Timothy Lane: Financial stability in one country?
Remarks by Mr Timothy Lane, Deputy Governor of the Bank of Canada, to the Weatherhead
Center for International Affairs, Harvard University, Cambridge, Massachusetts,
11 February 2013.
* * *
Introduction
During the years since the global financial crisis, financial reforms have been moving forward
on two distinct levels. The G-20 leaders' commitment to build a more stable and resilient
global financial system is being advanced through an ambitious global reform agenda. At the
same time, policy-makers in each country are implementing reforms intended to establish
more stable and resilient systems in their respective jurisdictions.
Financial stability in each country is, of course, an essential ingredient of global financial
stability: policies to achieve financial stability in different jurisdictions are in most cases highly
complementary, as a stable global financial system is made up of stable national financial
systems. But tensions do sometimes arise between these two objectives. At the root of these
tensions is the pervasiveness of cross-border spillovers - both from the risks affecting
financial stability and from some of the reforms designed to mitigate those risks.
In Canada - an open economy where the financial system is closely linked with those of the
United States and other countries - we have a privileged vantage point on these issues. Our
experience during the global financial crisis and its aftermath is a reminder that financial
stability at the national level cannot be fully secured in the face of economic and financial
shocks originating elsewhere. Financial instability speaks all languages and carries many
passports.
Furthermore, financial reforms have important cross-border implications that need to be
addressed to ensure that these reforms have their intended benefits. Thus, financial stability
is a shared responsibility that must be advanced through international cooperation. Reforms
agreed to at the global level need to be implemented fully and consistently in each
jurisdiction.
In my remarks today, I am going to draw on Canada's experience of the past few years to
illustrate these points. First, I will review how Canada fared during the financial crisis.
Second, I will discuss the risks to Canada's financial stability that have emerged in the wake
of the crisis. Third, I will focus on some important cross-border elements of the reform
agenda.
Canada and the crisis
It's now well known that Canada came through the financial crisis better than many other
major advanced economies, with a relatively short and shallow recession and a relatively
strong recovery. It is now over two years since Canada regained its pre-recession level of
both real GDP and employment (Chart 1).
An important reason Canada fared better than other countries was that our financial system
was more robust. Canada's banking system was rated "the soundest in the world" by The
Banker
magazine three years in a row, from 2008 to 2010. No Canadian financial institutions
failed - or had to be rescued by taxpayers - during the crisis. Leading up to the crisis, our
banks were less leveraged, less dependent on wholesale financing, and less exposed to the
structured financial products that brought down some of their peers in other countries. This in
turn reflected, at least in part, Canada's tougher regulatory standards and stricter supervision
and oversight. Canada's established policy framework and strong fiscal position gave the
authorities considerable room for manoeuvre when the crisis struck. These strengths, in turn,
were the legacy of the harsh lessons Canada learned during the 1980s and 1990s from
failures of two small banks and our own sovereign debt problem.
Nonetheless, Canada's financial stability came under stress during the crisis. Serious risks
materialized, and had to be countered by timely and aggressive policy action. Liquidity
conditions in Canada's core funding markets - although not as extreme as in other
jurisdictions - became very tight: in the climate of fear following the failure of Lehman
Brothers, many Canadian institutions had difficulty obtaining funding (Chart 2).
In response, the Bank of Canada provided substantial short-term liquidity support to the
financial system: we made this support available to a broader group of institutions, for longer
terms, and against a wider range of collateral than under normal conditions.
During this period, the Canadian government also provided longer-term funding to Canadian
banks to prevent a severe credit crunch in the private sector (Chart 3).1
As a result of these actions, Canada's core funding markets stayed open, and credit kept
flowing to the private sector (Chart 4).
As the global crisis gave way to the Great Recession, Canada's economy suffered the
consequences - mainly through a collapse in exports to the United States, which was in a
deep recession. Canada lost output amounting to more than 4 per cent of real GDP and job
losses equivalent to almost 2 1/2 per cent of our labour force. But an aggressive policy
response helped to prevent a worse outcome. The Bank of Canada eased policy
substantially in order to achieve its 2 per cent inflation target: it lowered the overnight policy
rate to its lowest possible level (1/4 per cent) and took the unconventional step of making a
conditional commitment to hold it there for more than a year (Chart 5).
Complementing this monetary policy response, the government introduced a broad-based
fiscal stimulus package amounting to about 3 1/2 per cent of GDP. While the recession did
put stress on the financial system - in particular, a tightening of credit conditions and an
increase in loan losses - the short duration of Canada's recession kept more serious threats
to financial stability at bay.
