Mark Carney: From green shoots to the harvest - comments on financial
stability
Remarks by Mr Mark Carney, Governor of the Bank of Canada, to the Regina & District
Chamber of Commerce, Regina, Saskatchewan, 18 June 2009.
* * *
It is a pleasure to be back in Saskatchewan. This great province has been one of the
fastestgrowing parts of the country in recent years, benefiting from increasing diversification into
biotechnology, alternative energy sources, and carbon-management solutions, among other
industries.
Today, I will refer to the traditional backbone of this economy: agriculture. I do so because
lately there has been much talk of "green shoots" in the global economy. From the initially
careful references to data that suggested a slowing of the rate of decline in global activity,
the use of the term "green shoots" has quickly evolved. Some now refer to green shoots as if
the global recovery is a foregone conclusion or even as if sustainable growth had already
begun.
Would that it were so easy. Saskatchewanians know that it is a long, anxious time between
the appearance of seedlings and the harvest. Much hard work remains, and external forces
can profoundly influence the outcome: too little or too much rain, hail, pests, and disease can
all frustrate even the most promising beginnings. And, in the end, global forces of supply and
demand determine the prices received. Old adages usually contain great wisdom: Just as
you don't count your chickens before they are hatched, we shouldn't presume that green
shoots today guarantee a bumper crop tomorrow.
Financial stability and the Bank of Canada
I want to extend this analogy to provide some perspective on recent developments in
Canadian financial stability. Financial stability is the resilience of the financial system to
unanticipated adverse shocks. This resilience determines the extent to which Canadian
households and businesses have access to the credit they need at appropriate terms and
conditions.
While our financial system is one of the soundest in the world, the ferocity of the
once-in-alifetime global financial tempest has affected all Canadians, regardless of their location or
occupation. So, does our financial system still leave us well positioned for our green shoots
to mature into a viable crop of summer wheat?1
The Bank of Canada is well placed to make this judgment. As part of our commitment to
promote the economic and financial welfare of Canada, the Bank actively fosters a stable
and efficient financial system. The Bank constantly assesses the major risks to the
soundness of our system, and helps to develop policies to mitigate them. In essence, we
worry not only about prospects of external shocks (the equivalent of weather or crop prices),
but also about the buffers that our banks, businesses, and households have (the equivalent
of the financial reserves farmers need to carry in case the harvest disappoints).
Twice a year, the Bank publishes its Financial System Review, or FSR - the most recent
edition appeared earlier this week. My talk today will draw on that analysis and assessment. I
will concentrate on three risks, in particular: 1) the liquidity and funding positions of our
banks, 2) the adequacy of their capital, and 3) the financial health of Canadian households. I
will conclude with a few observations on the economic outlook.
Assessment of overall financial stability
Since the autumn, the global economy has been in a deep and synchronized recession that
was triggered by the worst financial crisis since the Great Depression. In recent months,
financial market conditions have improved noticeably and further, gradual progress is likely
as numerous international policy initiatives gain traction. Equity markets have seen strong
gains in recent months (see Appendix, Chart 1), and credit markets have also rallied (Chart
2). While there is still a long way to go before economic and financial conditions return to
normal, markets seem to be turning their backs on worst-case scenarios. The panic that
engulfed global financial markets last fall is over.
Developments in Canadian financial stability over the past six months reflect the competing
influences of improved financial market conditions on the one hand and a deterioration in the
economic outlook on the other. Overall, the level of risk to the Canadian financial system is
judged to be broadly unchanged since last December.
I would sound a note of caution familiar to those who work the land. We are well prepared
but will still be tested. While the strong position of our banks has improved further in recent
months and the balance sheets of Canadian households remain relatively sound, the global
recession will mean that these reserves will be drawn upon in the months ahead.
Let me now turn to the three risks that I cited a moment ago, starting with liquidity and
funding for banks.
Liquidity and funding
At the heart of the financial crisis was the collapse of wholesale funding markets for banks.
Since August 2007, the very short-term interbank and repo markets have been under great
strain. During the most intense periods of the crisis around the collapse of Bear Stearns in
March 2008 and Lehman Brothers and others in the fall of last year, these markets seized up
entirely: Good collateral became unfinanceable overnight, firms failed, and risk aversion
across all financial markets skyrocketed.
This crisis of confidence was less acute in Canada, but still produced severe strains in our
wholesale funding markets. Heightened uncertainty made counterparties reluctant to extend
financing beyond the shortest maturities, resulting in intense funding pressures for Canadian
financial institutions. Banks cut back their market-making activities in order to conserve
balance sheet capacity, which further aggravated market volatility. These dynamics raised
the risk of an adverse feedback loop between the financial system and the real economy.
