Mark Carney: What are banks really for?
Remarks by Mr Mark Carney, Governor of the Bank of Canada, to the University of Alberta
School of Business, Edmonton, Alberta, 30 March 2009.
The original speech, which contains various links to the documents mentioned, can be found on the US Federal
Reserve System's website.
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Across the world's major economies, addressing the failures of banking ranks among the
highest policy priorities. In the harsh glare of the current financial turmoil, it is clear that many
banks outside of Canada were either not doing their jobs or were doing them in ways that
created enormous risks. It is vital that we learn from these mistakes to build a more robust
financial order.
The financial system should be the servant of the real economy. As one of my international
colleagues recently remarked, "it is time the banks stopped swanning around like the Queen
of England and resumed their traditional role as handmaidens to industry." It is apparent that
an era of self-absorbed finance that viewed itself as the apex of economic activity led to
widespread misallocation of capital. Now, in some major economies, the challenge is that
banks are not allocating capital at all. Around the world, banks are accused of not lending
enough, charging too aggressively when they do lend and, most fundamentally, of deepening
the recession rather than dampening it. These concerns are much less valid in Canada than
abroad, but we too should reflect upon them and respond accordingly.
My remarks today will address the role of banks and markets in our economy. In recent
years, these core elements of our financial system became increasingly intertwined, with
each expanding into the traditional role of the other, and each reliant on the health of the
other. This blurring between banks and markets led to the emergence of the so-called
"shadow banking" sector, whose presence helped trigger the crisis and whose absence will
complicate the recovery. We now face important policy questions about which activities
banks should perform, which should be located in sustainable, continuously-open markets,
and which should be prohibited.
The final answers to these questions require reflection and implementation will take time, but
broad direction is needed now. Markets are overshooting. On the current trajectory, virtually
all financial activities will be put back onto bank balance sheets at potentially tremendous
cost in terms of lost output and employment.
Restoring stability to financial markets requires broad direction on the type of global financial
system that should emerge from the current financial mess. Important steps will be taken at
this week's meeting of the leaders of the G-20 in London. Canada has much to offer these
discussions, and is participating actively and constructively.
Let me stress at the outset that many of my comments today apply more acutely
internationally than domestically. While some commentators have been too quick to ascribe
global failings to our local institutions, we should not engage in a bout of perverse envy. Our
system is better. Regulation has been more consistent. Our banks have been more
conservative. Credit conditions in Canada remain superior to those in virtually every other
industrialized country. That is not to suggest that access to credit is not a challenge, that
risks do not lie ahead, or that our system cannot be improved. However, many of the current
constraints in our system reflect the impact on Canada of failures in the international financial
system and of international institutions. The core of our system has many - although not all -
of the elements of a more sustainable global financial system.
The traditional roles of banks
Commercial banks perform several key functions in our economy. To begin with, banks are a
critical part of the payments system - the pipes through which financial transactions occur.
By facilitating decentralized exchange, the payments system is critical to the functioning of a
market economy. Like oxygen, the payments system passes unnoticed unless disrupted. It is
one of the Bank of Canada's jobs to oversee systemic elements of the payments system, as
well as its reliability. Reflecting years of investment and planning, our payments system has
functioned smoothly and reliably, despite the enormous shocks to our financial system over
the past two years.
The second important role of banks is to transform the maturities of assets and liabilities.
Banks take short-term liabilities, usually in the form of deposits, and transform them into
long-term assets, such as mortgages or corporate loans. Households and businesses can
therefore do the reverse, holding short-term assets and longer-term liabilities. This helps
them to plan for the future and to manage risks arising from uncertainties over their cash
flows. Banks also provide liquidity to their customers by allowing rapid access to those same
short-term assets. Indeed, by transacting at a wide range of maturities, banks provide
arbitrage which increases the efficiency of financial markets. This allows borrowers to obtain
the lowest rate of interest appropriate to their risk characteristics.
The social value of maturity transformation is without question. However, by definition, it also
leads to a maturity mismatch that creates a fundamental risk for banks. Banks hold liquid
reserves that are only a fraction of their outstanding obligations. What if a depositor wants his
money back, but that money is committed to long-term investment projects? Generally, this is
not a problem, because banks maintain sufficient liquidity to meet typical demands and can
borrow from other banks if the shock is larger than anticipated. But what if many depositors
want their money back at the same time? There is a tipping point when the liquidity problem
becomes self-fulfilling.
To manage this risk, banks rely on two crucial supports. First, deposit insurance gives
depositors the comfort that their funds will be there when they need them.1 Second, the Bank
of Canada acts as a lender of last resort to solvent but illiquid institutions.2
These support mechanisms are carefully crafted to discourage banks from taking
inappropriate risks while still providing the necessary support. They are also accompanied by
a robust regulatory framework. Bankers implicitly accept a social contract that gives them
access to liquidity support in times of a stress in return for regulation of their behaviour at all
times.
