May 19, 2011 / 7:40 PM / in 6 years

Bank of Canada warns pension funds of risky buys

VANCOUVER (Reuters) - The Bank of Canada warned on Thursday that Canadian pension funds and insurance companies could be tempted to invest in risky assets in order to fulfill expectations of obtaining decent returns.

<p>Bank of Canada Governor Mark Carney walks to a news conference in Ottawa April 13, 2011. REUTERS/Blair Gable</p>

Timothy Lane, deputy governor at the central bank, said institutional investors are often expected or required to deliver a target rate of return.

In an environment where interest rates are still at extraordinarily low levels following the global financial crisis, the only way to achieve certain targets is by taking on extra risk, which can be rewarded by higher yields, Lane said in a speech in Vancouver, British Columbia, to an audience of professionals in the pension industry.

“This is a particular instance of the ‘search for yield’ that often accompanies a long period of very low interest rates,” he said.

“It may be associated with excessive credit creation and undue risk-taking as investors seek higher returns, leading to the underpricing of risk and unsustainable increases in asset prices,” he said.

Lane said new risks to the financial system were emerging as a result of a two-speed global economic recovery in which emerging markets are growing robustly and starting to raise interest rates to cool their economies while growth in advanced economies remains sluggish and rates still very low.

In addition, sovereign debt problems could indirectly threaten Canadian banks even though direct exposure to peripheral European countries is small. Debt problems elsewhere could hit Canada through higher funding costs and a decline in asset price valuations.

Canadian banks emerged from the global crisis unscathed and without need of bailouts. But policymakers say it’s too early to declare victory.

The Canadian central bank is busy developing new tools and models for assessing these emerging risks and Lane urged increased vigilance by policymakers elsewhere as well.

“The influence of sustained low interest rates in major advanced economies on risk-taking behavior is a powerful dynamic that bears watching,” he said.

Lane made no reference to current monetary policy in his speech. In answers to questions from the audience he repeated the bank’s already-stated view that the impact on inflation from high oil prices will be short-lived.

“Certainly energy prices have risen and that has been reflected, as we expected it to, in a run-up in overall inflation,” Lane said.

“That’s something that we expect to have a temporary effect on inflation as it passes through to the overall price level, but as we’ve seen so, far core inflation remains well anchored.”

The bank is widely expected to keep interest rates on hold at 1.0 percent on May 31, its next policy announcement date, and resume tightening in the second half of this year.

Reporting by Allan Dowd; Writing by Louise Egan; editing by Peter Galloway

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