the outbreak in China would become a full-fledged pandemic. Financial conditions tightened at an extraordinary speed as uncertainty and stress in financial markets reached an elevated level.

Equity markets, including in Canada, declined abruptly and credit spreads jumped, especially in riskier market segments (Chart 1). Oil prices plummeted because of concerns about pandemic-related weakness in demand as well as intensified competition for market share. Portfolio outflows from emerging markets reached their fastest pace on record. Many of these markets depend on US-dollar funding and have limited policy tools to manage the effects of COVID‑19.

Many financial markets showed signs of panic as investors focused on worst-case scenarios. The effects were widespread, and the correlation between many asset prices climbed. The loss of investor confidence and extreme volatility caused a global flight from risks of all sorts. Market participants rushed to sell assets to increase cash holdings. Market makers became reluctant to facilitate trades. Financial markets became impaired, with a severe deterioration in liquidity conditions.

The worsening economic outlook combined with the flight to high-quality liquid assets pushed yields on government bonds down in most advanced economies. The Bank of Canada cut the policy interest rate by 150 basis points, and five-year Government of Canada bond yields fell close to an all-time low. A large package of government support programs in Canada, equal to about 12 percent of gross domestic product (GDP), helped mitigate the immediate impacts of the pandemic. And additional measures to restore market functioning and improve liquidity for financial markets and banks helped make the fiscal and monetary policies more effective. These measures are discussed in more detail in the next two sections.

The pricing of Canadian treasury bills and Government of Canada bonds sets the baseline for the entire fixed-income market. When the pricing of these securities becomes uncertain, it is harder to price other assets. In addition, Canadian government securities are essential collateral for trades in many other markets, allowing market makers to efficiently finance long positions and cover short positions. Because of this, a rapid drop in liquidity of Canadian government securities can make it more difficult to manage risk and can reinforce the transmission of liquidity strains across asset classes.

One of the affected markets is the provincial bond market, where liquidity deteriorated markedly in March (Chart 3). When market functioning is impaired, investors are reluctant to hold provincial debt, which makes it more challenging for issuers to get funding.

Moreover, a range of indicators clearly show that market liquidity drastically deteriorated in the Canadian corporate fixed-income market in March (Chart 4). The impaired liquidity placed additional pressure on business funding costs and the ability of firms to raise cash. Issuance of corporate bonds almost stopped entirely in sectors affected by COVID‑19. Corporations fell back on bank lines of credit.

The deterioration in market liquidity was also amplified in March by higher margin requirements. The increased frequency of margin calls coupled with falling collateral values caused funding problems for some investors who used leverage strategies. For example, some institutional investors use risk parity strategies that attempt to maintain a target level of volatility in each asset class.3 A sharp and sustained increase in volatility forced these investors to rapidly deleverage and rebalance their portfolios. Investors who use leverage and derivatives to exploit small differences in yields between markets faced similar challenges.4 Margin calls on these investors exacerbated the decline in market liquidity as the investors scrambled to sell assets to raise cash and cover their positions.

The Bank of Canada has intervened to support liquidity in key funding markets.5 Starting in mid-March, the Bank established and expanded a range of facilities and large-scale asset purchase programs to address problems with market functioning.

The size of the Bank’s balance sheet has roughly tripled, growing from $119 billion on March 4 to $392 billion on May 6. This increase is much larger and occurred much faster than the growth that occurred during the 2007–09 global financial crisis, when the Bank’s balance sheet increased by 50 percent from September 2008 to the peak of the crisis in March 2009.

These programs have helped improve market liquidity and market functioning across a wide range of markets (Chart 2, Chart 3, Chart 4 and Box 3). In particular, new issuance of Canadian corporate bonds rebounded to around $17 billion in April—one of the strongest monthly volumes since 2010.

The interactions between the various liquidity facilities have also likely amplified the positive impact on market confidence and functioning. The use of some programs declined in April, providing additional early signs of improvement in funding conditions. The Bank can scale the programs to address changing market conditions.

The Bank continues to deploy its policy tool kit to:

• support the flow of credit to the real economy
• strengthen the transmission of monetary policy so that lower policy rates can be passed through to borrowing costs

Access to credit is important for managing the economic stress

Banks

• Funding conditions for banks have become more challenging due to impaired market liquidity and increased concern about the future performance of lenders’ assets.
• Policy actions are giving banks flexibility to help manage these pressures and enabling them to continue to provide credit.