The Bank of Canada responded to these pressures by dramatically expanding our liquidity
facilities, and the Government of Canada implemented a program to purchase insured
mortgages with the help of the Canada Mortgage and Housing Corporation, thereby
increasing the access of Canadian institutions to longer-term financing. Reflecting both the
strength of our banks and the scale of our actions, conditions in Canada have been
consistently better than elsewhere (Chart 3). Since December, these policies have gained
considerable traction, helping to reinforce the improvement in domestic funding conditions as
the global financial crisis subsided (Chart 4).
This improvement has been reflected in a decline in the spreads on bank financing in money
markets, a moderate extension of maturities, and a substantial reduction in the cost of term
funding for Canadian banks. In addition, policy initiatives have allowed banks to increase
substantially their holdings of government securities, which has helped boost their liquidity
situation in a capital-efficient way. These improvements have been further supported by
strong growth in retail deposits and slowing credit growth (Chart 5). Market-making activity in
Canadian financial markets has also been recovering, although it remains less than
satisfactory.
Policy response
There are important lessons to be drawn from this experience. The performance of core
funding markets during the crisis intensified the financial panic and helped trigger the
recession. This is totally unacceptable. As a consequence, one of the Bank of Canada's top
priorities is to promote institutional changes to create more robust core funding markets.
Promising avenues to break such (il)liquidity spirals include introducing clearing houses,
standardizing products, implementing through-the-cycle margining, and ensuring more
effective netting. As the ultimate provider of liquidity to the system, the Bank is thinking
through whether to adapt its facilities to support continuous private liquidity creation.
Bank capitalization
Since the crisis began, the capital adequacy of banks around the world has been the subject
of intense scrutiny. Concerns moved quickly from bank exposures to U.S. subprime debt on
to structured products of all types as the crisis spread and, finally, to more traditional credits
to businesses and households as the recession took hold. Concerns about capital adequacy
for banks outside Canada were made worse by uncertainties caused by accounting
standards, valuation methodologies, and a loss of credibility of the Basel II regulatory capital
standard. It was not lost on investors that every single financial institution that failed had a
capital ratio well above its Basel II regulatory minimum the day before it went down. As a
consequence, investors have demanded ever-higher capital ratios from all banks, creating a
dynamic that has exacerbated the recession.
In this context, Canadian institutions have benefited from several factors: high initial
capitalization (minimums set by the Office of the Superintendent of Financial Institutions are
well above the Basel threshold), high-quality capital (with one of the highest proportions of
common equity), the clarity provided by a simple leverage cap, low exposure to structured
products, and clear valuation and disclosure standards (including rapid implementation of the
Financial Stability Forum's enhanced disclosure guidance of April 2008) (Chart 6).
Writedowns by Canadian banks have been relatively moderate to date, reflecting their
conservative lending practices and low exposure to highly impaired asset-backed products.
But Canadian banks, as the principal source of finance in our economy, are still exposed to
the risk of a marked deterioration in economic conditions, which would depress earnings and
generate losses in their household and corporate loan portfolios. In general, this risk is why
banks carry high capital buffers.
The macroprudential risk is that these capital buffers may not be allowed to play their
intended role in absorbing these losses because of market pressures to maintain inordinately
high capital ratios. This could force banks to curb balance sheet growth, causing a tightening
of credit conditions that would reinforce the negative impact of the economic downturn on the
financial system. Reflecting the generalized nature of the financial panic, as the crisis
unfolded, Canadian banks came under pressure from markets to increase their capital ratios.
In response, Canadian banks raised significant additional, high-quality capital from private
sources.
The recent improvement in market sentiment has been reinforced by the release in May of
the stress-test results for the 19 largest U.S. banks. These tests showed that the amounts of
additional capital that need to be raised are manageable - indeed, more than half of the
estimated shortfall has already been filled. The results have contributed to a general
improvement of confidence in the global banking sector. To the extent that global levels of
uncertainty and risk aversion have been lowered, this should also relieve some of the market
pressure on Canadian banks to maintain inordinately high capital ratios. It would be welcome
if buffers could serve their intended purpose, particularly in light of the extraordinary liquidity
and funding support that public authorities have provided to our financial institutions.
Policy response
The crisis has undermined the credibility and demonstrated the procyclicality of the current
bank capital regulatory regime. This, too, is unacceptable. An improved regime should be
dynamic (with buffers and provisions moving through the cycle), simple (including
Canadianstyle leverage caps), and coherent (consistent with broader initiatives such as moving
overthe-counter derivatives onto exchanges).2 The Bank is working with its domestic partners
and is using its positions on the Basel Committee of Banking Supervision, at the Financial
Stability Board, and in the G-20 to advance this goal.
In April, G-20 leaders made it a priority to find ways to reduce procyclicality in the financial
system (procyclicality in the financial sector resembles the hog cycle, except that the
boombust nature is further encouraged by regulations, accounting standards, and market
practices).3 To that end, our latest FSR provides detailed analysis of key issues, ranging
from reducing the procyclicality of bank capital regimes, compensation packages, and
valueat-risk-based risk-management practices.4 The Bank will continue to devote considerable
analytic resources to ensure Canada leads the G-20 effort to reduce procyclicality.
