Institut C.D. HOWE Institute
commentary NO. 429
Securing Monetary and Financial Stability: Why Canada Needs a Macroprudential Policy Framework
A newly created Macroprudential Policy Framework with clear objectives, tools and lines of responsibility could offer greater assurance of financial stability, while leaving the Bank of Canada to focus primarily on inflation and output stabilization.
Paul Jenkins and David Longworth The Institute’s Commitment to Quality
About The C.D. Howe Institute publications undergo rigorous external review Authors by academics and independent experts drawn from the public and private sectors. Paul Jenkins is a former Senior Deputy The Institute’s peer review process ensures the quality, integrity and Governor at the Bank objectivity of its policy research. The Institute will not publish any of Canada. He is a Senior study that, in its view, fails to meet the standards of the review process. Distinguished Fellow at The Institute requires that its authors publicly disclose any actual or Carleton University, a potential conflicts of interest of which they are aware. CIGI Distinguished Fellow; and Senior Fellow In its mission to educate and foster debate on essential public policy at the C.D. Howe Institute. issues, the C.D. Howe Institute provides nonpartisan policy advice to interested parties on a non-exclusive basis. The Institute will not David Longworth endorse any political party, elected official, candidate for elected office, is a former Deputy Governor of the Bank of Canada. He is or interest group. Adjunct Research Professor, Carleton University; Associate As a registered Canadian charity, the C.D. Howe Institute as a matter Director, Risk Policy and of course accepts donations from individuals, private and public Regulation Diploma Program, organizations, charitable foundations and others, by way of general Queen’s University; and project support. The Institute will not accept any donation that and Research Fellow, stipulates a predetermined result or policy stance or otherwise inhibits C.D. Howe Institute. its independence, or that of its staff and authors, in pursuing scholarly activities or disseminating research results.
. HOW .D E I Commentary No. 429 C N T S U T I T June 2015 T I
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E s e s s u e q n i t t i i l a o l p Finn Poschmann P s ol le i r cy u I s n es Vice-President, Policy Analysis tel bl lig nsa ence spe | Conseils indi $12.00 isbn 978-0-88806-951-1 issn 0824-8001 (print); issn 1703-0765 (online) The Study In Brief
Canada’s inflation-target agreement between the government and the Bank of Canada is up for renewal by 31 December 2016. In the aftermath of the 2008-2009 global financial crisis, one of the critical issues for consideration is the integration of price and financial stability in the conduct of policy. ThisCommentary addresses the importance for the conduct of monetary policy of having a separate coherent framework for macroprudential policy – designed to prevent the build-up of systemic, or system-wide, financial risks. A key lesson of the financial crisis was the insufficient attention being paid to these risks and their consequences for the economy. The importance of this issue can be seen in two ways. The first relates to the interactions between monetary and macroprudential policy tools in light of concerns about rising levels of household debt. At various times, there will be situations when only one policy tool is needed, when both policies need to be used in the same direction, or when the two policies need to work in opposite directions. The second relates to the Bank’s current “risk management approach” to monetary policy. In the absence of a government framework for the active use of macroprudential tools, this approach implies that monetary policy becomes a more important line of defence against systemic risks than it needs to be, with the risk of sub-optimal monetary policy outcomes. Our conclusions are threefold: • Canada’s 2 percent inflation target and policy framework has served the economy well, most importantly in anchoring inflation expectations; • over the past two years, Canadian monetary policy would have been better placed to combat low inflation and excess capacity had macroprudential policies been openly geared to reducing the systemic risks associated with rising household indebtedness and housing prices; and • drawing on best practices, the government needs to elevate macroprudential policies by establishing clear objectives, tools and lines of responsibility and accountability. The payoff for Canadians cannot be overstated: greater assurance of both financial stability, as a result of assigned responsibility for macroprudential policy, and monetary stability, as a result of the Bank of Canada’s continued primary focus on inflation and output stabilization.
C.D. Howe Institute Commentary© is a periodic analysis of, and commentary on, current public policy issues. Barry Norris and James Fleming edited the manuscript; Yang Zhao prepared it for publication. As with all Institute publications, the views expressed here are those of the authors and do not necessarily reflect the opinions of the Institute’s members or Board of Directors. Quotation with appropriate credit is permissible.
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The integration of financial stability considerations into the conduct of monetary policy has become an important issue in all countries. In Canada, how best to integrate price stability and financial stability is one of the central issues the Bank of Canada has identified in the lead-up to the 2016 renewal of the inflation-target agreement with the federal government (Côté 2014).
Inflation targeting was introduced in Canada in borrowers and financial institutions; (ii) regulatory 1991. After nearly 20 years of high and variable oversight of financial institutions; and (iii) inflation, with the Consumer Price Index (CPI) macroprudential policy. rising at an annual average rate of over 7 percent, This Commentary addresses why it is important the government and the Bank of Canada jointly for the conduct of monetary policy to have announced an explicit target path for reducing a complementary, coherent framework for inflation to levels considered to be consistent with macroprudential policy. We address two aspects overall price stability. Since then, Canada has had of this issue that have immediate and practical an explicit inflation target that has been extended implications for Canadian monetary policy. The first or renewed five times (Appendix A provides a brief relates to the interactions and spillover effects of history of the inflation-target renewal process).1 monetary and macroprudential policy. At the time of the 2011 renewal, the Bank of Depending on economic and financial Canada, as it did in 2006, recognized the need for conditions, there will be situations when only one flexibility in the conduct of monetary policy to policy tool is needed, when both policies need to play a role in support of financial stability. This be used in the same direction or when the two flexibility has been expressed in terms of the polices work in opposite directions. This means period over which the inflation target is achieved, policymakers need to understand not just the use of potentially involving a longer period to support each policy, but also what guides its use. Moreover, financial stability objectives. Nonetheless, monetary much of the impact of policies works through policy is seen as “the fourth line of defence” (Poloz expectations, which are heavily influenced by the 2014, 7) behind (i) the behaviour of individual guiding frameworks.
