Canada looks to rein in bank liquidity

Canada looks to rein in bank liquidity

By Krishna Guha, Bernard Simon and Chrystia Freeland in New York

Published: May 22 2008 22:38 | Last updated: May 23 2008 00:46

The Bank of Canada on Thursday became the first major central bank to signal it may soon begin to scale back the provision of extra liquidity to financial markets.

Mark Carney, the bank governor, told a business group in New York that a central bank should assess “when intervention has been sufficiently successful for it to exit”.

He said success should not necessarily be judged on the extent to which spreads between interbank lending rates and expected future policy rates had returned to pre-crisis levels because fundamentals were likely to have changed. Instead, the judgment to withdraw should be based on “evidence of better-functioning markets”.

He said bank funding costs in Canada “have fallen markedly over the last few weeks and are substantially below equivalent spreads in some other currencies”.

The central bank’s recent liquidity auctions have also pointed to diminishing funding pressures. Nonetheless, Mr Carney said the bank would need to keep an eye on market liquidity at the end of the current quarter.

In an interview with the Financial Times on Thursday he noted that liquidity stress in Canadian markets was much less pronounced than in the US or Europe. He said “the risk-management culture in our banks is very strong”.

The structural changes required in Canada’s financial system are not as large as elsewhere because more business has always been conducted on the banks’ balance sheets and their borrowings relative to capital are lower.

Canada did have a serious difficulty with asset-backed commercial paper but this appears to have been solved by a debt restructuring deal.

Mr Carney also credited strict leverage rules mandated by Canada’s regulator for ensuring the stability of the financial system.

Asked whether other countries should adopt similar rules, he said: “Yes, absolutely.”

The US Federal Reserve is also starting to consider how it will wind down its liquidity operations, though it is far from starting the process. Officials favour shifting the mix of its liquidity operations in favour of the term auction facility. In the near future, however, the Fed is more likely to increase the total volume of liquidity support than to reduce it.

Mr Carney said that central banks had to ensure their approach to liquidity was “symmetric” – even-handed – over the course of the economic cycle. If they were willing to provide emergency liquidity at times when the markets were desperate for it, they should be willing to extract liquidity at times when it was super-abundant, he said.

Central banks could not do this with their existing liquidity instruments. But it might be possible to achieve the same end by using “macro-prudential regulation” to prevent the emergence of excess liquidity at the peak of economic cycles.

Mr Carney appeared to raise the question whether the Bank of Canada would need to be given additional regulatory powers.

“There would be the added complication of determining where to house this regulatory authority and how it would be co-ordinated across jurisdictions,” he said.