Mark Carney: From hindsight to foresight
Remarks by Mr Mark Carney, Governor of the Bank of Canada, to Women in Capital
Markets, Toronto, Ontario, 17 December 2008.
* * *
It has been a difficult year for capital markets professionals. The turmoil has deteriorated into
a full-blown financial crisis. Most financial markets have experienced historic falls in prices,
and some are strained to the point of closing. Issues of financial stability that were once the
obsession of a pessimistic few are now the daily concern of many. Policy-makers have had
to respond with bold measures. These will work, although it will take time for confidence to
return and for capital to flow once again. In the interim, the dramatic repricing of risk across
financial assets will be increasingly mirrored in the real economy. Businesses are already
beginning to postpone large investments, and households now hesitate over major
purchases. Partly as a consequence of financial instability, next year will be a trying one for
many Canadians.
Few forecast these events; although, in an outbreak of retrospective foresight, an increasing
number now claim they saw it coming. The reality is that among all the banks, investors,
academics and policy-makers, only a handful were able to identify ahead of time the causes
and potential scale of the crisis.1 Central banks, ministries of finance and international
financial institutions all believed either that risks were being adequately managed or that
vulnerabilities lay elsewhere. Around the world, private banks exceeded their regulatory
capital requirements. Clearly, though, risks were not being managed properly and capital
was inadequate.
Now, in the rush to respond, we must avoid building the financial equivalent of the Maginot
line - overpreparing for a repeat of current events while remaining vulnerable to the root
causes of the next crisis. Rather, we must develop early-warning systems with precision and
with teeth. This will require progress internationally and domestically.
Internationally, both the Financial Stability Forum (FSF) and the International Monetary Fund
(IMF) must become more effective. There are several ways of accomplishing this. The first is
to divide more clearly responsibilities between these bodies, with the IMF having primary
responsibility for surveillance (i.e., the early-warning system) and the FSF for coordinating
the development of a resilient financial system. Second, policy-makers themselves must
become more engaged. The value of international organizations is not that their
bureaucracies possess unique powers of insight, but rather that they can convene senior
policy-makers, challenge them, and then forge a consensus on how to foster sustainable
global economic growth. Third, countries must recognize that membership in these
organizations brings responsibilities. This is why Canada successfully pushed at the recent
G-20 summit for mandatory regular reviews of each country's financial system by the IMF (a
process carried out under the Financial Sector Assessment Program or FSAP). Finally, it
matters who is around the table. In Washington last month, G-20 leaders agreed to expand
the FSF to include key emerging markets. These countries not only have first-hand
experience of financial crises but also are the major surplus countries who, as major capital
providers, need to be part of a global solution.2
Domestic responsibility for financial stability is currently shared among a large number of
federal and provincial bodies. This includes the Bank of Canada, which is mandated by
legislation to "promote the economic and financial welfare of Canada." Today I would like to
focus on how the Bank can fulfill this broad mandate by contributing to financial stability in
Canada.
A macroprudential approach
A clear lesson of the current crisis is the need to take a macroprudential approach to
financial stability. Macroprudential surveillance assesses current risks by looking at the broad
economic and financial conditions that can contribute to the buildup of risks to the financial
system and the economy as a whole. Macroprudential regulation seeks to improve the
resiliency of the financial system by designing standards and codes to limit the buildup of
financial and economic imbalances. Put simply, a macroprudential approach focuses on the
forest, not the trees.
Two topical fallacies of composition illustrate the point. The first is what Keynes termed the
"paradox of thrift." It may be individually rational for people to want to save more and
businesses to invest less during uncertain economic times. If this behaviour is widespread,
however, it becomes collectively irrational. Fear of recession feeds a recession. Similarly, a
bank may decide to hoard capital in anticipation of increased loan losses during a slowdown.
If all banks do the same, their actions will exacerbate the downturn and increase their
eventual losses. It is well-known that timely and properly calibrated monetary and fiscal
policy can address the first issue. It is less widely recognized that macroprudential regulation
can address the second.
In many ways, the central bank is ideally suited to bring a macroprudential approach to
financial stability. Our mandate demands that we take an economy-wide perspective.