The authors ouldw like to thank Finn Poschmann and Bill Robson at the C.D. Howe Institute, John Murray, Gordon Thiessen and several anonymous reviewers for their comments on earlier drafts of this Commentary. Any remaining errors remain the authors’ responsibility. 1 One of the distinguishing features of the renewal process has been the consistency in agreement to keep the target at an annual rate of increase in the CPI of 2 percent. Over the period from December 1995 to December 2014, annual CPI inflation averaged 1.9 percent. 3 Commentary 429
The second issue relates to the Bank of Canada’s to deal with these risks and promote financial current risk-management approach to monetary stability. policy (Poloz 2014, 2015). This approach implies Macroprudential policy can address both the that, as in the past couple of years, when active time dimension and the cross-sectional dimension macroprudential policy is little used and when there of systemic risk (CGFS 2010), both of which is no guiding framework, monetary policy becomes were present in the run-up to the financial crisis. a more immediate line of defence against systemic The time dimension of systemic risk refers to the financial risks than it needs to be, with exposure to buildup of risks associated with the financial cycle greater risk of suboptimal outcomes in missing the or credit cycle. In the run-up to the global financial inflation target and compromising monetary stability. crisis, these risks related to the rapid growth in Our conclusions are threefold: many countries of total credit, residential mortgage • Canada’s 2 percent inflation target and policy credit, especially US subprime mortgage credit, and framework have served the economy well, most house prices in real terms (that is, relative to the importantly in anchoring inflation expectations; general level of prices). Rapid credit growth was • over the past two years, Canadian monetary associated with a significant rise in the leverage of policy would have been better placed to banks in many countries, as their assets rose relative combat low inflation and excess capacity to capital. As well, there was a general increase in had macroprudential policy been openly the indebtedness of households relative to their and transparently geared to reducing the systemic risks associated with rising household incomes. indebtedness and real housing prices; and The cross-section dimension of systemic risk refers to the point-in-time interconnectedness • drawing on best practices, the federal government needs to elevate macroprudential policies by among financial institutions and markets, as well establishing clear objectives, tools and lines of as to the nature of their common exposure to responsibility and accountability. various credit, market and other risks. During the global financial crisis, large international banks had Why Macroprudential Policy Is multiple sizable interconnections through their Important participation in the interbank (deposit) market and the repo market – where collateral included Two key lessons of the global financial crisis of securitized instruments, with many of those 2008–09, among many, were that regulators and instruments based on US residential mortgage supervisors paid insufficient attention to the assets. In addition, many of these banks were buildup of systemic risks in the financial sector, exposed to credit risks in the same residential and that price stability does not guarantee financial (often subprime) mortgage markets, to market and stability. In turn, these two lessons – in conjunction liquidity risks related to securitized products and to with a close examination of market failures2 – counterparty risks related to AAA-rated insurance underlie the arguments for macroprudential policy companies, such as AIG and monoline insurers,
2 The elevantr market failures are those driven by strategic complementarities (herding), leading to the buildup of vulnerabilities in an expansion; fire sales; and interconnectedness, leading to a risk of contagion (Favara and Ratnovski 2014). 4
which focused on providing credit protection on Active macroprudential tools to address financial products. cross-section-dimension risks include capital Although the objective of macroprudential policy requirements related to the contribution to systemic is overall financial stability, some observers (for risk brought to the system by an individual bank. example, Barwell 2013) have distinguished between In practice, active macroprudential policy would an objective of financial system resiliency, on the need to tighten to prevent financial crises when one hand, and an objective of credit smoothing, on risks are building, as in periods of boom, and to the other. The former would focus on the ability ease when risks crystallize and a financial crisis of the financial system to continue to offer key appears imminent. In contrast to monetary policy, services after a shock – an unexpected change in which in normal times is implemented through some aspect of the economy. The latter would focus one instrument – the policy interest rate3 – active on smoothing the financial cycle so as to improve macroprudential policy draws on a number of economic efficiency by dampening booms and busts instruments to deal with the proximate sources in investment and asset prices. of rising systemic risk (market failures). Table 1 Implementing a macroprudential approach to lists those active macroprudential tools that have prudential regulation typically initially leads to been used, or that have been proposed, in advanced a one-time, structural change in the stringency economies. of requirements for bank capital (relative to total Among the possible active macroprudential and/or risk-weighted assets) and for liquidity, as tools are those that focus on signals coming from well as restrictions on certain interconnections aggregate credit growth. Resiliency against risks among banks. Decisions about these were made associated with rapid credit growth would be in the Basel III international accord on banking increased by raising required bank capital relative to regulation, and in some countries they have been risk-weighted assets or unweighted assets (simple augmented by further domestic regulation. leverage ratio). To the extent that increases in bank In addition, active macroprudential tools are capital requirements raise the cost of bank funding, being introduced that recognize that the source interest rates on loans would rise and contribute to and nature of systemic risks can change over time. credit smoothing as well. In addition, there could be Active macroprudential tools to address time- time-varying levies (taxes) on (new) credit. dimension risks include the countercyclical capital Active macroprudential tools can also focus on buffer, changes in required risk weights for assets signals coming from sectoral credit growth, through (in the calculation of risk-weighted capital ratios), varying the risk weights for the calculation of changes in required leverage ratios, changes in required bank capital or by requiring that certain liquidity requirements and changes in required minimum credit conditions be met – typically for credit conditions (such as loan-to-value ratios and mortgages or other collateralized borrowing. Active debt-service-to-income ratios) for certain types of tools can also respond to liquidity conditions, loans, especially mortgages. thus leading to the establishment of time-varying