Global deleveraging and Canada's unbalanced expansion
The years since the crisis have brought a different set of challenges to financial stability in
Canada. History teaches us that recoveries after a financial crisis are slower than those
following normal recessions - a pattern that has been well documented, in particular, by
Harvard professors Carmen Reinhart and Kenneth Rogoff.2 Typically, it takes output twice as
long to return to its pre-recession level after a financial crisis as in a normal recovery, and
potential output is permanently lower compared with its pre-crisis growth trajectory. This is
because the legacy of a financial crisis is a lot of debt. Working off that debt - in other words,
deleveraging - drags down the economy.
The recession following the recent global financial crisis has run true to form. In a world
awash in debt, repairing the balance sheets of banks, households and governments can take
years. In the United States and many other advanced economies, households are no longer
the engine of growth that they were before the crisis, since they have been curtailing their
spending to rebuild the wealth lost in the housing crash. While much progress has been
made, household deleveraging has hobbled private sector growth. In many countries,
financial institutions have also been restraining their lending because of the losses they
incurred and the need to become less heavily leveraged. And a number of governments too
have been restricting their spending and raising taxes, aiming to restore sustainable fiscal
positions.
This process of deleveraging in other advanced economies creates significant challenges for
Canada's financial stability. Specifically, the slow growth path resulting from deleveraging in
our largest trading partner - the United States - creates a headwind to Canada's economy.
This headwind has, in particular, been holding back Canada's exports, which are far from
recovering from their plunge at the start of the recession. As a result, Canada has relied on
domestic demand - mainly spending by households - to achieve even a modest rate of
economic growth (Chart 6).
Although it's better to have unbalanced growth than no growth, this pattern does pose certain
risks. Consumers have taken advantage of the stimulative financial conditions, including low
borrowing costs and easy availability of financing, that were put in place to counterbalance
the external headwinds. In doing so, they have pushed household debt to levels that pose a
significant risk (Chart 7).
The proportion of households with stretched financial positions that leave them vulnerable to
an adverse shock has grown significantly in recent years. These conditions are also reflected
in stretched valuations in some segments of Canada's housing market. Also, more houses
are being built than are needed given demographic trends (Chart 8).
These developments have led to a significant buildup of vulnerabilities in Canada's
household sector. The risk is that any shock to economic conditions could be amplified
through a deterioration of housing market conditions and a retrenchment of household
spending. These conditions could then be transmitted to the broader financial system
through a worsening of the credit quality of loans. This could prompt a tightening of credit
conditions and, in turn, set off a mutually reinforcing deterioration in real activity and financial
stability.
While the Bank of Canada has characterized these household vulnerabilities as the most
important domestic source of risk to Canada's financial stability, the origins of this risk are
only partly domestic: it is also an after-effect of the global crisis. The crisis gave rise to global
deleveraging and weak growth that created headwinds to Canada's economy. In the face of
those headwinds, very stimulative monetary policy has been needed to achieve the inflation
target. And that prolonged stimulative policy - "low for long" - creates significant risks to
financial stability.
I've highlighted the risks associated with the household sector, but low-for-long interest rates
can lead to risks elsewhere in the financial system. Periods of low interest rates may, in
some circumstances, trigger a "search for yield" driving excessive risk-taking - often through
investment strategies whose risks are not well understood.
Until recently, this tendency toward excessive risk-taking has been kept in check by the
climate of fear in the post-crisis global financial system - and an acute awareness of some
important tail risks. Market participants have been concerned about the euro area crisis, the
fiscal cliff in the United States, and the possibility of a hard landing in China. In the past few
months, extreme negative outcomes appear less likely, and market participants have
regained confidence. While it is good news that the tail risks have diminished, it also means
that it is now becoming even more important to monitor financial institutions' risk-taking
behaviour.
The risks of household imbalances, as well as other risks associated with low for long, can
be addressed in several ways. First, households, financial institutions and investors need to
make prudent decisions. More normal times will return, and with them more normal interest
rates and costs of borrowing. It is the responsibility of households to ensure that they can
service tomorrow the debts they take on today. As for investors, they are responsible for
managing the risks they face. Financial institutions also have a responsibility to make sure
that their clients can service their debts and more broadly, that they understand the risks to
which they are exposed.
