Remarks by Carolyn A. Wilkins
Senior Deputy Governor of the Bank of Canada
conference
Rotman School of Management "Are We Ready
For the Next Financial Crisis?"
Toronto, Ontario
March 22, 2018
Financial Stability: Taking Care of
Unfinished Business
A clear lesson of history is that a "sine qua non" for sustained economic recovery
following a financial crisis is a thoroughgoing repair of the financial system.
(Former Chair of the US Federal Reserve System Janet Yellen, 2009)1
Introduction
Here we are, 10 years after the financial crisis, still tallying the costs, studying causes
and drawing lessons from it.
The outcome would have been worse in 2008 and the following years had it not been
for the swift and coordinated efforts of policy-makers around the world to boost demand
and repair the financial system. Even so, it has been estimated that the crisis cost the
global economy 62 million jobs and more than US$10 trillion in lost output.2 Although
Canada's recession was less deep than experienced
in countries at the epicentre of the
crisis, it was still painful for many people.
It took more than a decade-and a series of aftershocks-to get to a place where we
feel that emergency measures, such as ultra-low interest rates, may at last no longer be
needed.
1
Yellen, "Comments on 'The Revival of Fiscal Policy'" (remarks to Annual AEA/ASSA
J.
Conference, San Francisco, California, January 4, 2009).
2
of job losses is relative to trend. See
This estimate "Global Employment Trends 2014: Risk of
a Jobless Recovery?" International Labour Organization, Geneva, January 21, 2014.
I would like to thank Grahame Johnson, Alexandra Lai and Harri Vikstedt for their help with this speech.
Not for publication before March 22, 2018
14:45 Eastern Time
While uncertainty about trade polices continues to cloud the global and Canadian
outlooks, for a central banker like me, this moment feels like it has been a long time
coming. We responded to contagion from abroad with aggressive monetary policy
actions. We have estimated that without these actions, the recession might have been a
year longer and an additional half a million jobs would have been lost.3 We worked with
our Canadian and international colleagues-and some of you here-to put critical
programs in place to ensure liquidity in core funding markets during the crisis. And, we
co-operated on a series of global financial reforms. Having been personally involved on
several fronts, I know just how much of a collective effort this was. Many of you here
today have worked hard in your own institutions to comply with new rules and shore up
risk management. We have all accomplished a lot.
But, let's face it, the job is still not done. Winston Churchill once "All men make
said,
learn from their mistakes." So, it is wise to have
mistakes, but only wise men
conferences like this one, where we can continue to reflect on what went wrong. That is
why I am pleased to be here; I would like to thank the organizers for the invitation.
The experts who spoke before me gave us insights into the genesis of the crisis and the
subsequent lessons. My intention is to push the conversation forward and spark
discussion in three areas where I believe we have unfinished business:
1. Understanding the role of monetary policy in financial stability-if there is one
thing we have learned since the turn of the century, it is that price stability does
not guarantee financial stability.
Keeping policy current as risks to the system
2. evolve-leverage and liquidity are
important usual suspects, but the trickiest part may be understanding the risks
that stem from interconnectedness in an ecosystem that is changing rapidly.
3. Being ready for when things go wrong-being well prepared will help keep the
financial damage to a minimum, especially for people who did not take the risk in
the first place.
Central banks, along with other authorities and financial system participants, have a
strong role to play in all these areas.
Monetary policy cannot do it all
Let me start with the role of monetary policy in financial stability. Monetary stability-
low, stable and predictable inflation-is at the heart of a solid macroeconomy and
financial stability. Since the Bank of Canada adopted its inflation-control target in 1991,
there has been a reduction in the variability of economic growth by more than one-third
and in unemployment by 40 per cent, even when accounting for the crisis. This has
been particularly beneficial for younger people and workers with a lower level of
3
These estimates were produced by running a simulation with ToTEM, the Bank of Canada's
main policy model.