Banks perform a third essential role of credit intermediation, channelling funds from savers to
investors. This allows savers to diversify their risk and all of us to smooth our consumption
over time. Young families can borrow to buy a house, students can pay for university.
Canadians can invest in low-risk, interest-bearing accounts for their retirements, and
businesses can finance working capital and investment.
Banks, markets, and the crisis
Banks are not the only game in town. In recent years, markets have grown to the point that
they are now an important alternative for corporate and household finance. From a financial
system perspective, the deepening of markets is generally very welcome because it makes
the system more robust and increases competition, which disciplines banking activity.
While markets expand the choices and lower the prices available to financial consumers,
they function differently from banks. Unlike banks, markets rely more completely on
confidence for liquidity. We have seen during this crisis that confidence is not always
present. Liquidity waxes and wanes, and with it, so do the prices of securities. In recent
months, as we have seen a fundamental repricing of virtually every financial asset across the
world, liquidity in many securities has fallen dramatically.
Banks have relationships with their customers. They follow borrowers over time and monitor
their payment history and reliability. When performing their role properly, banks tailor their
products to the borrower, imposing higher or lower standards as appropriate. In contrast,
markets are transaction oriented. They act as an intermediary between savers and borrowers
but maintain relationships with neither. Consequently, market instruments are more robust
when the underlying product is more standardized. Determining whether an activity is best
financed through a bank or a market depends on the relative benefits to that activity of
specialization versus standardization.
In response to increased competitive pressure from markets, banks have become direct
participants in markets. This move helped to sow the seeds of the crisis through three
channels in particular: wholesale funding, securitization, and proprietary trading.
First, banks have become increasingly heavy users of markets to fund their activities. In
recent years, many international banks borrowed in short-term markets to finance asset
growth and, in the process, to substantially increase their leverage. This made them
increasingly dependent on continuous access to liquidity in money and capital markets. In
the process, banks conflated a reliance on market liquidity with their access to central bank
liquidity. This exacerbated the potential liquidity problems of banks to a magnitude that we
now better appreciate.
Second, banks increasingly used securitization to straddle relationship banking and
transactional market-based finance. Under the originate-to-distribute business model, banks
originated a set of loans, repackaged them as securities, and sold them to investors. In
essence, banks took specialized loans and sold them in standardized packages. While
securitization promised to diversify risks for banks, the transfer of risk was frequently
incomplete. Banks often sold securities to "arms-length" conduits that they were later forced
to reintermediate or held onto AAA tranches of structures that proved far from risk-free. At
the extreme, the business models of some institutions were wholly reliant on the continuous
availability of markets for securitized assets (e.g., Northern Rock).
The global financial crisis exposed the fundamental incentive problems that can occur with
securitization. In the originate-to-distribute model, the incentives of the originating institution
were no longer aligned with those of the risk-holders. Once that relationship was severed,
the standards for new loans and their ongoing monitoring were adversely affected. However,
pricing and risk management did not reflect these changes until they were abruptly adjusted,
helping to trigger the onset of the crisis.
Third, many retail and commercial banks expanded into investment banking. This allowed
banks to package traditional lending with higher value-added agency business,
marketmaking activities and, increasingly proprietary trading. Banks' push into markets helped spur
the proliferation of over-the-counter derivative products, which created counterparty and
investment risks that were difficult to identify and control.
Incentive problems also plagued this transition. In many banks, a culture that rewarded
innovation and opacity over risk management and transparency eventually undermined its
creators. Senior managers and shareholders of banks discovered that actual risks were
much greater than originally thought. By that time, the more junior traders who had assumed
the risks had already been paid, largely in cash. Many large, complex institutions learned too
late that there can be principal-agent problems within firms, as well as between firms and
their shareholders.
Just as banks began doing what markets traditionally did best, there was an explosion in
highly specialized products that required monitoring and continuous access to funding
liquidity. More and more of the traditional functions of banks - including maturity
transformation and credit intermediation - were conducted through a broader range of
intermediaries and investment vehicles, which have been collectively referred to as the
"shadow banking" system. Shadow banks included investment banks (in other countries),
mortgage brokers, finance companies, structured investment vehicles (SIVs), hedge funds,
and other private asset pools.
The scale of these developments was remarkable. During this decade, banking assets grew
enormously, to anywhere from one and a half times to six times national GDP in Canada, the
United States, the United Kingdom, and Europe. In all countries besides Canada, much of
this growth was financed by increased leverage.3 In the final years of the boom, when
complacency about access to liquidity reached its zenith, the scale of the shadow banking
system exploded. The value of SIVs, for example, tripled in the three years to 2007. The
growth in financial activity and the increasingly complex array of financial players have
prompted a dramatic increase in claims within the financial system, as opposed to between
the financial system and the real economy, which created risks that were difficult to identify
and evaluate.