Among the policy measures that can be used to address emerging financial system
vulnerabilities, targeted prudential measures are often the best. The Canadian government
has tightened regulations pertaining to government-backed insured mortgages four times -
most recently in 2012.3 These changes involve more stringent requirements to qualify for
mortgages, shorter amortization periods and lower maximum loan-to-value ratios for
mortgages. In addition, the prudential regulator has recently issued guidelines for the
mortgage underwriting standards of lenders. If such targeted prudential measures turned out
to be insufficient, monetary policy could also be used, within a flexible inflation-targeting
framework, as a complementary instrument to address financial imbalances. So far, though,
that has not been necessary in Canada.
The growth of household credit has shown signs of moderating in recent months. The
momentum in house price growth, sales of existing homes, and new construction has also
moderated. Nonetheless, financial system risks associated with household imbalances
remain elevated. And it is possible either that household spending could regain momentum
or that a more sudden weakening could occur.
Think globally, act locally
So far, I have been using Canada's experience during and after the global financial crisis to
illustrate the cross-border dimension of the threats to financial stability. Now I would like to
talk about the cross-border dimension of the reform agenda and how it intersects with
national priorities and policy-making. Unprecedented in scope, the direction of reform is often
agreed at the global level, but where the rubber hits the road is usually at the national - and
in some cases even provincial or state-level.
In this context, one salient feature of the financial reforms is that they will not only benefit the
jurisdiction where they are implemented, but also other jurisdictions. If we look at the costs
and benefits of the Basel III reforms to increase capital at financial institutions, we see that
reforms impose costs on banks which may in part be passed on to their customers through
wider spreads between deposit and lending rates - in turn generating some broader
macroeconomic effects. At the same time, evidence suggests that higher capital standards
reduce the frequency and severity of financial crises.
Research at the Bank of Canada indicates that, on balance, the benefits will far outweigh the
costs: Basel III, by improving the safety and robustness of the Canadian and international
financial systems, should yield a net economic benefit to Canada equivalent to about
13 per cent of GDP in present-value terms. But here is the key point: three-quarters of the
prospective benefits for Canada arise from the decrease in the probability of financial crises
in other countries - and only one-quarter from the reduced probability of a financial crisis in
Canada itself.4 Similar logic would apply to the United States and other countries, but the
arithmetic is particularly compelling for a smaller open economy like Canada.
These calculations go a long way in explaining why Canada is so committed to the global
reform process - and to ensuring that reforms are fully implemented in all jurisdictions.
Canada has already put in place Basel III capital standards. While there have been delays in
some other jurisdictions, the largest financial institutions in the United States are already
Basel III compliant, in terms of capital. We trust that other jurisdictions will continue to move
forward to implement these agreed standards. To help ensure that they do - under the
principle "trust but verify" - a robust peer-review mechanism has been established to track
how jurisdictions are progressing in living up to their G-20 financial reform commitments.
All financial reform is local
Some of the reforms taking place at the national level mainly involve the implementation of
what has been agreed at the international level. Clearly, in putting these international
standards in place, individual countries need to align them with their own financial structures
and circumstances.
In some jurisdictions - the United States, the European Union and the United Kingdom -
reform has also been proceeding somewhat independently of the global process. A
prominent example in the United States is the Dodd-Frank Act which was passed into law in
2010 and is still in the process of being implemented through extensive rule making. Different
approaches to achieving broadly similar objectives are being followed in the European Union,
the United Kingdom and Japan.
While the various national reform agendas have essentially the same objectives as the global
agenda - a safe and efficient financial system - there can be tensions between them,
including conflicts, inconsistencies and overlaps, which can affect financial institutions and
their clients operating across national borders.
Reforms of over-the-counter derivatives trades are a good example. The United States and
Europe are taking a leadership position and pushing ahead with legislation in this area.
Conflicts in national regulation may arise, in which the rules of one jurisdiction cannot be
followed without contravening a requirement in another. For example, trade reporting rules
proposed by the U.S. Commodity Futures Trading Commission may require data that could
violate privacy and information laws in some other countries. Inconsistencies may occur
when requirements apply to certain products or participants in one country, but not in others.
Non-financial companies, for example, may or may not be exempt from central clearing
obligations depending on the country. Even in the absence of such conflicts and
inconsistencies, duplicate obligations across jurisdictions may increase compliance costs,
undermining economic efficiency.
National legislation can also have extra-territorial effects. An example is the Volcker Rule
banning proprietary trading by deposit-taking institutions, which is being introduced in the
United States as part of the Dodd-Frank legislation. Under the regulations initially proposed,
any foreign financial institution with operations in the United States would be required to
comply with the proprietary trading ban on its worldwide operations. Here, the intention is to
prevent institutions from shifting activities offshore in a bid to avoid the ban on proprietary
trading. Moreover, U.S. government bonds were exempted from the rule, while other
sovereign bonds were not. Thus, for example, Canadian financial institutions' trading in
Canadian government bonds could be restricted under U.S. law.