3 Even in abnormal times, when unconventional monetary policy in the form of forward guidance or asset purchases is used, the emphasis is typically on the effects on the term structure of government and private-sector interest rates. 5 Commentary 429
Table 1: Possible Active Macroprudential Tools for Advanced Economies
Focus Aggregate Credit Growth Sectoral Credit Growth Liquidity (or Balance Sheet Size)
Time Series Dimension
Countercyclical liquidity requirements Countercyclical capital buffer (Basel) Time-varying risk weights (BoE, EU) (EU, Europe) Credit conditions (loan-to-value ratio, Countercyclical simple leverage ratio (BoE, Time-varying reserve requirements debt-to-income ratio, debt-service-to- Europe) (remunerated or unremunerated) income ratio) (BoE, Europe) Time-varying loss-given-defaults for Time-varying levies on credit Time-varying levies on short-term deposits calculation of risk-weighted capital (EU) Time-varying (countercyclical) repo haircuts
Cross-section Dimension
Time-varying risk weights on financial Systemic capital surcharges (Basel) counterparties (BoE) Systemic leverage ratio surcharges (BoE, EU)
Note: Terms in brackets indicate that there is a framework in place to suggest the use of the tools. Basel denotes Basel III; BoE denotes Bank of England Financial Policy Committee; EU denotes under European Union legislation; Europe denotes a possible policy tool suggested for EU members by the European Systemic Risk Board. Sources: Authors’ compilation, based on Bank of England (2014, 2015a,b); European Systemic Risk Board (2014); Longworth (2010, 2011); and Lim et al. (2011).
liquidity requirements. These include aggregate individual banks, under the systemic capital liquidity (based on the two Basel III requirements), surcharges in Basel III, or for risk weights on non- required reserves at the central bank, whether bank financial counterparties. remunerated or not, levies (taxes) on non-core In many ways, macroprudential policy is still in funding such as wholesale short-term deposits and its infancy, with much left to be learned. Still, there requirements for minimum haircuts, which provide has been valuable experience with the use of many the extra collateral protection to cover credit and of macroprudential policy tools, especially since market risks in repo transactions (CGFS 2010; 2000. International Monetary Fund (IMF) studies Longworth 2010). – such as Cerutti, Claessens, and Laeven (2015); The settings of cross-sectional macroprudential Claessens, Ghosh, and Mihet (2014); and Zhang tools will also change over time, whether for and Zoli (2014) – have shown the effectiveness of 6
several tools, especially those related to the credit each other. For example, in a boom in output and conditions for obtaining mortgages or mortgage credit, monetary policy will be tightened to keep insurance.4 inflation from moving above the inflation target, while macroprudential policy will be tightened – The Inter action of for example, through the countercyclical capital Macroprudential and requirement – to raise the amount of capital that Monetary Policy banks have to cover their risks and/or to slow the growth of credit. Monetary policy and much of macroprudential At times, however, credit might be expanding policy are essentially countercyclical policies. In rapidly well before output rises to potential and normal times, monetary policy is the major tool for inflation returns to target from below. In these reducing the amplitude of business cycles, including cases, macroprudential policy might be tightened, 5 cycles in inflation. In such times, monetary policy while monetary policy remains loose or eases even has been shown to have major advantages relative further. As well, if credit growth is concentrated in to active countercyclical fiscal policy (Dodge 2002). particular sectors, there might be a greater case for In comparison, as discussed above, macroprudential tightening sectoral macroprudential policy than for policy is more related to dampening the financial tightening aggregate ones. cycle – including cycles in credit, credit conditions In general, it is clear that each policy needs and liquidity – or to increasing the resiliency of the to take into account any side effects it has on financial system to these cycles. the targets of the other policy (IMF 2013). This Put another way, monetary policy should target is similar to monetary and fiscal authorities price (and output) stability, while macroprudential knowing what the other is doing. When the policy should target financial stability. With two federal government changes fiscal policy, it needs targets, it is appropriate to have two instruments, to understand the demand, inflation and interest- 6 or classes of instruments, and to assign the targets rate implications, and similarly for the Bank of in that way. The various cycles that make up the Canada. It is to the mutual benefit of both to share financial cycle are both positively correlated among information about and analysis of their policies. themselves and positively correlated with the Another aspect of the relationship between business cycle. A typical financial cycle, however, active macroprudential and monetary policy is the is much longer than a typical business cycle optimal response of these policies to various types (Drehmann, Borio, and Tsatsaronis 2012). of shocks, when the “distortions” or “frictions” As both monetary and macroprudential policy associated with market failure are the ones typically lean against cycles, and as those cycles are positively assumed to be important. The major types of shocks correlated, in most periods they will reinforce are considered to be demand shocks, financial
4 Many countries’ experiences so far have involved only movements of the policy tool in one direction. 5 In abnormal times, when the economy is operating at the effective lower bound for nominal interest rates, monetary policy – of the unconventional variety – is still likely to be the most effective policy tool. However, it typically should be supported by expansionary fiscal policy. Moreover, there is an argument to set macroprudential instruments looser than normal, especially if the need to operate at the effective lower bound is because of financial crisis. 6 This is often known as Tinbergen’s Law. 7 Commentary 429
Table 2: Optimal Policy Response to Shocks (in the Theoretical Literature) Given Typical Assumptions about “Distortions”
Shock Monetary Policy Response Macroprudential Policy Response
Yes, alone (if stabilizes both inflation Demand shock Generally no and output)
Yes (targeted at specific financial Financial shock Generally no (too blunt an instrument) distortion).