Canadian banks have been facing funding pressures at a time when households and businesses need access to credit to weather the pandemic. Banks came into this stressful period with strong capital and liquidity positions. But the cost of wholesale funding rose rapidly in March (Chart 5). This was due to both impaired market liquidity (discussed in the previous section) and increased concerns about the quality of banks’ assets. These concerns reflect the potential for more loan losses as well as greater exposures from the use of credit lines and loan payment deferrals.

Policy actions are giving banks greater flexibility to manage funding pressures. This includes Bank of Canada term repo operations and the Standing Term Liquidity Facility (STLF). These programs provide a backup source of funding when markets are stressed. They also provide flexibility in relation to loan maturity and required collateral.

Term repo is the facility most used by banks, with outstanding amounts of $182 billion as at April 29. The new STLF facility is an important recent addition to the Bank of Canada’s tool kit because it is available to a wider range of lenders than the term repo facility. The Bank will lend using the STLF only when it has no concerns about the soundness of the borrower. Thirteen financial institutions, including large and small banks, have drawn a total of $10.7 billion from the STLF, and over 90 percent of that amount has already been paid back.

In addition, through the Insured Mortgage Purchase Program, administered by the Canada Mortgage and Housing Corporation, the Government of Canada stands ready to provide term funding through the purchase of up to $150 billion of insured mortgage pools.

The Office of the Superintendent of Financial Institutions (OSFI) provided regulatory flexibility to lenders, which reinforced the effectiveness of these programs. Reforms following the 2007–09 global financial crisis created larger and higher-quality capital and liquidity buffers. OSFI is now encouraging banks to use part of these buffers to help supply credit to the economy during this stressful period.6 OSFI lowered the Domestic Stability Buffer from 2.25 percent to 1 percent of banks’ total risk-weighted assets and reminded banks that it is acceptable for the Liquidity Coverage Ratio to fall below 100 percent during a period of financial stress.7^, 8 It has also made temporary changes to the calculation of the leverage ratio to exclude settlement balances held at the Bank of Canada and certain sovereign debt. This allows banks to use liquidity programs and make markets in Government of Canada securities without constraining lending. In addition, OSFI temporarily increased its limit for covered bonds to provide issuers with additional capacity to use these instruments as collateral for funding through the Bank of Canada.

The Bank of Canada facilities and other government policies have contributed to better overall market liquidity conditions and have helped undo some of the increase in bank funding costs since March. On one hand, households and businesses with variable-interest-rate loans, including home equity lines of credit, have benefited from lower policy interest rates. On the other hand, longer-term fixed lending rates have remained relatively flat because bank funding spreads and mortgage interest rate spreads are higher than they were before COVID‑19 (Chart 5).

Banks have expanded credit to their clients. Real estate secured lending to households posted the fastest growth since mid‑2017 in March, but this largely reflects strength in housing markets before the COVID‑19 outbreak. Bank non-mortgage loans to businesses were around 8 percent higher in March than in February (not annualized), driven by draws from credit lines.

Undrawn lines of credit available to businesses (around $900 billion) and households (around $800 billion) at the largest banks are some of the biggest potential sources of credit demand in the short term. In March and early April, businesses drew about 15 percent of their credit lines. In the energy sector, the utilization rate increased to close to 40 percent. Utilization rates are particularly high for many junior oil producers. The rate of drawdown by businesses has eased considerably since then, with some even paying back loans as they become more confident about having access to commercial paper and bond markets. So far, drawdowns of household credit lines have remained stable.

According to a recent survey, almost 30 percent of businesses requested additional credit from a financial institution in the first quarter. Small and medium-sized enterprises (SMEs) have reported a high rejection rate compared with normal times, indicating some stress.9 The government has introduced additional programs to help SMEs address their funding challenges. These include the Business Credit Availability Program, which allows the Business Development Bank of Canada (BDC) and Export Development Canada (EDC) to work with private lenders to maintain the flow of credit.10 In addition, loans issued by BDC increased sharply in April, reaching four times the typical monthly average.

Small and medium-sized lenders have an important role in providing credit to households and businesses. Among their diverse business models there are credit unions, monoline mortgage lenders, more diversified medium-sized lenders and subsidiaries of large financial groups. These lenders improve competition, and some fill important market niches, including by providing services to new Canadians and self-employed individuals.