Further, we have a strong motivation to maintain a stable, efficient financial system because
we rely on it to transmit our monetary policy actions. However, we do not have many of the
tools necessary to secure financial stability. Monetary policy is a blunt instrument, poorly
suited to addressing financial imbalances. Instead, macrofinancial stability should be one of
the core objectives of financial regulation. Until it is, under the current framework, the Bank
can promote financial stability through two tools: liquidity and advocacy.
The Bank is the ultimate source of liquidity within the economy. We have used our recently
enhanced powers under the Bank of Canada Act extensively throughout the crisis, with
measures that now total more than $36 billion of term liquidity. There are four important
points of context. First, we are not supplying net liquidity to the system - there is no new
central bank money. Rather, we are redistributing liquidity by exchanging liquid assets for
high-quality, though less-liquid ones. Second, we are substantially over-collateralized to
protect our balance sheet.3 Third, consistent with Canada's relatively strong banking system,
our liquidity provision has not been as large as elsewhere. For example, the Bank of Canada
is currently providing liquidity equivalent to around 1 per cent of total domestic banking
assets. The comparable figures are 4 per cent in Europe, 5 per cent in the United Kingdom
and 6 per cent in the United States. Finally, while the provision of extraordinary liquidity by
central banks is limiting the damage from the crisis, it has long been apparent that official
liquidity, irrespective of size, cannot re-open markets on its own.
The Bank's second tool - advocacy - has not received the same profile as the first - a fact I
hope to begin to change today. The Bank can promote financial stability by influencing public
sector policies and private sector behaviour. We do this in two ways; by leveraging our
position in key domestic and international organizations, and by producing solid analysis and
research to ground our advice. Domestically, we work closely with representatives from the
Federal Department of Finance, the Office of the Superintendent of Financial Institutions
(OSFI), the Canada Deposit Insurance Corporation, and the Financial Consumer Agency of
Canada. We meet regularly to share information, coordinate actions, and advise the federal
government on financial sector policy. Within this group, the Bank of Canada is the only
organization that brings a solely macroprudential perspective to the table - a perspective we
intend increasingly to assert.
Improving our analysis and sharpening our accountability
In recent years, the Bank has made financial stability a strategic priority. Strengthening this
priority was one of the primary motivations behind our internal reorganization last month. We
now have a department dedicated to financial stability, and we are investing heavily in our
research and analysis. We are hiring senior capital markets professionals and drawing on
leading academics as special advisers. In addition, the mandate of the Bank's Governing
Council has been sharpened to add financial stability assessment to its responsibilities. The
deputy governors and I should be held accountable for our analysis; others for whether or not
they follow our advice.
To be clear, we are not seeking to identify every worthy reform in the financial sector (they
are legion). Rather, we will seek to identify stresses in the economy as well as the
regulations and practices that have the potential for serious macroeconomic consequences.
In doing so, we will want occasionally to change behaviours, conventions and even
regulations to mitigate threats.
The latest edition of the Bank's Financial System Review (FSR), which was published last
week, is a first step. It contains, for the first time, the judgment of the Governing Council as to
the main risks to Canadian financial stability. I will return to this shortly. First, I will say a few
words regarding an article in the current FSR, which details efforts by Bank staff to construct
an early-warning indicator for financial stress in Canada.4
An early-warning system
The Bank of Canada has developed a financial stress indicator, the FSI, which uses a
number of domestic variables to measure the degree of financial stress in the economy.5 As
you would expect, the FSI is now showing record levels of stress. It is correlated with how
you all probably feel. While this indicator does an excellent job of measuring stress in real
time, our objective is to develop empirical measures that could forewarn of potential financial
crises. In other words, given that the FSI accurately measures financial stress, what
accurately predicts changes in the FSI?
It has been clear for some time that rapid growth in credit and sustained growth in asset
prices often precede financial crises. Bank researchers have found a promising tool for
assessing Canada's vulnerability to crisis: a combination of growth in domestic business
credit and real estate prices that tends to be a good predictor of changes to the Bank's
financial stress indicator one to two years in the future. However, this combination was
unable to predict the current crisis because the root causes came from outside Canada.
There is ongoing work at the Bank to refine these tools, which could prove important, not
only for predicting future periods of financial instability and thereby prompting timely
corrective actions, but also for the development of countercyclical capital rules that I will
discuss in a few minutes.
