OSFI Highlights Spillover Risks from Non-Bank Lending and Cyber Threats
Canada's federal banking regulator, the Office of the Superintendent of Financial Institutions (OSFI), has identified exposure to non-bank lenders, including hedge funds, as one of the top three risks to the financial sector. In its annual risk outlook released on Tuesday, OSFI emphasized the expansion of risks outside the traditional banking system, particularly in areas where non-bank lenders and investment funds are increasing their borrowing activities.
Growing Concerns Over Non-Bank Lending
Federally regulated financial institutions have become active lenders to private capital firms, their portfolio companies, and clients. OSFI noted that the opaque nature of this leveraged market can mask problems and intensify losses during times of stress. "Canadian institutions' exposures to private capital firms and their portfolio companies have grown considerably in recent years, representing a material component of the balance sheet," the report stated.
In addition to lending to and investing in private capital firms, Canadian institutions are also competing with less-regulated private lenders. "Competition with less-regulated firms can lead to riskier lending terms and the opaque nature of the market can mask weaknesses," OSFI warned.
Top Risks for 2026
OSFI's other top concerns include:
- Real estate secured lending: Housing and mortgage pressures have increased in some parts of the country, particularly in Toronto and Vancouver, with potential impacts from trade negotiations, global conflicts, and commodity prices.
- Liquidity and funding risk: This remains a critical area of focus for the regulator.
Cybersecurity and Other Key Risks
Despite high-level meetings in Ottawa this week about cyber risks posed by new artificial intelligence models, cybersecurity is further down on OSFI's list of highlighted risks. However, the regulator remains vigilant over a longer list of key risks, including:
- Wholesale credit risk
- Artificial intelligence
- Cyber and technology risks
- Integrity and security
- Third-party risk
Spillover Risks from Unregulated Players
OSFI flagged banks' increasing use of unregulated and lightly regulated financial players, such as hedge funds, to provide credit protection on their lending portfolios. This is often done through arrangements like synthetic risk transfers, where banks pool loans and sell tranches of credit risk to non-bank investors while retaining the loans on their balance sheets.
The regulator is concerned that these non-bank financial institutions might have reduced capacity to provide credit protection during times of stress, which could:
- Increase credit risk for banks
- Negatively impact their capital levels
- Crimp their ability to lend to core clients
Hedge Fund Involvement in Sovereign Bond Markets
OSFI also expressed concern about the potential impact on federally regulated financial institutions from increasing hedge fund involvement in sovereign bond markets, which underpin bank liquidity and capital frameworks. "Any material dislocation in the sovereign markets... could cause spillover—straining funding conditions and reducing liquidity coverage," OSFI stated.
The regulator's comprehensive risk assessment underscores the evolving challenges in Canada's financial landscape, emphasizing the need for continued vigilance and adaptive regulatory measures to safeguard the stability of the financial system.