In the COVID‑19 environment, small and medium-sized lenders face considerably different risks. For example, these lenders differ in terms of their funding models, with some smaller banks relying on brokered deposits, which have historically been less stable than retail deposits.11 Some may also have a higher concentration of exposures to heavily affected industries (e.g., commercial real estate and energy). Many smaller lenders manage these risks with higher capital levels. Like larger banks, most also have access to Bank liquidity facilities, including the new STLF.

Non-bank financing

• A large share of businesses refinancing in bond markets will likely face higher costs. The potential for the credit ratings of some businesses to be downgraded is intensifying refinancing risks.

Non-bank financing provides a valuable alternative to borrowing from traditional banks. As in many other countries, in Canada the non-financial corporate sector relies heavily on non-bank credit providers. For example, the amount of bonds outstanding issued by Canadian non-financial businesses increased from $205 billion in 2008 to $467 billion in 2019, with the increase evident across all sectors.

Refinancing needs for the next six months are in line with recent history, amounting to about $11 billion, of which around 70 percent is BBB-rated (i.e., BBB+, BBB or BBB-). The cost of refinancing using BBB-rated bonds has increased due to credit spreads that remain well above their pre‑COVID‑19 levels (Chart 6).

The risk of credit downgrades is intensifying refinancing risks. BBB-rated bonds account for about 73 percent of outstanding investment-grade bonds, totalling $283 billion (Chart 7). If all BBB-rated bonds with the same spread as BB+ bonds were downgraded, the stock of high-yield bonds would double to over $160 billion.

The energy sector has the most refinancing needs over the next six months ($6 billion) and faces the most potential downgrades (Chart 8). This sector’s ability to secure refinancing will be particularly tested with low oil prices. New credit programs being developed by BDC and EDC will help to mitigate the refinancing risks in the energy sector.12

A credit downgrade could put further pressure on firms’ cash flow positions through several channels:

• Funding costs could increase further.
• Restrictive covenants in debt contracts could constrain firms’ ability to make financial and operational adjustments.
• Margin calls could increase liquidity demands.

As discussed in the 2019 Financial System Review, a deterioration in the creditworthiness of some Canadian firms has led to increased reliance on debt funding from more fragile markets, including the US leveraged loans market. Following the COVID‑19 shock, riskier firms are finding it difficult to access these markets, partly due to the shift in investor sentiment.

Alternative lenders, such as mortgage investment corporations (MICs) and private lenders, have played a small but increasing role in providing credit to households and SMEs in recent years. Nationally, MICs are responsible for about 1.5 percent of residential mortgage lending. Private lenders are important in certain major markets. In the Greater Toronto Area, they account for about 7 percent of new residential mortgages. Recently, some alternative lenders suspended investor redemptions to avoid potential liquidity pressures. Other small independent lenders traditionally involved in the financing of SMEs have reported challenging market conditions that, if persistent, could jeopardize the future of their business. Households and SMEs that are being served by some of these lenders may find it more difficult to access credit in the future and may have limited alternative options if they cannot access traditional lenders.

Households and businesses are facing income losses

Households and housing markets

• Household employment incomes have been hit hard, and many Canadians face financial difficulty, especially those that are already highly indebted. Flexible income replacement policies play a central role in mitigating the impact on households.

COVID‑19 has led to a sharp loss in household employment incomes. A large share of the labour force is now unemployed or substantially underutilized (Chart 9). And this will continue for an unknown period. The unemployment rate in April 2020 was worse than that experienced during the 2007–09 global financial crisis, and those employed were working a lot fewer hours.

Income uncertainty and physical distancing have led to considerably slower activity in housing markets, with sales and listings both down sharply.13 Reduced liquidity in the housing market could add pressure to household finances since households may find it increasingly difficult to sell their homes. Most households now expect house prices to decline over the next 6 to 12 months.14

Affected households will struggle to manage income losses. The adjustment will be especially difficult for those that are highly indebted and must dedicate a large share of their incomes each month to regular payments (Box 4). In addition, many households have limited liquid assets. About 20 percent of all mortgage borrowers do not have enough liquid assets to cover two months of mortgage payments (Chart 10).15

Flexible policies are mitigating the economic impact. A strong feature of the federal government’s recently announced income replacement programs is that they can be scaled to respond to the size and duration of the economic impact.