Productivity shock, with borrower Yes, alone No collateral constraints
Productivity shock with endogenous Yes, with response to inflation as in the case Yes, with tighter policy to rein in credit as financial distortions from bank lending without such distortions bank lending affects systemic risk
Sources: IMF (2013); authors’ compilation.
shocks and productivity shocks. Table 2 summarizes Without a framework for macroprudential policy the findings of a recent IMF examination of the that lays out which macroprudential tools are to optimal responses in the theoretical literature. be used to deal with particular types of financial It is clear that monetary policy should be shocks, there is the risk that governments, as well the key policy in responding to demand and as the public, will look to the central bank to use productivity shocks. In comparison, financial its monetary policy tools to deal with them even shocks should be handled by macroprudential when that clearly would be suboptimal. Such risks policy instruments targeted at specific financial become increasingly unavoidable in the absence of a distortions, because monetary policy is too blunt an body assigned to vary active macroprudential tools. instrument. In the case of productivity shocks with Credibility problems for the central bank endogenous financial distortions (when buoyant easily could arise in such circumstances when financial markets affect the riskiness of lending), there is lack of clarity about the macroprudential macroprudential policy is likely to be important framework. Poor outcomes or lack of action could alongside monetary policy. be blamed on the central bank when they properly However, when macroprudential tools are should be attributed to a poor framework or poor imperfect, when financial sector distortions are implementation of macroprudential policy by the difficult to correct, in part because of unregulated relevant authority. areas, and when monetary policy is at the zero lower Moreover, clearly framed macroprudential bound the case for monetary policy’s augmenting policy, both structural and active, by containing macroprudential policy in dealing with financial financial risks, eases the burden on monetary policy shocks is strongest (Stein 2013). The implication is in normal times, and reduces the probability that that, in normal times, the better macroprudential monetary policy will have to operate at the effective policy is, the less appropriate it is to use monetary lower bound on interest rates (IMF 2013). policy to deal with financial stability issues. 8
Expected Policy that it is not clear if these adjustments were part of a slow process toward an appropriately tighter long- Given the interactions and spillovers described run level for the requirements, or if some of them above, it is clear that policymakers in one domain should be seen as a countercyclical tightening that must take into account recent and expected future might turn into a loosening when mortgage credit policy moves in the other domain. Consumers and growth becomes very low and/or housing prices fall businesses will also be taking into account expected (Longworth 2014). future policy moves. Indeed, one could argue that it is the “preemptive” policy design that does most of The Current Canadian the work in achieving policy objectives in the first Context place – it has, for example, stabilized medium-term inflation expectations in Canada. The global financial crisis vividly demonstrated In the formation of expectations, whether on the that the financial system can be both a source and part of policymakers or consumers and businesses, a propagation mechanism of shocks, with severe it is important to have a clear policy framework to consequences for the real economy in terms of, first, draw on – one that spells out objectives, instruments overinvestment in certain sectors, such as housing, and indicators/analysis – as well as supporting and then lost output, employment and incomes. communications. In the case of Canadian monetary Indeed, as we discussed above, whether through policy, all these are present, provided through the policy transmission channels from the financial inflation-targeting agreement between the Bank of to the real sectors of the economy or through Canada and the federal government, background consequential spillover effects, financial stability documents issued by the Bank at the time of target considerations need to be factored into the conduct renewal, press releases announcing monetary policy of monetary policy. decisions, Monetary Policy Reports and speeches In practical terms, what does this mean? and research articles. The debate has centred on two approaches. One In contrast, there is almost nothing available on argues that monetary policy must play a more active a framework for macroprudential policy in Canada, and deliberate role in “leaning” against financial with the sole exception of the countercyclical capital booms such as excessive credit growth and ease buffer. As a result, it is difficult for the Bank of less aggressively during busts (Borio 2014). The Canada to know in advance what macroprudential alternative view, while recognizing that economic policy instruments are likely to change over and financial stability are inextricably linked, puts the coming year. Since there is no single, easily the focus on clear assignment of responsibility. In observable or quantifiable target for systemic risk, this view, the paramount goal of monetary policy it is even more important to have a framework remains price stability, with macroprudential policy within which to assess, conduct and communicate predominant in dealing with systemic financial risks. macroprudential policies. It is this second approach that the Bank of Since 2008, the federal government has Canada endorsed in its 2011 inflation-target tightened mortgage insurance requirements four renewal background document. The Bank of times (Bank of Canada 2012, 24), through lowering England has gone the farthest in this direction with various loan-to-value ratio maximums, shortening the establishment of a separate policy framework maximum amortization periods and lowering for the conduct of macroprudential policy that relevant debt-service-to-income ratio maximums. includes objectives, instruments, transparency The absence of a formal framework for this set of and accountability. In Canada, the framework for de facto macroprudential policy instruments means macroprudential policy is far from clear, which 9 Commentary 429