Household and corporate balance sheets
The resilience of our financial institutions is obviously directly affected by the financial
resilience of Canadian households and corporations. Canadian firms entered this recession
in very strong shape. Corporate leverage is close to an historic low and is substantially below
that in other major countries (Chart 7).
The picture for Canadian households is more mixed. The starting point is relatively strong:
The debt-service ratio has been stable over the past year and remains just below its
longterm average. In addition, equity in Canadian homes is significantly higher than in the United
States (Chart 8).
However, a deeper-than-expected recession has meant that stresses are rising. Income
growth has slowed, and personal wealth levels have been eroded by lower house prices in
some regions; credit growth has continued to outpace income growth, contributing to higher
debt levels (Chart 9). At the same time, sharp increases in unemployment are raising the
incidence of financial stress among households (Chart 10). Non-performing household loans
and associated provisioning at Canadian financial institutions are thus increasing, although
the deterioration in credit quality is being mitigated to some extent by the decline in effective
borrowing rates (Chart 11).
The Bank has conducted a partial simulation exercise to estimate the impact on household
balance sheets of a more severe economic downturn than currently envisaged, which would
increase the unemployment rate to 10 per cent of the workforce. The results indicate that the
associated rise in financial stress among households would lead to a significant increase in
losses (which would reduce the Tier 1 capital ratios by about 1 percentage point) for financial
institutions, which is well within their capacity to absorb (Table 1).
The economic outlook
The global economy is in the midst of a major synchronized recession. The Bank expects
that growth will resume later this year but that the recovery internationally and in Canada will
be more muted than normal. In part, this reflects the need to correct a series of imbalances
across and within major economies. The recovery will initially owe much to monetary policy,
which has been very aggressive, and to fiscal policy, which is beginning to have an impact.
The effects of monetary and fiscal policy will reach full force in 2010. Self-sustaining demand
in most economic areas is not yet imminent.
It appears likely that the global economy is entering a period of lower potential growth. The
substantial capital misallocation and financial excesses of the boom years will take years to
work off. Recognizing the scale of the industrial restructuring and the decline in investment
over that period, the Bank has sharply lowered its estimate for Canadian productivity growth
and potential growth.
The shifting composition of global growth will have important implications for Canada. The
current pattern of U.S. activity, with its weakness in the housing and auto sectors, is proving
particularly challenging for our businesses. We expect the U.S. recovery to be relatively
subdued compared with historical experience, given its need to reduce excesses, particularly
of private debt.
More positively, the greater proportion of emerging-market growth in overall global growth
should create new opportunities. Our research indicates that, even in the throes of the crisis,
those emerging markets whose demand is most relevant to our exports are also generally
the most resilient. These countries can be expected to make up an increasing proportion of
global demand. This should provide an important support for commodity prices over the
medium term.
The Bank has acted proactively and aggressively to counter the major shocks to the
Canadian economy. We eased our policy rate to the lowest possible level - 1/4 per cent - to
support private demand and to achieve our 2 per cent inflation target. Conditional on the
outlook for inflation, the Bank expects the policy rate to remain at its current level until the
end of June 2010 in order to achieve the inflation target. The Bank retains considerable
additional flexibility, including unconventional measures, as outlined in the principles-based
framework in our April Monetary Policy Report.
Conclusion
Despite the global crisis, the Canadian financial system remains resilient. Prior to the crisis,
Canadian households, businesses, and financial institutions had not built up the high levels
of debt that have made other countries vulnerable. Canadian banks have bolstered their
already strong capital ratios with new private funds. Wholesale funding conditions have
improved significantly and are among the most competitive in the world. The liquidity of bank
balance sheets has improved. In short, our system is well positioned to face the strains of
both the current recession and a more muted recovery.
In farming, you are not in full control of your destiny, and your work is never done. Shocks
frequently come from above. You may hope for the best, but you must plan for the worst.
Even on the eve of summer, you know that it will soon be a long, cold winter, followed by
another spring. The cycle begins anew, and the process is renewed as you constantly
innovate by investing in new equipment and crop varieties. Ultimately, you are keepers of the
land to pass on to the next generation.
And so it is with financial stability. In a highly integrated global economy, shocks frequently
come from abroad. We plan for the worst by trying to build a system that can absorb blows
rather than amplify them. Canada has a strong system, but this crisis has proven that even
the best is not good enough. Just like farmers, policy-makers need to innovate to make our
financial system more resilient and efficient. This means more robust core funding markets, a
better bank capital regime, and, more broadly, a series of measures to reduce procyclicality.
The Bank will continue to work with our domestic and international partners to build such a
financial system, so that the economic harvest in Saskatchewan and across Canada can be
more consistently bountiful.
BIS Review 77/2009
BIS Review 77/2009
BIS Review 77/2009
BIS Review 77/2009
BIS Review 77/2009
BIS Review 77/2009