The Canada Emergency Response Benefit gives $2,000 per month to individuals who have lost their income due to COVID‑19. The Canada Emergency Wage Subsidy pays 75 percent of salaries—up to $847 per employee per week for qualifying businesses that keep employees on their payrolls.16 These measures can cover a large portion of core spending for many households, as demonstrated by median core expenses shown in Table 1.

Many households will also use loan payment deferrals or increased borrowing to help bridge income losses. Canadian banks have allowed more than 700,000 households to delay mortgage payments and have also provided increased flexibility on payments for credit cards and lines of credit. This is keeping debt payments down for many households. However, after the six-month deferral period ends, debt-service payments will rebound. The proportion of households with debt-service payments of more than 40 percent of their income, an indicator of household vulnerability, is likely to rise. This will be particularly the case for households whose incomes do not fully recover.

Despite the deferrals and added borrowing, some households are likely to fall behind on their loan payments. This typically appears first in missed credit card and auto loan payments and later in mortgage payments. The situation in Alberta and Saskatchewan, where the share of households that fell behind on their payments had already been increasing, is of particular concern.17

Compared with homeowners, renters tend to be less indebted but are more likely to work in industries heavily affected by COVID‑19. Those who experience difficulties in making rent payments could also pass on financial stress to landlords, many of whom are households with mortgages.

The longer the income shock lasts, the greater the risk of a rise in consumer insolvencies. Flexible policy support can adapt as the situation evolves (Box 5).

Businesses

• A sharp drop in revenues caused by COVID‑19 is creating great stress on many Canadian businesses, particularly those that are highly indebted and have few liquid assets. Government programs are helping businesses bridge the income gap.

In a recent survey, about one-third of Canadian businesses reported at least 40 percent less revenue in the first quarter of 2020 relative to the previous year.18 A further one-fifth reported declines of between 20 and 40 percent. SMEs, which employ a large majority of private sector workers, were particularly affected. On a sectoral basis, declines in business revenue were the greatest in accommodation and food services. Losses in the arts, entertainment and recreation sector as well as retail trade were also especially large.

The sharp drop in revenues caused by COVID‑19 makes it difficult for many businesses to meet fixed payments, including debt payments. The problem is particularly severe for highly indebted businesses (Box 4). It is also challenging for energy firms dealing with lower oil prices, many of whom were still adjusting to the previous collapse in world oil prices in 2014–16.

Businesses with a strong cash position have more capacity to make payments after a fall in revenues. Compared with the average firm, those in some of the industries most affected by COVID‑19—representing around one-third of corporate revenue in Canada—have less cash relative to their short-term financial obligations (Chart 11). And commodity-related sectors have among the lowest cash ratios.

Cash flow stresses have already led some businesses to sell assets. According to the recent survey, around 8 percent of firms liquidated 10 percent or more of their assets in the first quarter in response to COVID‑19.18 Smaller firms (those with less than 100 employees) were most likely to sell assets.

Whether firms will be able to meet their payment obligations during the COVID‑19 shutdown and recovery depends on more than just their cash buffers. It also depends on the size and duration of the decline in their revenue, their ability to reduce expenses, their access to credit and equity financing and the degree to which government programs can fill the gap.

Policy actions are helping businesses manage their cash flow needs and prepare for the recovery. Government policies such as the Canada Emergency Wage Subsidy and the Canada Emergency Commercial Rent Assistance Program help firms continue to pay their workers and make rent payments despite significant declines in revenues. Beyond these direct supports, firms will need to borrow to bridge their cash flow gaps. Programs like the Canada Emergency Business Account and Business Credit Availability Program help make credit accessible to businesses.19

Together, these programs fill a substantial portion of the cash flow gap for Canadian firms. For example, take a scenario in which revenues in all industries fall by 60 percent for three months. In this case, if businesses cut their operating expenses by between 20 and 30 percent, the total extra cash needed to meet their obligations over three months could be around $180 billion. In this scenario, government programs are sufficient to cover more than half of these needs (Chart 12). However, these calculations use industry averages and therefore likely underestimate aggregate cash shortfalls.

What started as a cash flow problem could develop into a solvency issue for some businesses. This becomes more likely if the loss in revenues extends over a long period. Lingering concerns about COVID‑19 could lower demand in some industries, damaging their earning capacity. For example, demand for travel services may recover very slowly. The potential for solvency problems also depends on the ability of businesses to access credit from financial markets and banks and therefore becomes more likely if stress in the financial system returns.