presents a serious constraint on the Bank of The Bank of Canada’s current risk-management Canada’s conduct of monetary policy. The current approach to monetary policy discusses financial situation facing the Canadian economy provides stability issues in terms of the financial risks that ample evidence. must be “taken into account” in the setting of With the global economy still reeling from the policy (Poloz 2014, 2015). Although this approach aftermath of the global financial crisis and, more gives weight to macroprudential risks, from the recently, from the precipitous drop in oil prices, perspective of overall economic well-being it does the Canadian economy has continued to need not go far enough to ensure a more complete accommodative monetary policy. Indeed, the Bank integration of the identification and management of Canada lowered its overnight policy rate by 25 of systemic risks into the conduct of both basis points to 0.75 percent on January 21, 2015. macroprudential and monetary policy. In taking this action, the Bank argued that the fall With active macroprudential policy rarely used in oil prices was “unambiguously negative for the and no framework to guide its future use, the Bank Canadian economy.”7 of Canada has had to take the current settings of Although justified in terms of countercyclical macroprudential tools, as well as the current starting demand-management policy and achieving points for the economy and financial stability risk, the inflation target, this cut posed a potentially as given. Thus, the Canadian economy has had only serious dilemma for the Bank in adding to the one tool – the policy interest rate – to deal with vulnerabilities and risks of an already-elevated level two objectives: keeping financial stability risk at a of household indebtedness. For some time, the “normal” (or “reasonable”) value,8 and keeping the Bank has been escalating its concern about these expected future medium-term inflation rate at the risks for the stability of the Canadian financial 2 percent inflation target. system. In its December 2014 and June 2015 Poloz (2014, figure 1) illustrates the constraints semi-annual Financial System Reviews (Bank of the Bank has faced in such a situation – as it did Canada 2014, 2015), it evaluated the impact of risks during most of 2013 and 2014. With one policy associated with household financial stress and a instrument, the Bank could have chosen:9 (i) to sharp correction in house prices at the highest level react only to financial stability risk, set the policy among the risks assessed by the Bank’s Governing interest rate higher and reduce financial stability Council. At the time of its January interest-rate risk to normal; (ii) to react only to factors affecting announcement, the Bank acknowledged that the rate the projected path for inflation, set the policy cut could add to the risks associated with household interest rate lower and achieve the inflation target debt levels, but argued that the risk for household in the medium term; or (iii) to aim for the “neutral debt arising from declines in employment and incomes zone” defined by the Bank, which balances financial as a result of the oil price shock was higher. stability risk and the expected inflation outcome or
7 Opening Statement, Stephen Poloz, press conference for release of the Monetary Policy Report, Jan 21, 2015. 8 We interpret below-normal financial stability risk as a situation where, given existing financial and economic conditions, financial regulations (including the settings of macroprudential tools) are so tight that costs in terms of economic efficiency outweigh the benefits of lower financial stability risk. 9 Appendix B uses a variant of the figure in Poloz (2014) to illustrate, in a rough-and-ready manner, these choices for a given fixed macroprudential policy and set of initial financial and economic conditions. The appendix also illustrates the possible outcomes when an optimal macroprudential policy framework is in place. 10
inflation risk. As Poloz (2015) describes, the Bank coordination; it can also recommend that other has been pursuing the third of these options. regulators and the European Union itself undertake In the presence of a set of active macroprudential appropriate macroprudential policy. tools and a framework to describe their use, the Legislation in place in the European Union, macroprudential authority would focus on keeping the United Kingdom and the United States has financial stability risk at a desired level – thus, in established the objectives, responsibilities, tools normal times, freeing the Bank of Canada to focus and other powers of the relevant committees on achieving the 2 percent inflation target in the (Table 4). In addition, the committees typically medium term of two years or so, not just over the have established an indicator framework to longer run. guide their decision-making. Also spelled out in legislation is the governance structure of the Frameworks, Authority to Act committees – including the chairperson, the and Governance voting (and nonvoting) members, the relationship with government and other regulatory bodies Since the global financial crisis, many countries have and accountability to legislatures and the public. created macroprudential authorities, in the form Canada has no comparable legislation, and has been of committees or individual institutions. Of the criticized by the IMF (2014) for weaknesses in its 34 countries surveyed by Haldane (2013), 23 had informal system.11 established committees that could take significant The model of the Bank of England’s FPC is action (see Table 3). Of these, in 14 cases – including perhaps the most useful for judging what type the United Kingdom, with its Financial Policy of framework should be put in place in Canada. Committee (FPC) at the Bank of England – the The FPC’s objective is the stability of the UK authority lies with the central bank. In 5 cases, financial system, and its responsibilities include the committees have been established essentially for removal or reduction of systemic risk. To meet its coordination among multiple regulatory agencies, responsibilities, the FPC has been granted specific including the Financial Stability Oversight Council tools by the UK Parliament (see Table 5).12 (FSOC) in the United States. In Canada, the Senior For each tool, the FPC has spelled out a Advisory Committee, which is not established complete framework describing how the committee 10 in legislation, acts informally. In the European plans to use it and specific “core indicators” that Union, the European Systemic Risk Board (ESRB) will help to guide its use (Bank of England 2014, – a supranational body, and therefore not part 2015a,b). At times, the FPC works closely with of the numbers in Table 3 – is a committee for the Bank of England Monetary Policy Committee,
