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,

price inflation is now well below the core rate of inflation. and in such circumstances, it is equally inappropriate to base our policy actions on swings in total cpi inflation. the slowing economy in the past year let me now look back at a rather difficult year for the economy. during 2001, we lowered interest rates at every fixed announcement date, in order to adjust to the changing economic circumstances. at the beginning of the year, our main concern was the impact that a slowing u. s. economy would have on canada. although domestic demand in canada was holding up, against a backdrop of weaker foreign demand, we lowered our target for the overnight rate through the first half of the year. both the old and new measures of core inflation also remove the effect of changes in indirect taxes. but by mid - summer, evidence began to accumulate that the u. s. slowdown would be more protracted than anticipated, and that economic activity outside north america would be much weaker. at the same time, there were indications that domestic demand in canada, which had held up well through the first part of the year, was softening. so at our 28 august fixed announcement date, we said that we had revised down our expectations for growth. then came the terrorist attacks of 11 september. their immediate impact and subsequent fallout compounded the problems of the economic slowdown. and the attacks presented a pressing challenge to the bank of canada and other central banks : to keep the world's financial systems operating smoothly. one of the bank's key functions is to promote financial stability in canada. that means keeping markets functioning well, even in times of extreme stress, such as the days immediately following 11 september. the bank of canada, as did other central banks around the world, stepped in to provide financial markets with ample access to domestic liquidity. and we reached an agreement with the u. s. federal reserve that would have permitted us to provide extra u. s. - dollar liquidity to canadian banks had it been necessary. in short, we made sure that the disruption did not turn into gridlock. if there was one positive thing to emerge from this terrible event, it was that the global financial system kept running as well as it did. but in the aftermath of these events, we were left with another challenge. that was to try to minimize the economic impact of the attacks. it was obvious that consumer and business confidence would suffer. we needed to do our part to help keep the loss of confidence as small