Current risks to stability
In the FSR, five major risks to financial stability were identified: first, the liquidity and funding
of financial institutions; second, their capital adequacy; third, the state of household balance
sheets; fourth, the possibility of a more prolonged downturn in the global economy; and fifth,
the threat of a destabilizing unwinding of global financial imbalances. Let me now spend a
few minutes discussing the first three of these risks in some detail, although I should stress
that these are risks, and not the most likely outcomes.
Funding and liquidity
The current crisis began in the summer of 2007 as liquidity dried up, leading to major
disruptions in money and bond markets. In response, the Bank of Canada provided
exceptional liquidity to core financial institutions, with the expectation that this liquidity would
cascade through the financial system. This was indeed the case this past spring. With the
intensification of the crisis since September, our liquidity efforts have been significantly
expanded. While these actions have sharply lowered money market spreads and
encouraged some lending at longer maturities, conditions remain far from normal.
Bond issuance has been slow to return, which is putting greater pressure on banks as the
sole source of lending growth. In tandem, financial institutions have curtailed their central
roles as intermediaries and market-makers. This feeds illiquidity and volatility in financial
markets and delays the return of confidence in the financial system. This could aggravate the
adverse feedback loop between the financial system and the real economy.
In essence, we have gone from one extreme - with overabundant liquidity leading to the
misallocation of capital - to another - where, in some systemically important markets, capital
is barely being allocated at all. The challenge for policy-makers is to provide transition
support that effectively restarts rather than replaces markets. As I have argued elsewhere,
this may require structural changes to some markets, including the greater use of clearing
houses, and a re-thinking of the scale and frequency of central bank liquidity operations.6
Procyclical capital adequacy
The second risk identified in the FSR is the procyclicality of bank capital. Put simply, banks
characteristically increase leverage in a boom, further feeding the expansion, before
reducing leverage in a downturn, exacerbating the slowdown. Regulation often reinforces
these tendencies when it should lean against them. This is now a serious global problem.
Banks outside of Canada are under enormous pressure to reduce leverage. Given the scope
of likely ultimate losses from structured products alone, it would take an enormous amount of
capital to reduce average leverage ratios to Canadian levels. Bank of Canada research
estimates that U.S., U.K. and European banks would need to raise a combined US$1.2
trillion to bring their leverage ratios down to Canadian levels. These capital needs will rise
linearly with any recession-induced writedowns. In this environment, banks are inclined to
hoard capital, rather than deploy it. In a world with guarantees, liquidity and funding support,
regulators should not reinforce this tendency.
In Canada, our banks are not facing the same pressures to de-lever as their counterparts
abroad. Still, their loan portfolios would experience higher credit losses in a deep or
prolonged downturn. The risk identified in the FSR is that market forces could compel banks
to maintain higher capital ratios than necessary to guard against the possibility of worse
economic outcome. This could lead banks to slow balance sheet growth, which would tighten
lending conditions for both households and businesses and weaken the economy. Ultimately,
the financial institutions themselves would suffer from this self-fulfilling prophecy.
Given these concerns, the Superintendent of Financial Institutions last month took the
welcome step of giving Canadian banks more flexibility by allowing them to raise the
proportion of preferred shares that comprise their Tier 1 capital from 30 per cent to 40 per
cent. The lower absolute leverage of Canadian institutions and the higher quality of their Tier
1 capital should mean that they can expand lending faster than their international peers. The
value of this virtually unique advantage of our economy should not be underestimated.
The Bank is working with its international counterparts to examine how the current regulatory
capital framework may amplify fluctuations in economic and financial conditions.7 Under
current rules, capital requirements are linked to the credit risk in an institution's portfolio. In
an upturn, risk goes down, banks are required to hold less capital, and the growth of credit
increases. The problem is that this can amplify swings in financial conditions and lead to the
emergence of financial imbalances. Recall the link between credit growth and future financial
stress that I just mentioned. Then, during the downturn when credit risk increases, banks are
required to increase capital holdings, thus exacerbating the economic weakness and
financial stress.
This is the motivation for proposals to have capital requirements move procyclically. Banks
could be required to build up capital buffers during times of rapid credit expansion. This
would strengthen their balance sheets and reduce the risk that financial imbalances will
develop from overly easy financial conditions. During a downturn, banks could then draw
down these buffers, which would reduce the need to liquidate assets or restrict loan growth
at a time when credit conditions and asset prices are already under stress. In this way,
capital requirements would moderate the ups and downs of the credit cycle - the reverse of
what currently happens - reducing the risk of a future crisis.
