AIMCo CEO Evan Siddall on Shadow Banks and Investing More in Canada

AIMCo CEO Evan Siddall wrote an op-ed for the Globe and Mail stating ‘shadow banks’ aren’t a problem for the financial system – they are the solution:

During the Great Financial Crisis of 2008-09, society paid a heavy price for having allowed financial institutions to become “too big to fail.” Now that the issue has been addressed through reforms, a new one has seemingly emerged: In the face of fears about the rise of “shadow banks,” regulatory sabres are being rattled among global financial regulators about non-bank financial institutions, or NBFI.

The term NBFI captures a wide range of enterprises and therefore defies a common regulatory approach. It is not monolithic and includes such varied enterprises as pension fund investment managers such as AIMCo, insurance companies, investment banks, broker dealers, hedge funds, mortgage investment companies – and still others. However, this diversity should rather be seen as a source of strength, not as a vulnerability.

NBFIs provide stability and balance in the financial system. That borrowers can secure loans through several non-bank models provides a wider range of competitive financing sources that strengthens our financial system. For example, my colleagues estimate that private lending by NBFIs over the past two years has replaced as much as US$1-trillion in merger-and-acquisition financing activity, as banks have been sidelined.

These developments, together with reforms after the financial crisis, most notably those strengthening bank minimum capital and liquidity requirements, have made the world a much safer place financially. In the past year, markets largely shrugged off the respective collapses of Credit Suisse, Silicon Valley Bank and First Republic. That would have been unthinkable 15 years ago.

Fears about increases in lending by NBFIs are overblown and regulatory backlash therefore risks undoing one of the intended consequences of recent regulatory reforms: slowing the growth of big banks.

These big banks, which are subject to heavier regulations, call lending by NBFIs “regulatory arbitrage,” as nefarious a term as “shadow banking.” In his annual letter, JP Morgan Chase chief executive Jamie Dimon bemoaned the declining market share of banks in the financial system. He decried NBFI’s regulatory arbitrage and accused them of “dancing in the streets” because of it.

That’s rich, since the implicit government guarantee of banks that the reforms have ended was the likely the greatest regulatory arbitrage in history. Let us not forget the US$15-trillion in bailouts, government guarantees of bank liabilities and special central bank liquidity schemes that saved a global economy brought to its knees.

Indeed, that “heads I win, tails you lose” moral hazard benefited JP Morgan the most of any bank, as the largest such institution by far.

Banks are more heavily regulated, for good reason. Their core business is maturity transformation: Borrowing short-term deposits from savers to fund long-term loans to companies, mortgagees and others. They are also highly levered, often up to 14 to 1. Bank runs, a crisis of confidence, can turn a solvent, functioning bank into one that has to shut its doors overnight.

While banks are an essential accelerator of economic growth, their susceptibility to bank runs is a key source of financial instability. Government-sponsored deposit insurance therefore helps reduce the risk of bank runs. As a consequence, banks must submit to more stringent regulation.

That’s the deal, Jamie, and you know it.

Nevertheless, the more NBFIs look like banks – for example, with open-ended short-term funding, high levels of leverage, significant derivative exposures – the more liquidity they should hold and be required to hold. The Bank of England’s systemic stress test of NBFIs made sense after a liquidity squeeze that was triggered by sharp declines in British government bonds (Gilts) in 2022.

That is why while private lending accounts for less than 10 per cent of our investing and we carefully target our use of derivatives. AIMCo constantly measures our own 60-day “stressed liquidity coverage” to protect against exactly these financial catastrophes. The Canadian “Maple 8″ pension fund investors also communicate regularly with the Bank of Canada to anticipate and manage financial market stresses.

We are still paying the huge bills from the bailouts of 2008 and 2009 that severely damaged people’s trust in our financial system. A rush to regulate non-bank institutions seems tempting in light of the regulatory oversights that precipitated the problem 15 years ago. But critics need to understand that regulatory progress since then has created a more stable, resilient and trustworthy financial system, the rise of NBFIs included.

There is a lot of discussion these days on shadow banks and the systemic risks they pose to the financial system. 

To wit, Game of Trades recently posted this on X:

And just today I read this:

Moreover, not wanting to be outdone, big banks want in on the private credit boom:

So what is going on here? Do shadow banks pose systemic risks to the global financial system?

I think Evan Siddall makes a good point in his op-ed, namely, not all non-bank financial institutions, or NBFIs, operate the same way and some are a lot more prudent than others but this diversity of actors has been good for the market, providing much needed financing solutions to small and medium sized enterprises.

However, Evan also states this:

Fears about increases in lending by NBFIs are overblown and regulatory backlash therefore risks undoing one of the intended consequences of recent regulatory reforms: slowing the growth of big banks.

Big banks want in, there's no two ways about it, and that rings alarm bells in my head that now is definitely the time to increase regulatory scrutiny in the private credit space. 

Why? Because you want to make sure everyone is respecting minimum underwriting standards and now is probably the time to scrutinize lending before we head into a major recession.

And there are important risks and considerations in the space.

For example, Amy Stone of Barron's recently discussed Blackstone’s gigantic private credit fund, BCRED, stating this:

The fund, which launched on Jan. 7, 2021, has distributed 10.5% annually to investors since inception, the company said in a letter to shareholders on Monday. Its total return since launch has been 10.1%, outpacing high-yield, bank loan, and corporate bond indexes during that time, the letter added. Those are the publicly traded asset classes that private credit is most comparable to. 

