This commentary was first published in the Financial Post on September 23, 2009.
The G20 leaders meet today in Pittsburgh. While macroprudential regulation is likely to be on the agenda, countries continue to wrestle with how, if at all, this concept fits within existing legal frameworks and indeed whether new regulators or committees will be created in each country. But, taking a step back, what does "macroprudential regulation" mean? Should Canada proceed down this road? If so, how?
Macroprudential regulation focuses on the financial system as a whole, seeking to minimize system-wide distress in order to avoid reductions in aggregate output (GDP). This is unlike microprudential regulation which seeks to minimize distress in individual institutions in order to protect depositors. Macroprudential regulation focuses on common exposures across financial systems and institutions rather than the entity-specific focus of microprudential regulation.
Underlying the concept of macroprudential regulation is the idea that rational behaviour on the part of individual institutions may lead to unstable aggregate outcomes. Those charged with dispensing macroprudential regulation will be obliged continuously to examine the financial system as a whole (including financial markets, financial instruments, and financial infrastructure as well as individual players, such as institutional and retail investors, depositors etc.). By contrast, those committed to microprudential regulation may not see such surveillance as important as they seek to ensure that institutions are liquid and well-capitalized (for example). They may not consider that if all financial institutions, acting in their rational self-interest, simultaneously adopted tighter lending standards, the system as a whole may become insufficiently liquid, with lending grinding to a halt.
To some extent Canada has macroprudential regulation in place already. In its preamble, the Bank of Canada Act provides the bank with the mandate “generally [to] promote the economic and financial welfare of Canada.” The bank is tasked with regulating credit and currency in the best interests of the economic life of the nation and controlling national monetary policy. It has the authority to act as a liquidity provider of last resort in our financial system and has responsibility for the oversight of clearing and settlement systems for the purpose of controlling systemic risk.
But macroprudential regulation in the G20 context means more than this. It would entail an obligation to assess potential vulnerabilities in the financial system and to issue early warnings that alert financial sector stakeholders to the buildup of systemic risk. It may involve making recommendations to various regulatory bodies and other stakeholders about prevention of activities that cause systemic risk. It may include sharing information about Canada’s financial system with regulatory agencies nationally and internationally.
Some argue that the Canadian financial system exhibited resilience through the credit crisis and that Canadian banks are risk averse in any case. They contend, therefore, that the case for macroprudential regulation in Canada has not been made. However, Canada had its own crisis manifested in asset-backed commercial paper (ABCP). The crisis revealed an “asset-liability mismatch” (as Chant explains) where investors lost confidence in the values of the longer-term assets backing the short-term commercial paper. It was difficult for them to determine the quality of the collateral backing their claims. ABCP implicated numerous aspects of our financial system, including securities, mortgage markets, and securitizations. Given that existing regulators generally believed that ABCP fell outside of their respective mandates, ABCP indicates why we need a macroprudential regulator (and indeed why existing regulators need to be involved in the process of institutionalizing this regulation).
Viewing ABCP as a wake-up call, it seems “prudent” to endorse the G20 call for macroprudential regulation. Broadly speaking, two options exist. The first, to use existing agencies as macroprudential regulators, appears to be the option favoured by Nicholas Le Pan in a recent report. Le Pan argues that “macroprudential regulation is ill-defined and has the potential to conflict with both the regulation and supervision of individual institutions.” He argues against assigning responsibility for the stability of the financial system to a single agency because “what matters more are processes to promote the realistic consideration of risk …to resolve tradeoffs among different policies, and to strengthen the will to act.”
On this model, the regulatory structure changes only slightly to accommodate macroprudential regulatory concerns. Le Pan cites OSFI’s mandate which includes “monitoring and evaluating system-wide or sectoral events or issues that may have a negative impact on the financial condition of financial institutions.” The implication is that no new regulatory authority is needed, and to the extent that Canada is “going macroprudential,” OSFI is the institution for the task. However, it seems that OSFI’s mandate to evaluate system-wide conditions relates to microprudential purposes (i.e. assessing the impact on the depositors, policyholders and creditors of financial institutions) and when read in the context of the OSFI Act as a whole, this interpretation is persuasive.
But does this mean that OSFI couldn’t engage in macroprudential regulation on a prospective basis? While macroprudential regulation relates to the functioning of financial institutions, it also involves markets and institutions outside OSFI’s purview. For example, both derivatives trading and mortgage markets were central to the securitizations at the heart of ABCP. But OSFI’s current mandate doesn’t extend to securities markets and doesn’t cover many issues that arise in mortgage transactions. In short, OSFI’s ability to engage in macroprudential oversight is limited.
Another option is to create a separate committee with a specific mandate to focus on the system as a whole and to ensure that information sharing occurs among existing regulators. This body could be comprised of representatives from the relevant institutions: the federal Department of Finance, the Canadian Securities Commission (to be formed), OSFI, the Canada Deposit Insurance Corporation, the Financial Consumer Agency of Canada and the Bank of Canada. The committee would be charged with assessing systemic risks on a regular basis and discussing measures for mitigating those risks. The relevant regulators would bear responsibility for implementation where policies fall within their respective domains and could be accountable to this committee.
Some may argue that Canada has too many regulators, and adding an additional body — even a committee of this sort — would detract from the focus on their individual mandates. However, Canada’s multi-faceted institutional landscape is the very reason that Canada needs a separate body with a specific mandate to oversee its complex financial markets. Given their individual responsibilities over separate aspects of the financial system, none of these bodies can realistically be charged with monitoring the entire system.
There are many issues to be resolved in moving down the path toward macroprudential regulation: How do the stakeholders involved develop shared understandings about what “macroprudential regulation” means? What structure will be put in place to ensure that our markets have macroprudential oversight? To ensure accountability, will the body have legislative authority? As we work towards resolving these and other issues, Canadians would do well to heed the call for macroprudential regulation, responding positively, decisively and collectively.