education, who tend to have more precarious employment.4 Successful inflation
targeting in Canada and elsewhere is considered one of the factors behind this "Great
Moderation," together with some helpful changes to structural policies and a little good
luck.5
We know that many factors contributed to the crisis-including inadequate regulatory
safeguards and global macroeconomic imbalances. That said, the crisis made clear
what some economists had previously suspected: price stability alone is not enough to
ensure financial stability and could, in some circumstances, contribute to the buildup of
financial vulnerabilities.6 Central bankers were of course already aware that
vulnerabilities could build up via the traditional channel of monetary policy that works
through asset prices and credit markets. But we learned the hard way that another
channel-the risk-taking channel-could be a powerful amplification mechanism. In fact,
it is now evident that low interest rates encourage people not only to borrow more but
also to make riskier investments to get better returns.7
Hindsight is 20/20, but we can all think of an episode that fits the risk-taking narrative.
For me, it is the substantial rise in the issuance of structured credit in the mid-2000s that
facilitated a huge increase in subprime mortgages and leveraged buyouts driven by
private equity.8
The unfinished business here is coming to a consensus about what monetary policy can
and should do about financial vulnerabilities, and about how monetary policy fits into the
rest of the policy framework. Clearly microprudential and macroprudential regulations
are on the front lines, and inflation targeting is the central bank's primary mission.
Nevertheless, we take financial stability into account in our decisions, consistent with
4
For estimates by demographic group of the benefits of reduced cyclical variability, see Table 2
in T. Macklem,
"Promoting Growth, Mitigating Cycles and Inequality: The Role of Price and
(remarks to the
Financial Stability" Brazil-Canada Chamber of Commerce, São Paulo, Brazil,
March 12, 2012).
5
(remarks to the Eastern Economic Association,
See B. S. Bernanke, "The Great Moderation"
Washington, DC, February 20, 2004).
6
See, for example, W. R. White, "Is Price Stability Enough?" Bank for International Settlements
Working Paper No. 205 (April 2006).
7
Paligorova and J. A. Sierra Jimenez,
See T. "Monetary Policy and the Risk-Taking Channel:
Bank of Canada Review
Insights from the Lending Behaviour of Banks," (Autumn 2012): 23-30;
C. Borio and H. Zhu, "Capital Regulation, Risk-Taking and Monetary Policy: A Missing Link in
the Transmission Mechanism?" Journal of Financial Stability 8 (4) (December 2012): 236-251;
V. Bruno and H. S. Shin, "Capital Flows and the Risk-Taking Channel of Monetary Policy,"
Journal of Monetary Economics 71 (April 2015): 119-132; G. Dell'Ariccia, L. Laeven and G. A.
Suarez, "Bank Leverage and Monetary Policy's Risk-Taking Channel: Evidence from the United
States," The Journal of Finance 72 (2) (April 2017): 613-654.
8
For more on leveraged buyouts, see Committee on the Global Financial System, "Private
Equity and Leveraged Finance Markets," CGFS Papers No. 30 (July 2008).
our risk-management approach.9 The current situation offers an example. With high
levels of household debt and the Canadian economy operating close to capacity,
monetary policy actions to achieve the inflation target and support financial stability are
currently complementary. The Bank of Canada has underscored that there is
nonetheless a fine balance to be struck here: while moving too slowly would allow more
time for financial vulnerabilities to build, moving too quickly could have outsized effects,
given the high level of household indebtedness.
There may be, in different situations, a case for taking longer to bring inflation back to
target than the usual six to eight quarters.10 That was something we considered in
late 2013. Inflation was running below target and the economy had excess capacity,
which might have warranted an easing in policy. However, we judged that the best
course of action was to leave our policy rate at 1 per cent to avoid exacerbating
financial vulnerabilities in the household sector, while still returning inflation to target
over a reasonable time horizon.