10 The Senior Advisory Committee is chaired by the deputy minister of finance and includes the Bank of Canada, the Office of the Superintendent of Financial Institutions, the Canada Deposit Insurance Corporation and the Financial Consumer Agency of Canada. 11 The IMF notes that, “[w]hile the current informal system has worked well, it could be enhanced by clearly assigning the mandate to a single body for monitoring systemic risk to facilitate macroprudential oversight. No single body has the mandate for macroprudential oversight nor do any of the oversight committees have the membership that would allow for a comprehensive view of systemic risk across all financial institutions and markets in Canada” (IMF 2014, 25). 12 In practice, this means that the FPC can direct the use of these tools by the Prudential Regulatory Authority and Financial Conduct Authority. 11 Commentary 429
Table 3: Macroprudential Governance Frameworks, by Number of Countries, 2013
Authority Type of Committee Multiple agencies, including Multiple agencies, not Central bank finance ministry including finance ministry 14 (+1*) Committee for action 8 0 (including United Kingdom) 4 Committee for coordination 0** (including Canada 1 and United States)
No committee 2 1*** 3***
Note: Total number of countries surveyed: 34. * The dditionala country is Finland, where there is a single authority with a committee for action, but it is housed in the banking supervisor. ** If the European Union were a country, it would belong in this cell. *** The ultiplem agencies have distinct responsibilities. Sources: Haldane (2013, table 2); authors’ compilation. which involves the sharing of all relevant The 2016 Inflation-Target information, briefings and analysis with members of Renewal both committees (Carney 2014).13 In strong contrast to the FPC, the FSOC in Appropriate and robust assignments of the United States has limited tools at its disposal, responsibility and accountability are a critical part and has become part of a somewhat unwieldy of the effective functioning of an economy. Canada’s regulatory system with an extremely large number inflation-target monetary policy framework has of regulators, which could dilute its will to act. served Canadians well in providing certainty The FPC, the ESRB and the FSOC all have about the direction of policy, thereby anchoring clear governance structures. As part of these expectations to the 2 percent target, and in structures, the committees include the relevant responding symmetrically to shocks, both small and regulators of financial institutions and markets, as large. Four criteria form the basis of this framework: well as a representative of the government (whether • a clear and achievable objective; in a voting or nonvoting capacity). Jenkins and • effective tools capable of meeting the policy Thiessen (2012) recommend a governance structure objective; for Canada that would involve establishment of a • an agency responsible for policy implementation committee in legislation with formal responsibility with the authority to take measures needed to for macroprudential policy and the necessary achieve the objective; and powers to take action (see Appendix C). • a well-defined process of accountability for the responsible agency.
13 The overnorg and two deputy governors of the Bank of England are members of both committees. 12
Table 4: Macroprudential Frameworks and Governance Structures, European Union, the United Kingdom, and the United States
European Union United Kingdom United States
Macroprudential Body Financial Stability Oversight European Systemic Risk Board Financial Policy Committee Council
Framework
Contribute to prevent/ mitigate Protect and enhance the stability of Identify threats to financial stability systemic risks; help safeguard the the UK financial system and respond to emerging risks Objective stability of the financial system, including by strengthening its resilience Macroprudential oversight of the Systemic risk identification, Information sharing and Responsibilities financial system monitoring and removal or coordination reduction None directly; European rules give Extra risk-weighted capital Monitoring; certain limited types of Tools national authorities several active requirements, leverage tools, rulemaking. macroprudential tools housing tools Issue warnings and Make recommendations Make recommendation to recommendations on a “comply or Congress; recommend stricter Other Powers explain” basis standards for “systemically important financial institutions” Risk dashboard “Core indicators” specific to each Work with Office of Financial Indicators tool Research
Governance
European Central Bank (ECB) Bank of England (BoE) Treasury Housed in
President, ECB Governor, BoE Secretary of the Treasury Chaired by
38: 2 from ECB, 28 central bank 10: 5 from BoE, 1 from Financial 10: 1 Secretary of the Treasury; governors; 3 European regulators, Conduct Authority (FCA), 4 1 Fed chair; 7 federal regulators; Voting members 1 from European Commissions, 4 external 1 insurance expert others Can issue warnings or Give certain directions to Coordination among member recommendations to EU or to Prudential Regulatory Authority regulators. Authority to direct Relationship with regulatory authorities and FCA; make recommendations information collection by Office of other bodies to them and Treasury; works with Financial Research BoE Monetary Policy Committee European Parliament and public UK Parliament and public US Congress and public Accountability
Sources: Authors’ compilation; Bank of England (2014, 2015a,b); Bank of England, Financial Policy Committee website, available at http://www.bankofengland.co.uk/financialstability/pages/fpc/default.aspx; Barwell (2013); Carney (2014); European Systemic Risk Board website, available at https://www.esrb.europa.eu/home/html/index.en.html; Financial Stability Oversight Committee website, available at http://www.treasury.gov/initiatives/fsoc/Pages/home.aspx; and Sharp (2014). 13 Commentary 429
Table 5: Bank of England Financial Policy Committee’s Powers over Specific Tools
Tools to Supplement (Risk-weighted) Leverage Ratio Tools Housing Tools Capital Requirements
• Countercyclical capital buffer • Loan-to-value ratios • Sectoral capital requirements • Countercyclical leverage ratio buffer • Debt-to-income ratios o Residential property, including mortgages • Supplementary leverage ratio buffer • Interest coverage ratios (for o Commercial property for systemically important banks mortgaged rental housing) o Other parts of the financial sector
Sources: Authors’ compilation; and Bank of England (2014, 2015a,b).