These proposed regulations have raised concerns that U.S. law could dictate the structure of
major financial institutions in many other jurisdictions. Other jurisdictions - including Canada
- have objected, both because they do not wish to have U.S. law applied to the primarily
domestic operations of their institutions, and also because they do not agree that the Volcker
Rule is the only - or the most effective way to prevent excessive risk-taking in financial
institutions.
An essential element of resolving potential tensions is mutual recognition: each jurisdiction
should have a sufficiently strong regime that other jurisdictions can accept as broadly
equivalent, eliminating the need to impose their own rules across borders.5 The foundation of
mutual recognition is to have generally accepted global standards together with a robust
peer-review mechanism to ensure that those standards are applied consistently across
jurisdictions.
Collaborative resolution
Given the interconnectedness of financial institutions, collaboration is a key element of
implementing reforms. One area where collaboration is particularly important is in the
resolution of systemically important financial institutions - those deemed "too big to fail."
Designing a clear framework for resolution has been a priority of the global financial reform
agenda. Owing to the size and complexity of cross-border linkages in banking and financial
markets, when a major financial institution or market is impaired in one country, shocks can
quickly spread to the financial systems of other countries. During the crisis, differences in
rules - and in interests - across jurisdictions impeded the resolution of financial institutions
such as Lehman Brothers.
In this light, it is essential to have a clear basis for cross-border collaboration in the resolution
process. For banks identified as globally systemically important (G?SIBs),
crisis-management groups have largely been established to provide a forum for the ongoing
exchange of information and the coordination of recovery and resolution measures. The
G-SIBs are preparing "recovery and resolution plans" that would facilitate an orderly winding
up of the institution if that becomes necessary. Achieving the most beneficial level of
co-operation for cross-border resolution, however, is a challenge. While the establishment of
the crisis-management groups is an essential element in the process, much remains to be
done.
Financial protectionism
The issues I have raised, the cross-border dimensions of both financial instability and reform,
could have another unintended result: that of a more fragmented global financial system.
This tendency - as reflected, for example, in the decline in cross-border financing since the
crisis - stems naturally from the greater perceived risks of cross-border financial activities,
together with regulations that seek to protect domestic financial systems (Chart 9).
A reduction in cross-border interconnectedness may help to reduce contagion, but an
unintended consequence could be excessive concentration and interconnectedness within
countries. More generally, barriers to the movement of capital may carry a significant cost, in
the form of lost economic efficiency and growth. From a global perspective, these
considerations need to be balanced carefully.
If we look at the deleveraging of financial institutions, a necessary step as they repair
balance sheets and meet new regulations, we see that how they deleverage can lead to
fragmentation.
For instance, in the European Union, national regulators have discouraged banks from
deleveraging through restricting credit in their own respective jurisdictions. Partly for this
reason, a number of banks, particularly in the euro area, have been withdrawing from
international activity. In part, this has also meant increasing banks' exposure to their own
sovereigns - a major channel amplifying stress during the recent euro-area crisis.
A second source of fragmentation is the potential conflict between rules in different
jurisdictions. To the extent that conflicting, duplicate and/or extra-territorial regulations make
cross-border activity disproportionately costly, they may create incentives for financial
institutions to concentrate their activities in their own jurisdictions.
Fragmentation can also occur from explicit financial protectionism. Some emerging market
economies, for example, have sought to insulate their own financial systems from turbulent
global financial conditions through a range of measures designed to constrain cross-border
capital flows, including capital controls which in some cases are accompanied by foreign
exchange market intervention. The adoption of such measures by a number of countries
could result in a greater concentration of risk in national economies and ultimately undermine
global economic growth.
Conclusion
The global reform agenda, which is critical to financial stability across countries, will need, by
its very nature, to be underpinned by global cooperation. New standards agreed upon at the
international level must be implemented at the national level. As we move past the
policy-development phase, processes are being put in place to monitor implementation,
including cross-country peer reviews of specific standards by the Financial Stability Board.
Domestic reform initiatives are equally important, but need to be harmonized in an integrated
world. If conflicts and inconsistencies arise from the requirements of different jurisdictions,
these initiatives may not succeed in establishing a safer global financial system.
Financial stability is necessary for sustainable economic growth. But it's a public good: its
benefits are widely shared. Can it be achieved in one country alone? Not a chance. We're all
in this together.
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