There is still debate about how best to integrate financial stability considerations into
monetary policy. I would like to highlight a couple of promising avenues to help advance
this discussion. The first is to invest in policy models that do a better job of capturing the
interlinkages between the financial system and the economy, such as those that can
don't
lead to defaults on loans, asset fire sales and other real-world events. I think any
model will ever be perfect, so we will always be operating with a heavy dose of
uncertainty. Yet, this research will yield insightful answers to the question of how
monetary policy should respond to a buildup of financial vulnerabilities, if at all.11
The second avenue is to strengthen our framework for macroprudential policies, which
are better suited to target financial system risks. Taking a page from the
inflationtargeting regime, there is a benefit to clarity about objectives, governance and tools for
the job.12 The focus in Canada has understandably been on macroprudential policies
related to household finance to improve the quality of debt and limit its growth. Many of
these policies, such as recent changes to mortgage underwriting rules, are aimed at
increasing the resilience of the financial system on an ongoing basis. Authorities could
use other tools to dampen financial cycles and boost the resilience of the banking
system when bank credit has been growing rapidly. An example is the countercyclical
capital buffer introduced as part of the Basel III reforms. The Bank of England has put
9
S. Poloz, A Practitioner's
See S. "Integrating Uncertainty and Monetary Policy-Making:
Bank of Canada Staff Discussion Paper
Perspective," No. 2014-6 (October 2014).
10
For more on the role of monetary policy in counteracting financial imbalances and the related
case for a flexible target horizon, see J. Boivin, T. Lane and C. Meh,
"Should Monetary Policy
Be Used to Counteract Financial Imbalances?" Bank of Canada Review (Summer 2010): 23-36;
and D. Coletti, J. Selody and C. A. Wilkins,
"Another Look at the Inflation-Target Horizon," Bank
of Canada Review (Summer 2006): 31-37.
11
For an example of such an exercise, see Box 6 in "Renewal of the Inflation-Control Target:
Bank of Canada (2016): 28.
Background Information-October 2016,"
12
Committee on the Global Financial System, "Objective-Setting and Communication of
Macroprudential Policies," CGFS Papers No. 57 (November 2016).
such countercyclical measures in place, and the Office of the Superintendent of
Financial Institutions (OSFI) is working on implementing similar measures in Canada.13
Despite the promise of macroprudential policy, we need to be humble about what we
know in practice. As we gain experience with these tools, in Canada and abroad, we
should sharpen our understanding of their effectiveness. And we should continue to
strengthen the framework in which monetary policy and macroprudential policies
reinforce each other.14 A solid framework is essential to reduce the likelihood of undue
pressure for monetary policy to lean against the build-up of financial vulnerabilities.
Interest rates are a blunt tool, so using them to achieve financial stability could have
suboptimal outcomes from the perspectives of both monetary policy and financial
stability.
That is why it is imperative that academics and central banks focus our efforts on a
number of areas. At the Bank of Canada, we are exploring new sources of microdata to
better understand vulnerabilities and monitor the effectiveness of macroprudential tools
and monetary policy. We are developing policy models that have relevant institutional
features and rich heterogeneity in income and wealth to get a better handle on the
efficacy and impact of macroprudential policy tools.
Even with improvements in these areas, we know that monetary and macroprudential
policies will be insufficient to fully safeguard financial stability.
Keeping policy current as risks evolve
This brings me to the second area of unfinished business, which is that our regulatory
and supervisory practices need to stay current as risks evolve. The key issues that got
us into the crisis-leverage, illiquidity and interconnectedness-are still the right ones to
look at. We have taken great steps to identify, manage and mitigate these vulnerabilities
in financial institutions. Basel III is largely in place globally, which has tightened banks'
capital and liquidity requirements and set a limit on leverage. We have enhanced bank
resolution tools and shifted the largest portions of over-the-counter derivatives to central
13
For more information on the Bank of England's buffers, see
countercyclical bank capital "The
Policy Committee's (April
Financial Approach to Setting the Countercyclical Capital Buffer"
2016).