Equity market prices are one way to gauge concerns over the solvency of non-financial corporations. These prices and their volatility, combined with balance sheet information, can be used to calculate a measure of “distance to default.” This measure can be interpreted as an indicator of the likelihood that a firm’s debt obligations will exceed its asset value.20 On this basis, market prices imply concern about the ability of some firms to weather this shock (Chart 13).

Policy actions that provide credit support to businesses limit the rise in non-performing loans caused by cash shortfalls in the scenario (Chart 15, “With policy”). Nonetheless, the peak is higher than those experienced in 2003 (4.8 percent) and 2010 (4.1 percent).

A counterfactual scenario without policy actions or household loan payment deferrals is also simulated. In the absence of these measures, households and businesses would fare much worse (Chart 14 and Chart 15, “No policy”).

In the “With policy” scenario, business loans are the biggest contributor to credit losses, and market losses also reduce capital. Losses from household lending are less pronounced. Still, losses on consumer loans such as credit cards are high compared with residential mortgage portfolios, which are protected by collateral and, in some cases, mortgage insurance.

The increase in the Domestic Stability Buffer (DSB) in recent years has helped banks come into this period with a substantial capital buffer. The DSB was reduced in March, allowing banks to continue lending even as their capital level declines. Their capital ratio in the scenario remains above the new 9 percent regulatory requirement (Chart 16).

The six largest banks entered the COVID‑19 period with strong capital and liquidity buffers, a diversified asset base, the capacity to generate income and the protection of a robust mortgage insurance system. The Canadian economy was also in a solid position before the onset of COVID‑19. With these strengths, as well as the aggressive government policy response to the pandemic, the largest banks are in a good position to manage the consequences. Without the aggressive policy responses, banks would be faring much worse, with important negative effects on the availability of credit to households and businesses.

Asset managers

• The liquidity management strategies of fund managers, supported by policy measures, have helped bond funds limit and manage an increase in redemptions without amplifying negative effects on market liquidity.

Asset managers are playing a growing role in financing the Canadian corporate sector. In the past decade, corporate debt held by investment funds has increased rapidly, especially among Canadian open-ended fixed-income mutual funds (bond funds). These funds now hold 23 percent of all corporate bonds.

COVID‑19 caused the value of bond fund assets to fall. Some investors reacted by exiting these funds, with redemptions reaching $14 billion in March, amounting to around 4.5 percent of assets under management (Table 2).

The Bank of Canada’s liquidity and asset purchase facilities helped to calm markets and limit investor redemptions. Fund managers also played a role in preventing large redemptions by intensifying relationship management with investors. The redemptions from bond funds were substantially less than what is predicted by a model simulation based on the credit spreads that prevailed in March (Table 2).23

In addition, both securities regulators and fund managers took actions that helped funds meet outflows. Securities regulators gave bond fund managers additional flexibility to use borrowing to manage liquidity demand for investor redemptions.24

Anecdotal evidence suggests that most fund managers met the demand for redemptions with cash and other liquid assets. Available data suggest that cash holdings of bond funds declined from 4.2 percent to 3 percent of assets under management in the quarter ending in March.

The combined actions of fund managers and authorities helped prevent funds from amplifying adverse liquidity conditions by selling bonds in a market under severe liquidity strains.25 If bond funds face another wave of large redemptions, they may be more vulnerable because they have used part of their cash buffer. By rapidly rebuilding their cash buffers, they can help avoid future forced sales of assets that are less liquid.26

The recent activation of the Contingent Term Repo Facility by the Bank could provide liquidity to market participants outside the traditional banking sector, such as asset managers. Mitigation measures have also been taken to prevent forced sales by asset managers due to possible credit downgrades. These measures include:

• more flexibility by fund regulators regarding how quickly fund managers must divest downgraded bonds
• postponement of index rebalancing to prevent forced sales of downgraded bonds by index funds

Financial market infrastructures

• Financial market infrastructures are operating well, supporting the continuous functioning of core funding markets and important payment systems. Operational changes related to COVID‑19, the high volume and value of transactions and elevated market volatility are all being managed carefully.