Financial institutions, including many banks, came to rely on high levels of liquidity in
markets. In the United States, the total value of commercial paper rose by more than 60 per
cent and the ABCP market by more than 80 per cent in the three years before the crisis. In
essence, the shadow banking system practiced maturity transformation without a safety net -
that is, it was wholly reliant on the continuous availability of funding markets. The collapse in
market liquidity that began in August 2007 crystallized these risks.
The regulatory system neither appreciated the scale of this activity nor adequately adapted to
the new risks created by it. The shadow banking system was not supported, regulated, or
monitored in the same fashion as the banking system. With hindsight, the shift towards the
shadow banking system that emerged in other countries was allowed to go too far for too
long.
Financial deleveraging
The financial crisis is now reversing the decades-long transition from bank-based,
relationship-oriented finance towards market-based, transaction-oriented finance. Banks are
playing a larger role in the ongoing extension of credit. However, this transition carries
enormous risks. Banks alone cannot support the same level of economic activity as the
entire system did before, particularly since many need to delever. Moreover, the financial
system as a whole is more robust when both banks and markets are strong, healthy, and
liquid.
Financial deleveraging is now one of the dominant forces in the global economy. After a
decade during which household debt, leverage in the financial sector, and cross-border
capital flows all rose rapidly, all have slowed or are now falling. The duration and orderliness
of these shifts will help to determine the severity of the global recession.
Financial institutions around the world must bring their leverage down to more sustainable
levels by shrinking assets and raising more capital. Considerable, albeit disruptive, progress
has been made in the shadow banking system, where SIVs and other conduits have been
largely wound up. Hedge fund assets under management have been cut in half to about
US$1 trillion, and the leverage applied to these assets has been substantially reduced. As
liquidity in many funding markets has dried up, so has embedded leverage in many pension
funds. However, there has been less progress in the regulated banking sector. This is a large
task. We estimate that to bring leverage ratios down to Canadian levels by raising capital
alone, global banks would need more than US$1 trillion in new capital, before any additional
writedowns on assets.
The deleveraging process has contributed to a dramatic reversal in cross-border capital
flows. Many of the largest global banks have dramatically curtailed their international
activities. Hedge funds have similarly retreated to their home countries in anticipation of
redemptions and over concerns for cross-border liquidity. The Institute of International
Finance (IIF) estimates that net flows from private creditors to emerging markets, which
topped US$630 billion in 2007, will be negative this year. Once the crisis passes, the scale of
cross-border financial transactions is unlikely to return to pre-crisis levels. This reflects both
the re-emergence of home bias amongst investors and the impact of measures to support
domestic institutions. This financial protectionism, if not checked, could permanently impair
cross-border capital flows and could be a serious setback for the global economy.
Reform of the global financial system
It is clear that the global financial system needs to be restructured, but doing so requires a
clear view of the objectives. The fundamental objective is a system that efficiently supports
economic growth while providing financial consumers with choices. The system must be
robust to shocks, dampening rather than amplifying their effect on the real economy. It
should also support sensible innovation. The system needs both stable banks and robust
markets, since both play a central role in financing and, if properly structured, each can
support the other.
Achieving these objectives will require a range of measures starting with short-term initiatives
to keep the system functioning and then bridging to more fundamental long-term reforms,
which help define the roles of banks and markets.
Keeping the system functioning
Extraordinary measures have been taken to underpin the financial system. All G-20 countries
have explicitly and repeatedly confirmed that no systemically important institution will be
allowed to fail. In some countries, there has been direct support for banks through capital
injections using public money. Support has also taken less direct forms, such as liquidity
support to help keep open the markets on which banks and market participants depend.
Some of these measures are expediencies taken in the midst of a crisis and elements may
need to be adjusted later to support a more permanent solution.4
For example banks have been provided with considerable liquidity support to reflect the scale
of the funding pressures. The broader intent has been to grease the wheels of the financial
system. In providing liquidity to banks at the core of the system, central banks expected that
key markets would resume functioning as liquidity cascaded down to other market
participants and, ultimately, through private credit creation to the real economy. However, the
weaker the starting point of regulated institutions and the greater the importance of the
shadow banking sector, the longer the healing process has taken.
While the provision of extraordinary liquidity 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.
Reopening markets will ultimately require a series of measures to improve the infrastructure
of core funding markets, securitization, and credit default swaps (CDS).