A similar set of criteria should form the basis of a objectives: price stability on the one hand, and framework for macroprudential policy in Canada, financial stability on the other. Equally important, and thus create strong incentives to act. Additional however, with these frameworks and assignments in desirable criteria for a macroprudential framework place, each set of policies would be able to factor in would be the power to require information for the actions of the other policy and what is guiding systemic risk purposes from all financial institutions those actions. and infrastructures (whether or not they are As we have discussed, these interactions can currently federally regulated), and the requirement enhance or reduce the effectiveness of each policy. that the agency publish a framework for the use of Seen this way, two frameworks working side-by- each of its tools, including the indicators that would side would enhance overall policy effectiveness be used to guide this use. in a transparent manner and greatly reduce Although much remains to be learned about the uncertainty about policy. With both monetary best way to conduct macroprudential policy, the and macroprudential policy frameworks in presence of a framework embodying these criteria, place, grounded by the criteria presented above, especially a clear objective, would maximize the Canadians could be confident in the authorities’ effectiveness of “learning by doing” – just as such commitment to monetary and financial stability. For criteria did for inflation targeting, especially in the policymakers, being able to exercise “constrained 1990s. discretion”14 within a clearly defined policy With two coherent frameworks, the instruments framework would strengthen policy credibility of policy would be assigned on the basis of their and legitimacy. The alternative – which is what we comparative advantage in meeting the stated policy currently have in Canada – risks misjudgment and
14 Constrained discretion typically refers to a situation where it is preferable to delegate decision-making to an independent institution that will implement policy period by period, exercising discretion within a clearly defined policy framework. 14
policy errors. In addition, effective communication to guide current and future changes in instrument becomes difficult, leading to the risk of settings – monetary policy is able to concentrate on misunderstanding among Canadians and dislodging dealing with inflation risk and output stabilization, their expectations about policy outcomes. making both inflation and output less volatile What does this mean for the 2016 renewal than they otherwise would be. Put differently, if of the inflation target? A clear macroprudential monetary policy focuses on what it can achieve, policy framework, drawing on the practices of policy credibility is enhanced and inflation other countries, is needed – one that has clarity expectations remain well anchored. of objectives, transparency and accountability – if Over the past two years, Canadian monetary monetary policy is to continue to deliver good policy would have been better placed to combat outcomes for Canadians. Ideally, prior to agreement low inflation and low output had macroprudential on the 2016 renewal, the federal government would policies been openly and transparently geared to take steps to put such a framework in place. Only reducing the systemic risks associated with high then could financial stability considerations truly be household indebtedness and high and rising real factored into the conduct of monetary policy. housing prices. In the context of the upcoming inflation-target Conclusion renewal, the Bank of Canada is again looking at the role of monetary policy in dealing with There would be significant advantages to the financial stability. But this role differs in: (i) the Canadian economy overall, and to the Bank of situation when active macroprudential policy is Canada as the monetary authority, in having a used to combat systemic risks within the context well-formulated macroprudential policy that of a well-defined framework describing the use specifies the active macroprudential policy tools to of active tools; and (ii) the situation when active use to limit systemic risks, and thereby to promote macroprudential policy is little used and lacks a financial stability. framework for use, making monetary policy a more The global financial crisis showed that important line of defence against systemic risks macroprudential policy is essential to reduce than it needs to be, with concomitant exposure to a the risk of financial crises – indeed, the G20 greater risk of missing the inflation target. reform agenda has been built on that premise. In The federal government, therefore, needs response, many advanced countries have legislated to legislate a best-practices macroprudential macroprudential policy frameworks, including framework with appropriate governance. The clear governance structures and specific active payoff for Canadians cannot be overstated: greater macroprudential tools. Canada, however, has not assurance of financial stability as a result of the done so. direct assignment of responsibilities for active When appropriate active macroprudential macroprudential policy, and of monetary stability as tools are used wisely to combat systemic risks a result of the Bank of Canada’s continued primary – in the context of a government-mandated focus on inflation and output stabilization. macroprudential authority with a clear framework 15 Commentary 429