COVID‑19 poses challenges for financial market infrastructures (FMIs) because it has amplified the volume and value of transactions, increased market volatility and changed the operational environment. FMIs under the Bank’s oversight are managing these challenges, however, and continue to operate normally. Improvements in the ability of FMIs to manage risk since the 2007–09 global financial crisis, including the implementation of globally agreed-upon Principles for Financial Market Infrastructures, have put FMIs in a good position to handle the challenges. Some FMIs are using the lessons learned from the pandemic to improve their risk models further.

FMIs have invoked their business continuity plans, so most employees are working remotely, and only staff responsible for essential operations are on site. Despite increases in volumes and values transacted, activity remains within capacity constraints.

FMIs continue to assess how the COVID‑19 pandemic is affecting their ability to manage the default of one or more participants. Price fluctuations in excess of those included in FMI’s standard stress tests could result in central counterparties having insufficient financial resources to manage the default of a clearing member. In addition, impaired market liquidity and a more challenging operational environment could make it more difficult than usual to liquidate collateral and replace positions after a default.

Central counterparties have responded to higher market volatility by collecting more financial resources. For example, initial margins at the Canadian Derivatives Clearing Corporation (CDCC) have increased significantly. This includes a discretionary increase in initial margins beyond what was required by the standard model. As a result, the CDCC has more prefunded financial resources at its disposal if a clearing member were to default. More collateral improves the protection of FMIs but places additional pressure on the funding and liquidity positions of member financial institutions.

For payment systems, the Bank is committed to providing all the liquidity necessary to maintain their smooth functioning. To that end, the Bank has taken significant measures, including activating and expanding liquidity and asset purchase facilities and allowing settlement balances to increase.

The Bank also continues to work with the six largest Canadian banks and Payments Canada to enhance the resiliency of the wholesale payments systems through benchmarking, testing and information sharing. And the Bank continues to promote a modern, safe and efficient payments sector, even as innovation may be accelerating in response to COVID‑19 (Box 6).

Operational challenges

• Illness and remote work could disrupt crucial financial services. They might also leave financial institutions more exposed to cyber threats. The Canadian Financial Sector Resiliency Group meets regularly to share information and promote a coordinated response.

COVID‑19 has made financial system operations vulnerable to disruptions because some vital staff may become ill. In addition, not all roles can be effectively performed remotely. For example, security or technical requirements may require restricting some trading floor or back-office functions to onsite work. In addition, impaired communication and coordination may make remote work less effective.

The more challenging operational environment may have contributed to the market dislocations observed in March. It likely became more difficult to find counterparties, especially in over-the-counter markets where one-on-one negotiation is crucial. This contributed to greater uncertainty around market prices and overall market stress.

Major financial institutions, FMIs, central banks and governments have business continuity plans in place that help manage this vulnerability. Overall, these plans are allowing the financial services sector to continue to operate well in a remote work environment. Still, some challenges are surfacing as the plans are executed. For example, some firms have not provided adequate network capacity to support mass remote work, and network bandwidth in residential areas may not be sufficient to deal with it. In addition, it is unclear if these arrangements—designed to manage short-term disruptions—are sustainable for a long period. Financial institutions also need to closely monitor key service providers to identify any developing problems.

The Bank of Canada leads the Canadian Financial Sector Resiliency Group (CFRG). The mandate of the CFRG is to coordinate both resiliency initiatives and critical responses to systemic-level operational incidents in the financial sector. The CFRG Steering Committee currently meets biweekly to share status updates on the impacts of COVID‑19 and emerging operational issues, including cyber threats. This includes sharing information on business continuity plans and contributing to cross-government operational resilience initiatives, such as the weekly critical infrastructure discussion at the National Cross Sector Forum led by Public Safety Canada.

In addition, the move to remote work, increased pressure on information technology staff and general uncertainty could expose new weaknesses and leave financial institutions more exposed to other operational vulnerabilities. For example:

• Financial institutions may be much less capable of responding to and containing a cyber incident while they manage the effects of COVID‑19.
• A remote work environment that is difficult for security staff to control has changed and expanded attack surfaces that an attacker might exploit. The Canadian Centre for Cyber Security expects the remote workforce to almost certainly be targeted more and more by foreign intelligence services and cyber criminals.
• Changing trading patterns have made trade surveillance—which is necessary for security and compliance purposes—much more challenging.
• There is evidence of increased phishing and malware attacks designed to take advantage of the growth in remote work and the public appetite for information related to COVID‑19. Cyber criminals are also using public interest in new government support programs to lure users to malicious websites.