This macroprudential approach to capital requirements is tremendously important, but it is
also complex, with a number of practical and logistical concerns. Such a system could be
accomplished by linking capital requirements to movements in credit-cycle indicators, such
as loan growth and asset prices. For example, our research on the determinants of financial
stress that I mentioned a moment ago can help inform the development of such regulatory
guidelines. It is probably unrealistic to think that ex ante a perfect formula can be derived.
Ultimately, there are important questions regarding the balance of rules and discretion and,
regarding the latter, who should exercise that discretion.
Household balance sheets
The third risk relates to the health of Canadian household balance sheets. Household credit
makes up about 60 per cent of the Canadian banking sector's total loan exposure, so losses
on household lending would likely have an immediate impact on capital adequacy and
forward profitability. The household sector could be an important channel through which
global economic weakness affects the Canadian financial sector more widely.
While the Canadian household sector remains relatively healthy, its resilience will be tested
during the recession. Various indicators of financial stress, such as bankruptcies and loans in
arrears, have increased recently from historically low levels. Falling equity markets and
softening house prices have put pressure on household balance sheets at a time when the
ratio of debt to income is already at a record high of 140 per cent. The household
debt-toasset ratio has risen as the credit crisis intensified, reaching 19 per cent at the end of the
third quarter - the highest level since 1990. At the same time, the debt-service ratio of
households actually declined modestly to 7.5 per cent, well below the historical average of
9.2 per cent seen since 1992, owing to lower effective borrowing costs. This gives a measure
of assurance that most households can comfortably manage their debts.
The health of Canadian households is obviously important to our banking sector. If the global
economic downturn were significantly more severe than projected, then household defaults
in Canada could rise sharply. This risk would be magnified if banks begin to tighten credit
conditions to households more significantly than they have so far. In the FSR, we examined
these risks using a simulated stress test. Specifically, we examined an extreme scenario
where nominal household income drops at an average annual rate of 2 per cent for six
straight quarters as a result of global economic weakness. Such an event could double -
from 3 per cent to 6 per cent - the proportion of Canadian households considered to be
vulnerable; that is, with debt-service ratios above 40 per cent of income. Further, those
vulnerable households would own 13 per cent of total household debt, a figure double the
average of the past 10 years. If this scenario were to materialize, it would prompt significant
losses among Canada's banks.
However, it is important not to overplay this scenario, since it actually illustrates the strength
of our system. First, the scenario is extreme - the annual growth of household income has
not been negative during any quarter over the 37 years for which data are available. Second,
while the average Tier 1 capital ratio of our banks would fall from 9.7 per cent to about 8.8
per cent, this figure is still more than two times the minimum ratio allowed under the Basel II
Accord, and well above OSFI's 7 per cent threshold.
There are a number of reasons why the risk posed by household balance sheets is
significantly lower in Canada than elsewhere, not the least of which is Canada's more
conservative lending culture. For example, subprime mortgages account for less than 5 per
cent of Canadian mortgage lending, roughly one-third the level in the United States. Further,
since Canada requires insurance on high-loan-to-value mortgages and Canada Mortgage
Bonds carry an explicit sovereign guarantee, there has been no negative feedback loop
between the housing market and the financial sector as has been all too apparent in other
major economies. While Canada's debt-service ratio remains below its historical average, as
I mentioned, the debt-service ratio in the United States remains above its historical average.
Further, the absolute cost of household debt in Canada - both mortgage and other loans -
has fallen by about 100 basis points since the onset of the crisis last year.
Nonetheless, the Bank of Canada will continue to closely monitor the risk posed to financial
stability from household balance sheets. In addition, the Bank will closely consider the
possibility that households may be more sensitive to shocks to their income or wealth as it
develops its outlook for Canadian growth and inflation.
Conclusion
In times of crisis, it is easy to understand the links between financial stability and the real
economy. While these are all too apparent, it is sometimes hard to see the end of the crisis.
But end it will. The actions that policy-makers are taking will be effective. The global
economy will emerge from this period of weakness. In the years ahead, when times are
better, the need to promote financial stability may not be as clear-cut, even though it will be
no less important. The Bank of Canada will continue to take a macroprudential approach. We
will use all the tools at our disposal to promote financial stability at home and abroad and, in
so doing, continue to contribute to the economic and financial welfare of Canada.