The fund has ballooned to $50.7 billion in assets as some financial advisors have embraced alternative investments generally, and private credit, or loans made to private companies, in particular. Private credit offers high yields, floating rates, and has some defensive characteristics at a time when interest rates are fluctuating.

The 10.1% total return since inception is far less than the 10.5% that the fund has returned to investors annually over three years. That’s because its net asset value dipped in 2022 and increased only 0.6% over the three years. Nonetheless, its loans yielded more than 12%, outearning its annualized distribution yield, according to the shareholder letter. The extra yield accrued to its NAV. The fund’s 2023 total return was 14.4% for Class I shares.

The shareholder letter says the distributions have been consistent, despite shifting interest rates. “Every year has expressed a different market environment,” the letter says, pointing out that benchmark interest rates were very low in 2021, rose sharply in 2022, and then remained high in 2023. “Despite these different environments, BCRED’s defensive portfolio demonstrated resilience by delivering strong total returns for its shareholders.”

Liquidity premium? Although the fund’s three-year total return performed better than indexes of comparable publicly traded assets, private credit differs from them by being much less liquid. BCRED, which is structured as a private business development company, allows investors to redeem shares quarterly and even then, redemptions may be restricted if a lot of investors want to get out at the same time. 

This happened at BREIT, Blackstone’s large private real estate fund, which deployed gates when too many investors sought to exit the fund in 2022 amid concerns about weakness in corporate real estate. Such gates protect the remaining investors because the fund’s portfolio managers don’t need to sell holdings at fire-sale prices to meet redemptions. Such restrictions can be a shock, however, to investors who are used to being able to sell securities immediately. 

Advisors need to make sure their clients have long time horizons and understand the risks of investing in a fund with liquidity constraints. If the economy turns south and credit spreads widen, investors in BCRED could seek to exit and trigger such gates. So far BCRED has fulfilled all redemption requests.

BCRED’s managers see favorable conditions ahead. “Entering 2024, we continue to be optimistic as favorable market tailwinds have the potential to benefit private credit funds,” its shareholder letter says.

Like some other private credit vehicles, BCRED has some defensive characteristics. It is made up of 98% senior secured loans (meaning they’re first in line to get paid back in defaults). The loans are made directly to a diverse set of large private companies that, although they may not be rated investment grade, can generally cover their interest expenses from cash flow. Blackstone, by virtue of its size and scale, can negotiate strong investor protections, or covenants.

Because they aren’t traded, private credit funds tend to be less volatile than their publicly traded counterparts, such as business development companies, or BDCs.

A pullback in corporate lending by some banks has helped fuel the growth of private credit as an asset class, but it has attracted critics, who are concerned a dearth of regulation in private markets puts broader financial markets at risk. Regulators are taking a closer look, and advisors should scrutinize fees and management strategy closely, which isn’t easy in private funds.

Now, I'm much more comfortable with large, sophisticated pension funds investing in Blackstone, Apollo and other large funds because they have the long investment horizon and sophistication to understand the risks involved.

Again, we have not had a serious recession in a while and if that happens, private credit will be battle tested.

That's why Pimco is taking a contrarian bet here. 

And this is why I'm reticent to recommend private credit at large to investors.

If you're going to invest in the space, make sure you go with someone experienced like Antares Capital (see recent comment where Andrew Edgell,Senior Managing Director & Global Head of Credit Investments at CPP Investments talked about how he sees private debt faring in the credit cycle ahead).

The way I see it, the problem isn't with the top funds in the space, it's with new entrants, including big banks, which I call the Johnny-come-lately funds who take a lot more risks to make bigger returns.

That's a disaster in the making and it will reverberate across the industry.


In related news, AIMCo chief executive Evan Siddall said last Thursday in an interview with BNN Bloomberg that the Trans Mountain pipeline is the type of Canadian infrastructure asset that the investment manager would consider if it is made available:

AIMCo spokeswoman Carolyn Quick later confirmed the remarks in an email to The Canadian Press.

The Trans Mountain pipeline is Canada’s only oil export pipeline to the West Coast, and construction on its ongoing expansion project is expected to be complete in the near future.

The federal government purchased the pipeline in 2018 in order to ensure the completion of the expansion, but has indicated it does not wish to be the long-term owner of the pipeline.

AIMCo is one of Canada’s largest institutional investors, with 17 pension, endowment and government fund clients in Alberta.

I personally believe that AIMCo or another large Canadian pension fund would be a great fit to own the Trans Mountain pipeline but unfortunately, I do not see the federal government selling this asset anytime soon.

Lastly, I commend AIMCo for being recognized once again as Alberta's top employer, especially for young people.

An organization where young employees feel engaged and thrive is one with a solid future.

I will give Evan Siddall and all his senior team credit here because they take the culture of the organization very seriously and want to make sure all employees feel valued and engaged.

Below, Evan Siddall, CEO of the Alberta Investment Management Corporation (AIMCo), joins BNN Bloomberg to talk about the investing landscape for pension funds in Canada. He says Canada is currently attractive but needs more incentives to attract more Canadian national and foreign buyers.