For system financial risk, use regulation not monetary policy

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Canada needs a framework that specifies policy tools to be used in limiting systemic risks

High and rising household debt is raising red flags. In its June Financial System Review, the Bank of Canada evaluated risks to financial stability associated with household financial stress and a sharp correction in housing prices, and came to the conclusion that the impact of these risks stood at the highest level among those it assesses.

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What can be done to address such vulnerabilities and risks? We believe that they should be addressed primarily through a new, clear framework for using regulatory tools aimed specifically at financial system stability risks, so-called systemic risks, and not by monetary policy.

That means financial regulatory policies assigned to the specific tasks of dampening the financial cycle — including cycles in credit, credit conditions and liquidity — or increasing the resiliency of the financial system to these cycles. The global financial crisis, in which rapid credit creation lay at the heart, showed that such policies are essential to reduce the risk of financial crisis.

In response, many advanced countries have legislated “macroprudential” policy frameworks, including clear governance structures with specific tools, or instruments, to use actively to get the job done. Canada, however, has not yet done so.

The absence of such a framework in Canada presents a serious constraint on the Bank of Canada’s conduct of monetary policy. With Canada’s inflation-target agreement between the government and the Bank of Canada up for renewal by the end of next year, we have an opportunity to address this gap.

The integration of financial stability considerations into the conduct of monetary policy has become an important issue in all countries. How best to integrate monetary 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 active ‘macroprudential’ policy rarely used, the Bank of Canada has only one tool — the policy interest rate

While the Bank of Canada’s current risk-management approach to monetary policy takes into account financial stability risks in the setting of policy, this approach alone cannot ensure effective management of both systemic risks and inflation control.

With the global economy still reeling from the aftermath of the global financial crisis and, more recently, with the drop in oil prices, the Canadian economy continues to require accommodative monetary policy. Indeed, the Bank of Canada lowered its overnight policy rate by 25 basis points to 0.75 per cent on January 21, 2015.

Although justified in terms of countercyclical demand-management policy and achieving the Bank’s 2 per cent inflation target, this cut in rates poses a potentially serious dilemma for the Bank, adding to the vulnerabilities and risks of an already-elevated level of household indebtedness.

With active “macroprudential” policy rarely used, and no framework to guide its use, the Bank of Canada has only one tool—the policy interest rate—to deal with both financial stability and inflation control. This risks compromising monetary stability by forcing the Bank to deal with two targets–financial and monetary stability — with a single instrument.

There would be significant advantages to the Canadian economy overall, and to the Bank of Canada as the monetary authority, in having a well-formulated framework that specifies the active policy tools to be used in limiting systemic risks, and thereby promoting financial stability. These tools could include mortgage insurance requirements and add-ons to the required equity capital for financial institutions.

Over the past two years, Canadian monetary policy would have been better placed to combat low inflation and low output had financial system-oriented policies been openly and transparently geared to reducing the systemic risks associated with high household indebtedness and high and rising housing prices.

The role of monetary policy in dealing with financial stability depends on whether active macroprudential policy is used to combat systemic risks within the context of a well-defined framework describing the use of active tools. In the present situation, where active macroprudential policy is little used and lacks a framework for use, monetary policy becomes a more important line of defense against systemic risks than it needs to be.

Ideally, prior to agreement on the 2016 renewal, the federal government, drawing on best practices elsewhere–such as those of the U.K. government and Bank of England– would take steps to put such a framework in place. As part of the framework, independence and responsibility for active tools should be given to a committee, functioning as a single body but made up of the current regulatory and supervisory agencies.

Appropriate and robust assignments of responsibility and accountability are a critical part of the effective functioning of an economy. With two targets, it is appropriate to have two instruments, or classes of instruments, one assigned to each target.

The payoff for Canadians cannot be overstated: greater assurance of financial stability as a result of the direct assignment of responsibilities for active macroprudential policy, and of monetary stability as a result of the Bank of Canada’s continued primary focus on inflation and output stabilization.

Paul Jenkins is a former Senior Deputy Governor, and David Longworth a former Deputy Governor, at the Bank of Canada. They are also Senior and Research Fellows at the C.D. Howe Institute.