14
For more information on the nexus between monetary and macroprudential policy, see
S. Alpanda, G. Cateau and C. Meh, "A Policy Model to Analyze Macroprudential
Regulations and Monetary Policy," Bank of Canada Staff Working Paper No. 2014-6 (February
Bank of
2014); M. Kuncl, "Assessment of the Effects of Macroprudential Tightening in Canada,"
Molico,
Canada Staff Analytical Note No. 2016-12 (August 2016); H. E. Damar and M. "On the
Nexus of Monetary Policy and Financial Stability: Effectiveness of Macroprudential Tools in
Building Resilience and Mitigating Financial Imbalances," Bank of Canada Staff Discussion
Paper No. 2016-11 (May 2016); and J. Allen, T. Grieder, B. Peterson and T. Roberts, "The
Impact of Macroprudential Housing Finance Tools in Canada," Journal of Financial
Intermediation (in press) (September 1, 2017).
counterparties (CCPs). And, many of the weaknesses in market-based financing that
made the system vulnerable before the crisis have been addressed.15
The job is never done, however, because risk is constantly shifting. We learned from the
crisis that, while trouble is a complex brew, financial innovation is usually a key
ingredient. Financial innovation has not slowed since the crisis. It can often help
That's why risk management
improve our financial system, yet it can also carry risks.
needs to become more nimble.
A couple of areas worry me right now, and they need concerted attention. Both relate to
interconnectedness and trust in the system.
My first concern is one that I know is shared by many here in relation to your own
activities: cyber risk. In fact, a recent survey conducted by Risk.net found that disruption
in information technology leads the list of the top 10 operational risks for 2018.16 When it
comes to cyber risk, and many other operational risks, we are all connected. Now, some
new technologies, such as cloud computing, may be safer than legacy systems. Yet
cyber risk is heightened in other ways because of an increasing number of points of
access to core parts of the financial system and the growing sophistication of those
launching cyber attacks. It is part of our digital world.
The Bank of Canada is responsible for oversight of critical financial market
infrastructures (FMIs). We already impose strong requirements to support the stability of
these infrastructures, such as payment systems and CCPs, and we are working to
further contain and respond to cyber risks. The systems that underpin all financial
transactions in our economy are highly interconnected, and a cyber attack on one could
quickly propagate and cause major disruptions.17 The costs might not stop there.
Households and businesses typically do not think about these systems because they
operate smoothly behind the scenes. However, trust in core systems could be
undermined if participants felt that their information or assets were vulnerable. That is
why we are working with Payments Canada and the six largest Canadian banks to
reduce the chance of a serious cyber event, and to mitigate the impact and recover
quickly if such an event were to materialize.
My second area of concern is related to the rapid pace of financial innovation. Such
innovation can bring lower costs and increase the range of investment strategies.
Exchange-traded products, for example, offer investors relatively easy access to illiquid,
complex strategies. The issue is that some of these strategies rely on derivative
15
Board,
Financial Stability "Assessment of Shadow Banking Activities, Risks and the Adequacy
of Post-Crisis Policy Tools to Address Financial Stability Concerns," July 3, 2017.
16
See S. Marlin, Risk.net
"Top 10 Op Risks: IT Disruption Heads 2018 Poll," (February 21,
2018).
17
S. Poloz, (speech
For more on cyber risk, see S. "Three Things Keeping Me Awake at Night"
to the Canadian Club Toronto, Toronto, Ontario, December 14, 2017).