Appendix A: A Brief History the Bank has taken the opportunity of each of Canada’s Inflation-Target renewal to update its research and definition of core Renewal Process inflation. In addition, background documents since 2001 have documented the benefits of achieving the In 1991, the federal government and the Bank of 2 percent target. Canada announced explicit targets for reducing Even during the turbulent years of the global inflation on a path to price stability. Although the financial crisis, the inflation-targeting regime timetable was not precise, the objective was to proved a clear and coherent framework within reduce total CPI inflation to 2 percent by the end which the Bank could respond forcefully and in of 1995. a timely way in providing aggressive monetary Further reductions were then anticipated until stimulus. These years again demonstrated the a level of inflation consistent with price stability flexibility of the inflation-targeting framework to (to be defined) was achieved. In a background respond to shocks. document, the Bank laid out the main technical The Bank of Canada’s practical, yet disciplined issues in its approach to achieving the targets. Since approach to carrying out its responsibilities is then, the joint announcement has been extended also clearly evident in its rigor in identifying and or renewed five times, most recently in November 15 undertaking research leading up to a renewal. 2011 for the period through December 31, 2016. This has been especially evident since the 2001 Several common threads run through each renewal, which for the first time introduced a of the inflation-target renewal processes. One five-year term for the joint agreement. The Bank is the common sense approach of learning took an additional step with the 2006 renewal by from experience and research before judging announcing a three-year concerted effort to identify the objectives and the operational approaches. what it deemed would be the key issues ahead of Although the desire from the outset was to have a the next renewal in 2011: the costs and benefits of long-run target consistent with price stability – and an inflation rate lower than 2 percent, and the costs thus confidence in the future value of money – it and benefits of replacing the current inflation target was only after 10 years of experience, in the May with a longer-term, price-level target. 2001 renewal, that monetary policy was explicitly The Bank did indeed undertake a concerted aimed at the 2 percent mid-point of the target research effort on these two issues. But, in the range. Prior to that, the focus had been on holding aftermath of the global financial crisis, it added a inflation inside the range. third area to its research agenda ahead of the 2011 Similarly, in its original 1991 background renewal: how financial stability concerns should be document, the Bank of Canada stressed the taken into consideration in the conduct of monetary importance of looking through the volatile policy. In its 2011 renewal document, the Bank components of the CPI in setting policy. Typically,
15 The Bank of Canada website has a section dedicated to the 2016 renewal, with the issues clearly laid out and easy access to previous renewal announcements and background documents, as well as to the Bank’s research (past and current) relevant to those issues; see “Renewing Canada’s Inflation Control Agreement,” at http://www.bankofcanada.ca/core-functions/ monetary-policy/renewing-canadas-inflation-control-agreement/. 16
recognized, as it did in 2006, the need on occasion to the 2016 renewal: on the links between financial for flexibility in the conduct of monetary policy to market developments and the economy, on the zero play a role in support of financial stability. lower bound on nominal interest rates and on the This flexibility has been expressed in terms formation of expectations. In a November 2014 of the period over which the inflation target is speech (Côté 2014), Deputy Governor Agathe Côté achieved, potentially involving a longer horizon added three issues to this list: the optimal rate of to support financial stability objectives. Monetary inflation, especially in light of a greater probability policy, nonetheless, has been seen as “the that policy would be constrained by the zero lower fourth line of defence” behind the behaviour of bound, the measurement of core inflation and the individual borrowers and financial institutions, integration of financial stability considerations into regulatory oversight of financial institutions and the formulation and conduct of monetary policy. macroprudential policy. In its 2011 background document, the Bank also identified three research areas to receive particular attention over the five years leading up 17 Commentary 429
Appendix B
Figure A1: Expected Policy Outcomes Given Policy Settings, 2013–14, with One and Two Active Policy Tools
Financial stability risk “Lower” interest-rate setting Possible decisions for a given to achieve in ation target macroprudential policy Possible decisions with an appropriately tight macroprudential policy
“Moderate” interest-rate setting to balance nancial stability risk and expected future in ation Normal
Neutral zone where policy rate would not change “Higher” interest-rate setting to reduce nancial stability risk to normal 2% in ation target Expected future in ation
Source: Authors, using a variant of figure 1 in Poloz (2014). 18
Appendix C: The Need for a in place. One explanation offered is that, because Fr amework the Canadian financial system withstood the financial crisis meltdown better than most, there is Jenkins and Thiessen (2102) discuss four alternative no need for action. Financial institution regulation macroprudential models for Canada: proved effective, and the oligopolistic nature of • the minister of finance is given responsibility, Canada’s financial system is itself risk averse. with the current regulatory and supervisory Jenkins and Thiessen make the counterargument agencies acting as an advisory committee; that there is a need for strong incentives to provide • the Bank of Canada, on its own, is given expert analysis and ensure prompt action to deal responsibility; with systemic, or system-wide, risks within a • the current regulatory and supervisory agencies transparent governance structure. What exists are individually given responsibility within their today is opaque and uncertain. We further argue mandates, but they exchange information and coordinate their actions; or in this Commentary that, in the absence of a macroprudential framework, there is the risk that • a committee made up of the current regulatory and supervisory agencies is given the monetary stability will be compromised by forcing responsibility and independence to function as a the Bank of Canada to deal with both financial and single body. monetary stability with a single instrument. All four have their strengths and weaknesses, but Jenkins and Thiessen recommend the last of them. Canada, however, has yet to put such a framework 19 Commentary 429
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