Mr Thiessen reports on the future of the Canadian financial sector, the economy and monetary policy  (Central Bank Articles and Speeches, 22 Mar 1999)
Central bank: boc | Type: speech | Date: 1999-03-22

## Mr Thiessen reports on the future of the Canadian financial sector, the economy and monetar policyRemarks by Mr Gordon Thiessen, Governor of the Bank of Canada, to the Mennonite Savings a Credit Union Kitchener, Ontario 22 March 1999.I am delighted to be with you this evening to celebrate the 35th annual meeting of the Savings and Credit Union.

On this occasion, I propose to speak about the Canadian econom monetary policy.

But given this audience, I thought I might start with some remarks on the the Canadian financial sector - a subject that has certainly grabbed its share of headlines year!In December 1996 the Minister of Finance appointed a Task Force to assess the current situ the future prospects of the Canadian financial services sector, and to make recommendat change.

In early 1998, while this inquiry was still on, four of Canada's six largest bank plans to merge.

The Task Force submitted its report (the MacKay Report) last Septemb December 1998 the Minister of Finance, having taken into account that report as well as as of the proposed mergers by the Office of the Superintendent of Financial Institutions Competition Bureau, decided not to allow the mergers.

The Government is now examining the i facing the financial services sector and, in the course of 1999, it intends to present it modifying the relevant regulatory framework.The Bank of Canada is one of several agencies in Ottawa that provide advice to the Min Finance on the appropriate legislative framework for the financial industry.

Because of thi in a position to comment on specific proposals for change.

But what I can do is offer som comments on the broad issues involved in ensuring an efficient and sound financial ind Canada as we strive to adapt to ongoing worldwide changes in the provision of financial serv

## Potential reforms of the Canadian financial systemCanadian financial institutions are among the best providers of financial services in the w days, they are operating in an intensely competitive global marketplace, teeming with change by rapid advances in technology and innovative new financial products.

These powerful forc transformed the way financial institutions around the world operate and the way they mar deliver their services.Globalization creates both opportunities and challenges.

We must make sure that Canadian f institutions can compete effectively in both domestic and international markets, and tha offer Canadians innovative, world-class financial services.

The MacKay Task Force says thi we should enhance competition in the financial services industry.

How?

Primarily by r restrictions on existing providers of those services and by encouraging new players to enterMembers of this audience know that one of the proposals for strengthening the position of participants is to give credit unions the option to form cooperative banks.

More generall prudential concerns can be resolved, the Task Force suggests that the regulation of credi re-examined to encourage them to become more active, dynamic competitors within the fina industry.We would all agree that consumers of financial services are best served when there is competition among financial institutions.

A strongly competitive financial industry wil customers with the best deals for loans, deposits, insurance, and so on.

Such an industry wo more innovative and should provide a wider range of services.But the appropriate legislative framework for financial services cannot be one that simply competition without regard for the safety and soundness of the industry.Why all this concern about safety?

And why do we regulate this particular industry more closely virtually all others?There are two main reasons.

First, the financial industry is the repository for the wealth of number of small savers.

For most of these savers, it is very difficult and costly to make a p judgment of the risks involved in doing business with a particular bank, credit union, or ins company.The second reason has to do with what we call systemic risk, or contagion.

This refers to the ri problems in one particular financial institution will be transmitted to others.

Contagion can when depositor nervousness about one institution spreads to others.

As well, since the payme system links financial institutions closely together, the failure of one institution can potentia serious losses for others.Governments have addressed safety concerns by imposing capital requirements on financial institutions, restricting their ability to engage in risky activities, supervising their adhere reducing practices, and setting up deposit insurance.

To limit contagion, central banks have the to make liquidity loans to financial institutions in the payments system.

And most central ban industrial countries have been involved in initiatives to minimize the potential for systemic their payments systems. 1When depositors feel 'protected', however, they are less inclined to monitor the riskiness of fi institutions.

Thus, governments feel a greater need to regulate to reduce the risks of insti failure.

This tends to have side effects which could potentially restrict competition.What then is the scope of increasing competition, by encouraging new players and by reducin restrictions on existing ones, without undermining the safety and stability of the system?

Cl there can be a tension between the goals of fostering greater competition within the financial and of preserving safety and stability.

To find a balance between the twin objectives of efficie safety has always been a challenge for governments when they examine proposals to change the regulatory framework for the financial system.I do not mean to make this sound like an impossible task.

There are bound to be some changes t can help promote competition without adding substantial risk to the system.

More generally, thou believe that we need to examine ways that could ease the tension between efficiency and safety. example, if we are to encourage the entry of new financial institutions as a means of promo greater competition, perhaps we should also consider a more formal, explicit policy of 'early when an institution runs into trouble.One possible approach would be that when institutions reach some minimum level of capital, th would be required to recapitalize themselves or find a merger partner within a short period of Otherwise, and well before they became insolvent, they would be sold or wound up by the regulato authorities.

Such an approach might help reduce risks to depositors, to the deposit insurance s and to other creditors of financial institutions.

This is not a new idea.

The United States has moved in that direction and so have we in Canada, to a certain extent.

But there may be room to further down this path and, in so doing, to provide managers of financial institutions with s incentives to avoid getting into financial difficulties.To summarize, I agree with the MacKay Task Force that encouraging new participants and reducing restrictions on existing players in the financial industry would benefit customers through imp service and lower costs.