structures that have counterparty and collateral risks.18 These products can be
surprisingly troublesome if they are not well understood, yet become popular,
back to Canada's experience with
particularly with retail investors. This hearkens
thirdparty asset-backed commercial paper leading up to the crisis. A recent-albeit more
contained-example is inverse volatility exchange-traded products. Many investors
were attracted to the high returns earned on these products in the low-volatility
environment of recent years. At the beginning of February, however, these products lost
nearly all their value in one day when US equity volatility spiked.19 The good news is
that markets were resilient to this event. The unease is because, aside from the obvious
suitability issue, many were unaware of the extent of the underlying interlinkages
between products, in this case, leveraged long and short volatility products. These
interlinkages, or dynamics, worked to amplify the volatility by creating a one-way market
in VIX futures.20
Even further along the risk spectrum are private crypto assets. I do not refer to the
existing products as currency because they do not perform any of the key functions of
money. While activity may be too small right now to be systemic, at some point they
could have financial stability implications. The crypto world is moving fast, and is largely
unchecked. This certainly raises concerns about investor protection, market integrity
and the use of crypto assets in illegal activities. In fact, there is evidence of widespread
use of some crypto assets for money laundering and other illegal activities, and some
rather spectacular incidents of theft and fraud have occurred. And we have seen
significant financial risk, given the volatility and illiquidity of the assets.
Authorities should work toward a coherent set of policies for crypto assets that is
aligned internationally. This strategy will need to cover risks in both cash and derivatives
products, as well as in the related ecosystem. The Canadian Securities Administrators
(CSA) launched work on offerings of crypto assets last year, noting that-where
appropriate-they are treating these as securities.21 I just returned from the G20
meetings in Buenos Aires and am pleased that the G20 is increasing its focus in this
area, given the global nature of these products.22
18
See I. Foucher and K. Gray, "Exchange-Traded Funds: Evolution of Benefits, Vulnerabilities
Financial System Review
and Risks," Bank of Canada (December 2014): 37-46.
19
These ETPs formed part of a larger "short vol" trade, which before early February some
estimates put as high as US$2 trillion, and which allowed retail investors to access complex and
leveraged trading strategies that were typically done only by sophisticated investors. See Box 3
in the Bank of Canada Financial System Review (November 2017): 14.
20
See Box A in Bank for International Settlements, "International Banking and Financial Market
Developments," BIS Quarterly Review (March 2018).
21
For more information, see CSA Staff Notice 46-307 Cryptocurrency Offerings (August 24,
2017). See also Committee on Payments and Market Infrastructures Markets Committee,
Bank for International Settlements (March 2018).
"Central Bank Digital Currencies,"
22
G20's March 20
For more information, see the communiqué.
My bottom line here is that we need a sharpened focus on consumer and investor
protection, and market integrity. These are foundational elements of a sound financial
system because they support trust.
Plan for when things go wrong
The last area I want to highlight is readiness: we need to be prepared for when things
go wrong. It is impossible to be rid of all risks, and undesirable as well. A modern
economy advances because people work hard and are willing to stick their necks out.
That means that some risk will materialize. That said, the system should be able to
withstand some failures without imposing huge costs on those who did not take the risk
in the first place.
We have made a lot of progress in a number of areas, but more needs to be done. For
example, we identified the financial institutions and FMIs that could have outsized
impacts on the financial system if they failed, and we are subjecting them to more
stringent regulation and supervision, including recovery and resolution planning.23
Central banks and international policy organizations have also worked to develop
earlywarning indicators of risks to the global financial system.24 While these are helpful as a
starting point, we need to recognize their limitations, particularly if they rely on
deviations from historical trends or threshold values. That is why it is important to push
the analysis further to properly gauge the risk. Stress tests are an excellent way to help
us understand what could happen if financial institutions were subject to adverse
events, such as a steep house price decline or a Brexit vote. They also provide practical
information about what might be needed to withstand and recover from these events.
The Bank of Canada works with other organizations, such as OSFI and the International
Monetary Fund, to conduct regular stress-testing exercises of financial institutions and
to improve our modelling techniques.25
The unfinished business here is that models used for stress testing capture mainly
firstround effects, with limited ability to identify spillovers that we know can end up being
Bank's current framework
even more important. For example, while the does capture
second-round effects that could come from interbank exposures and asset fire sales, it
could be improved. The Bank, and others who conduct stress tests, could introduce
23
The Basel Committee on Banking Supervision has developed quantitative metrics for
identifying global systemically important banks (G-SIBs) and a set of principles (no quantitative
metrics) for assessing domestic systemically important banks (D-SIBs): "Global Systemically
Important Banks: Updated Assessment Methodology and the Higher Loss Absorbency
(July 2013) and
Requirement" "A Framework for Dealing with Domestic Systemically Important
(October 2012).
