Shadow Banking Draws Canadians Where U.S. Banks Are Warned Away

Canada’s largest money managers are joining the ranks of America’s shadow banks.

Public Sector Pension Investment Board, Canada’s fifth-largest pension plan, said last month it intends to open a loan-origination business in New York by year-end. That follows the Canada Pension Plan Investment Board’s $12 billion deal to acquire General Electric Co.’s business that lends to smaller companies.

The Canadians are part of a wave of institutions unencumbered by U.S. regulation searching for higher returns in the market for risky loans to American companies. Bank supervisors there are pressuring the biggest lenders to pull back from deals that load up companies with too much debt, seeking to avoid a credit bubble that could damage the U.S. economy.

“Whenever you have regulatory constraints and it closes down a market, it provides opportunities for those who fall outside the regulatory constraints,” said Alan White, professor of investment strategy at University of Toronto’s Rotman School of Management.

Joining Apollo

The Canadian funds, which have pioneered the strategy of using alternative investments in pensions, are joining private-equity giants KKR & Co. and Apollo Global Management LLC and other nonbank firms in seeking to profit from high-yield credit as central banks around the world suppress interest rates. Canada’s biggest private-equity firm, Onex Corp., has also moved deeper into the U.S. market, ramping up its business packaging the debt as securities with an eye to doubling that unit’s assets in two years.

For the Canadians, the yields are a significant boost to what’s available back home in ultra-safe government bonds. U.S. leveraged loans yielded an average 5.3 percent last month, while loans to middle-market companies yielded 6.3 percent, according to Standard & Poor’s Capital IQ Leveraged Commentary & Data. Lending money to the Canadian government for five years on the other hand currently yields 0.8 percent and 1.5 percent for 10.

Extending Push

With the purchase of GE’s lending unit, Canada Pension is expanding a push it first made into U.S. lending in 2008. The unit helps buyout firms line up funding.

“For us, it’s an opportunity to gain significant exposure to the middle-market lending space,” said Mark Jenkins, global head of private investment at Canada Pension, which manages C$264 billion ($201 billion) on behalf of 18 million Canadians.

The risks associated with purchasing the mid-size leveraged loan business are not as pronounced as some would suggest, in part because the size of the loans are relatively small and not concentrated with any one company, he said.

The GE business will operate independently from Canada Pension and won’t be integrated into the pension fund itself, he said. Outside of the middle-market loan space, any other leveraged credit exposure will come out of the principle credit group at the pension fund, he said.

The new credit office at Canada’s Public Sector Pension, which manages C$112 billion for federal public servants, will include loan originations and other alternative debt securities, said Jessica McEachern, a PSP spokeswoman. Over time, the intent is to transfer the expertise it builds in the U.S. to Montreal, she said.

U.S. banks have been pulling back after a post-crisis crackdown on risky lending. As part of the increased oversight, banking regulators issued fresh lending guidelines in 2013 aimed at tightening underwriting standards.

Into Shadows

As the business gets picked up by lenders that don’t have the same level of oversight, it’s raised concern that underwriting standards could slip further.

“We are seeing some activities migrate into the shadow banking system to escape prudent capital, liquidity, or risk management standards,” Thomas Curry, the U.S. Comptroller of the Currency and one of the regulators that set the lending guidelines, said in an e-mailed statement. “Regulators should pay close attention to the movement of risk throughout the entire financial-services industry.”

Shadow banks are firms that act like lenders but don’t have depositors, federal bank regulations or access to the Federal Reserve’s discount window, where banks can borrow when money is tight.

“Do we want pensioners in Canada taking risk? Well, if they leave all their money in bank deposits and Canadian government bonds, they’ll be very safe but they won’t make very much,” said Darrell Duffie, a Canadian economist at California’s Stanford University. “The question is, how much of these leveraged loans and other risky assets the pension funds take.”