Lawrence Schembri: Stress prevention - central banks and financial
stability
Remarks by Mr Lawrence Schembri, Deputy Governor of the Bank of Canada, at a joint Bank
of Canada, International Monetary Fund, Centre for International Governance Innovation and
Peterson Institute for International Economics workshop, Ottawa, Ontario, 6 May 2016.
* * *
For the better part of the past two centuries, central banks have played an important role in the
maintenance of financial stability, but primarily one of "stress or crisis management." In
particular, central banks have served as lender of last resort, providing liquidity to prevent
stress from sparking contagion in solvent, but illiquid, financial institutions.
But that role is starting to change.
While central banks responded boldly to the global financial crisis with liquidity provision and
monetary policy actions to avoid a repeat of the Great Depression, the severity of the economic
fallout obliges us to ask whether they could have done more to prevent it, rather than just trying
to manage and mitigate its economic impact.
This query goes well beyond considering whether monetary policy aggravated the financial
vulnerabilities that contributed to the crisis and raises broader questions concerning the
responsibilities of central banks.
It's time, then, for central banks to rethink their role in financial stability:
• first, by recognizing that while the best contribution monetary policy can make to
financial stability is price and macroeconomic stability, this is a necessary, but not
sufficient, condition for financial stability;
• second, by focusing on crisis prevention through means other than monetary policy,
while at the same time modernizing their role as liquidity provider or lender of last
resort; and
third, by enhancing their contribution to financial stability by exploiting two of their key
•
strengths - their financial-system-wide perspective and their analytical capacity.
Going beyond monetary policy as a crisis prevention tool
In thinking about enhancing the role of central banks, we should reconsider two notions that
have helped to advance our analysis.
The first is the "lean versus clean" debate. As Lars Svensson has compellingly argued,
monetary policy is too blunt an instrument to be used to mitigate financial vulnerabilities. Other
tools are better suited for this purpose.
The second notion is the "lines of defence" analogy, with monetary policy serving as the last
defensive barrier when other measures to reduce financial vulnerabilities and mitigate systemic
risks are either absent or inadequate. This view suggests that actions be taken sequentially.
Consider, instead, how we promote road safety and prevent car accidents, which require the
simultaneous application of standards for
• driver education and competence;
• automobile operations and safety; and
• road quality and appropriate signage.
A similar tri-fold approach for financial stability would entail clear objectives accompanied by
the necessary powers and instruments for
• financial education and information for consumers, lenders and investors;
microprudential regulation and supervision; and
•
• macroprudential monitoring and regulation.
A broader contribution for central banks
So how can central banks broaden their contribution to financial stability?
By promoting financial stability through the following measures:
First, by encouraging prudence on the part of borrowers and lenders.
Most central banks publish or contribute to financial system reviews or financial stability
reports. Such reviews or reports monitor and assess financial vulnerabilities and risks and
serve as an early warning mechanism. In addition, the underlying analysis in them provides a
basis for recommendations for pre-emptive policy actions. These publications are thus an
important means for central banks to contribute to financial stability.
For example, the Bank of Canada has used its Financial System Review to inform households
and lending institutions of our assessment of the vulnerability associated with elevated
household debt in an effort to encourage all parties to exercise appropriate caution.
Second, by enhancing market discipline through increased transparency.
By making their analyses and assessments public, central banks can increase awareness of
financial system vulnerabilities, risks and their potential triggers so that investors and other
market participants can appropriately price and manage risk.
Third, by strengthening regulation and supervision of the financial sector.
Since the crisis, the regulatory and supervisory framework for financial systems has been
strengthened, and more rigorous global standards have been implemented in many
jurisdictions. Central banks contributed to the development of these standards through their
involvement in international forums such as the Financial Stability Board and other
standardsetting bodies. An important example is the Basel III regulatory reforms, which require banks
to hold more and higher-quality capital and meet new liquidity and leverage requirements and
have thus made the banking system more resilient.
While some central banks, including the Bank of Canada, are not directly involved in
overseeing the implementation of these new standards, they can help evaluate their
effectiveness. By working with regulators to implement coherent macro stress tests on the
banking system they can jointly assess the ability of the banking system to withstand severe
macroeconomic shocks. These tests would incorporate existing vulnerabilities. Their main goal
is to encourage the institutions themselves, as well as the supervisory bodies, to take remedial
measures to increase resilience, as necessary.
In addition, given their system-wide perspective, central banks can monitor and evaluate
unintended consequences of regulatory standards on the financial system and real economy,
especially with respect to market functioning and the availability of credit.
Fourth, by contributing to the monitoring of systemic risk and the development of
macroprudential measures.
As noted, most central banks do in-depth analyses of financial vulnerabilities. They also often
investigate possible remedial measures to mitigate the vulnerabilities and they share their work
with other agencies responsible for macroprudential oversight. The mechanisms for doing this
differ according to the macropudential policy framework in each jurisdiction.
Valuable aspects of the analyses by central banks include monitoring for the impacts of
financial innovation and possible instances of risky regulatory arbitrage, as well as the
identification of data gaps.
Again, because of a central bank's system-wide perspective and analytical capacity these
contributions are essential for the formulation of appropriate macroprudential policy.
Such policy initiatives come in all sizes, but let me give you an example of what we did here in
Canada. In the immediate aftermath of the crisis, household debt and house prices resumed
growing faster than disposable income in response to lower interest rates and the recovering
economy. The Department of Finance and a number of agencies, including the Bank of
Canada, worked together to mitigate this growing systemic vulnerability.
The Bank's analysis of household debt and house prices helped inform the regulatory changes
that were adopted. The federal government tightened rules for government-supported
mortgage insurance, including increasing minimum down payments. For its part, Canada's
bank regulator, the Office of the Superintendent of Financial Institutions, released new
guidance on mortgage underwriting and mortgage insurance that implemented enhanced
global standards.
These measures were successful in slowing household credit growth and they complemented
the Bank of Canada's accommodative monetary policy by better targeting the stimulus to the
most creditworthy households.
To further enhance our contribution to macroprudential oversight in Canada, we have two
aspirations:
1. To develop a framework for system-wide macro-level stress tests that integrates
different sectors of the financial system - banking, insurance and investment funds - as well
as financial markets and financial infrastructures.
2. To improve our models to better understand the interactions between monetary and
macroprudential policy.
Conclusion
Let me summarize and conclude.
The public often sees central banks as responsible for financial stability, but, in practice, this
is a mandate the banks rightly share with the government and other financial regulators and
supervisors. So although central banks don't themselves have a broad set of instruments to
mitigate financial vulnerabilities, they do have that system-wide view, which they can and do
use to promote financial stability by making public their analyses of financial vulnerabilities and
risks and making recommendations for preventive policy actions.
In the end, how central banks contribute to financial stability, in conjunction with other public
authorities, will depend on the macroprudential framework in place. What we have learned
from the participants at this conference is that the framework varies across jurisdictions,
typically reflecting differences in institutional settings, and that the different structures seem to
be working well. Thus, the important take-away from this evidence is that the framework's form
matters less than its function and that the measure of success should be macroprudential
outcomes, namely lower systemic risk and fewer instances of severe financial stress.
At the same time that central banks are enhancing their efforts to promote financial stability,
they must maintain their focus on monetary policy to achieve price and macroeconomic
stability. These are necessary conditions for financial stability.
On behalf of my colleagues here at the Bank of Canada, thank you for joining us and for sharing
your views on this important issue.