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A recent Bank of Canada report puts the value of this shadow sector in Canada at the end of 2017 at $1.5 trillion — about 10 per cent of total financial assets and 34 per cent of total assets of all deposit-taking institutions. The sector’s share of overall financial activity hasn’t actually grown. But in absolute terms its assets have doubled since 2005, growing 30 per cent between 2015 and 2017 alone. It’s now too big to ignore.

On the one hand, then, these financial institutions provide much needed competitive alternatives for both depositors and borrowers. But both because they aren’t as closely regulated as banks and because deposit insurance doesn’t cover their liabilities (which in the example were the mutual fund shares the NBFI issued) they might increase overall risk in the financial system. If an NBFI goes down, the damage to the system may well be greater than it was when the shadow institutions were smaller.

In some recent research we tried to determine whether the shadow sector might hinder the Bank of Canada in hitting its two per cent inflation target, and if so, why and how that might in turn affect financial stability.

When we think about how monetary policy affects the real economy, the story goes something like this: the Bank of Canada surprises markets with a hike in the overnight rate, causing an increase in the cost to banks of providing loans, which lowers the supply of credit available in the broader economy, which in turn slows spending, investment, and the economy at large. But this story is about traditional banks alone. How might the shadow sector change the story?