Banks"
24
For example, see Bank for International Settlements, "Early Warning Indicators of Banking
and T. Duprey and T. Roberts,
Crises: Expanding the Family" (March 2018); "A Barometer of
Bank of Canada Staff Analytical Note No.
Canadian Financial System Vulnerabilities," 2017-24
(December 2017).
25
K. Anand, G. Bédard-Pagé and V. Traclet, "Stress Testing the Canadian Banking System: A
System-Wide Approach," Bank of Canada Financial System Review (June 2014): 61-68.
behavioural aspects, such as the reactions of bank managers and other financial market
participants, and feedback to the real economy. This would require mapping a broader
range of interconnections among financial players, which is not a trivial exercise. We
would also need to keep this mapping fresh by considering changes in the financial
system that might affect the results. An example would be potential changes in the
stickiness of retail deposits in an environment of open banking.
Of course, it's not all about banks.
Stress-testing frameworks have been designed for
CCPs to test their capacity to absorb losses stemming from the default of a participant.
More work is being done here as well. Many CCPs have clearing members in common,
and so international standard-setting bodies are developing a framework for supervisory
stress tests of multiple CCPs across jurisdictions.
We know that being well prepared will increase the odds that financial institutions will
recover from stress events; we also know that recovery is not always possible. Effective
resolution regimes and credible plans are needed to resolve systemically important
financial institutions if they fail. Together with other members of the Financial Stability
Board, Canada has committed to establishing effective resolution regimes for its
systemically important banks (D-SIBs) and FMIs.
As part of this effort, Canada introduced the legislative framework for a bail-in regime to
ensure that people who invest in long-term bank-issued debt, along with equity holders,
share in the financial burden of resolving systemically important banks.26 Aside from
protecting the taxpayer, this kind of regime will help avoid adverse implications for the
distribution of wealth that can follow a bailout.27 It will also support market discipline on
banks in good times.28
Development of the rest of the framework is also under way. Canadian banks are
working hard with the Canada Deposit Insurance Corporation on their resolution plans.
These plans are particularly complicated for those with significant cross-border
activities, because home and host regulatory authorities need to develop a clearer
sense of how financial institutions with global footprints would collaborate in stressful
Canada's this year's
times. With respect to systemically important FMIs, federal budget
included plans to implement a resolution framework, although it still needs to be
operationalized. Rest assured, we will not be satisfied until all these plans meet an
appropriate standard.
26
For details, see
"Backgrounder: Regulations to Implement the Bank Recapitalization (Bail-in)
Department of Finance Canada
Regime," (June 2017).
27
This cost is analyzed in J. Schroth, Bank of
"Financial Crisis Interventions," Canada Staff
Working Paper No. 2016-29 (June 2016).
28
See P. P. Mora, "The 'Too Big to Fail' Subsidy in Canada: Some Estimates," Bank of Canada
Staff Working Paper No. 2018-9 (February 2018).
Conclusion
It's time to wrap up. Janet Yellen said in 2009 that an imperative
"for sustained
economic recovery following a financial crisis is a thoroughgoing repair of the financial
On
system." this front, we have accomplished much over the past decade, and we are
now reaping the benefits.
They might not be durable, though, unless we focus on some unfinished business:
refining our understanding of the role of monetary policy in supporting financial stability,
keeping regulatory and supervisory policies current as risks evolve, and planning for
recovery and resolution when things go wrong. The Bank of Canada is committed to
playing a strong role in all of these areas, both domestically and at international tables.
And let us remember, whether it is through our own financial decisions, our advice to
policy-makers or our policy actions, we all play a role in the health of the financial
system, and in the trust that people place in it.