But this may have the potential to increase risks for the financial sy we need to look at ways to avoid having these risks add to the costs of deposit insurance and1 In Canada, under the Payment Clearing and Settlement Act, the Bank of Canada has been given formal oversight responsibility for ensuring that appropriate arrangements are in place to manage and control sys risk in major clearing and settlement systems.costs for other users of financial services.

One approach, as I mentioned, is to move furt 'early exit' arrangements for troubled financial institutions.

Such arrangements might not implement.

But if we could move in this direction, there might be more scope to benef enhanced competition without exposing users of financial services to unacceptable r compromising the stability of the system.I would now like to turn to our economic situation and monetary policy.

## The state of our economyThe past year has been a trying one, both for the world economy and for Canada.

Still, consi seriousness of the global difficulties we have been facing, the Canadian economy has cop better than expected, and certainly better than in the past.

This is because it is in soun than it has been for many years.

Canadian businesses have been investing in new techno increase productivity and efficiency.

Governments are no longer draining national savings t huge budget deficits.

And with the Bank of Canada's commitment to inflation control t inflation is low and stable.But what about our economic prospects as we look ahead?Let me start with the financial climate.

Global financial markets have been calmer recently with the turbulence last autumn after Russia declared a debt moratorium.

Cuts in official i around the world since then, and the success of some emerging market economies in addressi problems, have clearly helped.

International investors' fears have abated, and markets see regained a sense of their ability to assess risks and discriminate among borrowers.When it comes to the world economic environment, there is still uncertainty out there.

But also positive elements in the picture.One area of uncertainty is the financial problems in Brazil and the extent of related weakness in Latin America more generally.

If the Brazilians follow through on their fiscal program and limit the inflationary fallout from the depreciation of their currency, fina pressures should ease, and growth in Brazil should resume next year.But the foremost uncertainty in the outlook continues to centre on Japan, where the economy in a slump.

Nevertheless, if present efforts at bank reform continue, and if stimulative ma initiatives are pursued systematically, the Japanese economy should begin a gradual recover by late 1999.The economic expansion in the other industrial countries, which together account for abou world output, should remain relatively well sustained.

In Europe, economic activity has sof interest rate cuts since the autumn and the easing of global financial strains should confidence and domestic spending in coming months.The most positive element, certainly from a Canadian perspective, has been the rema performance of the United States.

That economy ended 1998 on a much stronger note than had expected, growing at an annual rate of 6% in the fourth quarter of 1998.

Thus, its u momentum going into 1999 is much greater than most had supposed.

This is confirmed by some o advance data for early 1999.

So even if growth slows, as expected, the US economy should c to operate at high levels.There are also signs that the sharp economic downturns in some of the Asian countries most by the financial crisis are bottoming out.

The economy of South Korea has started to expan Thailand economic activity seems to have stabilized.

However, a broad-based recovery in th has yet to take hold and will depend, to an important degree, on economic conditions in JapaHere in Canada, the impact of the global turbulence since the summer of 1997 was felt main through the lower demand for the key primary commodities we produce and the 20% decline in thei prices between mid-1997 and end-1998.

But consumer and business confidence were also affected, and that dampened domestic spending.

Consequently, the Canadian economy expanded by just under 3% through 1998 (fourth quarter over fourth quarter) compared with over 4% in 1997.However, after some weakness through last summer and early autumn, our economy showed renewed strength recently.

Helped by buoyant US demand, easing global financial strains, and the rebo from major labour disruptions, economic activity grew at an annual rate of 4.6% in the final quar 1998.

And this was accompanied by robust, broad-based employment gains through the closing months of 1998 and into early 1999.With world economic and financial conditions still fragile and the timing of a firm recover primary commodity prices uncertain, projections for 1999 remain tentative.

But with recent hea employment growth, domestic spending should continue to contribute to an expanding economy.

And sustained US demand, coupled with our improved competitiveness, should continue to bolster ou exports.

Altogether, we are looking at a somewhat more positive scenario than seemed possible l autumn.

## The response of monetary policy to international turbulenceLet me now say a few words about how the Bank responded to the exceptional global events of th past couple of years.As commodity prices tumbled, we became less well-off as a nation.

Distressing as that is, it is a Canada had to face.

And our currency moved downwards, reflecting - not causing - the drop in ou economic prosperity and the need to adjust.When shocks like this hit us from time to time, movements in the external value of the Canad dollar help 'buffer' the shock and smooth the process of adjustment.

If the currency is not allo move, the adjustment will drag out and cost more in terms of losses in output and employment.However, the relatively orderly depreciation of our currency through to July 1998 accelera following the Russian crisis last August.

And Canadian longer-term interest rates rose sharply time when comparable US rates were falling.

To us at the Bank, this signalled a potential lo confidence in Canadian dollar assets, which we moved to head off by raising the Bank Rate by 1 basis points.

In so doing, we sought to limit the harmful effects of financial volatility on co by temporarily placing particular emphasis on calming markets.The situation has improved since then.

Interest rates have been cut in all major industrial co and a measure of stability has returned to world financial markets.

With this, concerns in Can markets have diminished, allowing us to unwind three-quarters of last August's increase in the Rate.

Calmer financial markets should now make it possible for the Bank to refocus attention on medium-term policy objective of keeping the underlying trend of inflation inside the target ran 1% to 3%.In conclusion, let me say that, given the financial market volatility and the global economic slo of the past couple of years, our economy has coped relatively well.

And we begin 1999 on a posi note.

This is testament to Canada's improved basic economic foundation these days.

And it gives reason to remain positive about our future despite lingering international uncertainties.