Building systemic markets
A robust and efficient financial system needs core markets for interbank lending, commercial
paper, and repos of high-quality securities that are continuously open, even under periods of
stress. To that end, the Bank of Canada is currently engaged in wide-ranging discussions
with market participants, regulators, and other central banks on the steps that may be
needed to create continuously open markets. Potential measures include improving the
transparency of securities (as with ABCP), standardizing terms such as through-the-cycle
haircuts for repos, and exploring the potential use of clearing houses to limit counterparty
risks. Regulations and standards could reinforce these initiatives. Central bank operations
could also be adapted to create a market-maker of last resort.
Authorities are also taking important steps to improve the functioning of key markets such as
securitization and CDS by creating more robust infrastructure and standardizing the
products. For example, to reduce opacity, the models and data underlying securities could be
published to move securitization from black box to open source. An extreme would be to
standardize securities by introducing a government "wrap" or guarantee, as is the case with
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Canada Mortgage Bonds.5 Similarly, a host of measures are being pursued to make the
CDS market more sustainable. The U.S. Federal Reserve has improved clearing and
settlement arrangements, and has encouraged the move of CDS onto clearing houses. This
will encourage the standardization of these products, while making CDS counterparties -
often banks - less systemically important at the margin.
The limits between banks and markets
These initiatives will change the margin between banks and markets and will make markets
much more robust. This will reduce risks to those institutions that rely on these markets and
reduce the extent to which certain banks are "too interconnected to fail." Nonetheless, even
with these changes, banks can be expected to continue to be active market participants.
For some, such progress is insufficient. A simple lesson that they draw from the crisis is that
banks should be divorced from markets. To those who think this way, banks are most
naturally heavily regulated utilities that collect deposits and make loans. Once banks become
involved in the market "casino," they are overwhelmed by the resulting risk-management
challenges and all too often have to draw on their public safety nets. Indeed, the very
existence of those safety nets may encourage excess risk taking and promote financial
crises. That is why some advocate restricting banks' activities to their "core" functions of
deposit taking and lending. The range of activities related to the markets would be kept
outside the heavily regulated banking sector. To this way of thinking, banks could not then
get themselves into trouble or, if they did, their demise could be safely managed.
In the midst of the crisis, this is a seductive viewpoint, but its practical value may be limited
for three reasons.
First, banks perform a broad range of market-related activities that are vital to the existence
of markets. Canadian banks are the major agents, market makers, underwriters, and traders
of most government debt and corporate debt. Even with substantial improvements to market
infrastructure, it is difficult to see markets functioning effectively in the absence of bank
participation. These activities can be distinguished from principal positions or proprietary
investments and are essential to well-functioning markets. Efforts to improve market
infrastructure described above will make markets less risky and the system as a whole more
robust.
Second, banks are the major providers of cross-border financing products ranging from trade
finance, to foreign exchange hedging, to foreign financing. In a world of global supply chains
and corporations, it would be very costly to prohibit bank provision of these services that
have become integral to global commerce. Moreover, with global cross-border flows already
under such pressure, further impediments would be extremely risky.
Third, the crisis has demonstrated that there are many firms that have been deemed
systemic and worthy of rescue even though they were not deposit-taking banks. Efforts to
build more robust markets and to define clearer and more comprehensive resolution
schemes may limit these cases in the future, but they are unlikely to eliminate them entirely.
In my opinion, a better approach is the plan by the G-20 to expand the perimeter of
regulation. As a general principle, all financial activities that can pose a systemic risk to
financial stability should be supervised and regulated. This will include pools of capital of
material size, leverage, and maturity mismatches. In addition, to avoid regulatory arbitrage,
markets should be regulated according to economic substance, placing similar activities into
the same regulatory bucket, even if undertaken in different institutions. Regulating by
economic substance should limit the destabilizing impact of shadow banks on the banks
themselves.
In many respects, the relative success of Canadian banks and their consolidated supervision
by the Office of the Superintendent of Financial Institutions demonstrates that, with the
proper regulatory regime and professional management, banks can be much more than
utilities. In this spirit, Canada is contributing to the international debate on financial sector
reform. We are stressing the need for a macroprudential (i.e., comprehensive and
systemwide) approach that takes into account the importance of banks, markets, and the
interactions between them.
Conclusion
Our principal preoccupation is weathering the financial and economic storm, but as we
respond to the current tempest, policy-makers must also focus on where we want to end up
when calmer conditions arrive. Our destination should be one where banks and financial
markets play critical, and complementary, roles in a financial system to support long-term
economic prosperity. The system as a whole will be more stable if market infrastructure is
substantially improved, market products are more standardized and transparent, and banks
can fulfill their market-making roles with appropriate liquidity backstops.
As the G-20 pursues its critical agenda of financial reform, Canada will contribute an
important perspective on these issues, drawing on the fine example we continue to set.