Proceedings of the Standing Senate Committee on
Banking, Trade and Commerce
Issue 4 - Evidence - November 2, 2011
OTTAWA, Wednesday, November 2, 2011
The Standing Senate Committee on Banking, Trade and Commerce met this day at 4:19 p.m. to study the present state of the domestic and international financial system.
Senator Michael A. Meighen (Chair) in the chair.
[Translation]
The Chair: Welcome to our meeting of the Standing Senate Committee on Banking, Trade and Commerce to study the present state of the domestic and international financial system.
[English]
My name is Michael Meighen, and I am a senator from Ontario. I have the honour to chair the Standing Senate Committee on Banking, Trade and Commerce.
[Translation]
Our Deputy Chair, Senator Hervieux-Payette should be arriving shortly.
[English]
Perhaps I will introduce the other members of the committee present. On my left are Senator Massicotte, from Quebec; Senator Moore, from Nova Scotia; and Senator Ringuette, from New Brunswick.
On my right are Senator Gerstein, from Ontario; Senator Greene, from Nova Scotia; Senator Tkachuk, from Saskatchewan; Senator Stewart Olsen, from New Brunswick; Senator Smith, from Quebec; and Senator Oliver, from Nova Scotia.
We are very pleased to welcome back to our committee as witnesses Mark Carney, Governor of the Bank of Canada; and Deputy Governor, Tiff Macklem. Both have appeared before us on a number of occasions and are always willing to do so; and we appreciate that very much.
An old senator once was heard to ask: "Does man make the times or do the times make the man?'' In face of the global economic circumstances faced by Canada since 2008, I think both parts of the saying apply to the Bank of Canada. In fact, any objective observer of the Bank of Canada's decisions and work in recent years could easily conclude that Canada has been well served by the clarity, insight and, dare I say, occasional fearlessness that Mr. Carney, Mr. Macklem and their associates have brought to the job.
Mr. Carney, I understand that as a young hockey player you used to get revved up before the big game by listening to the music of AC/DC; I believe the song title was Hells Bells. To cite a lyric from a classic song written by an even more famous group, The Beatles, A Day in the Life, the governor and his team at Canada's central bank have definitely made the grade.
Mr. Carney and Mr. Macklem are before us to discuss the Monetary Policy Report and other matters of concern to committee members.
Governor, please proceed.
Mark J. Carney, Governor, Bank of Canada: Thank you, Mr. Chair and members, for your welcome and kind words. That must break precedent, the first time that AC/DC has been read into the record of these hearings.
We are pleased to be here to discuss our October Monetary Policy Report, which we published last week. I will take a few minutes to go through the principal elements of it.
The global economy has slowed markedly as several downside risks to our projection that we outlined in our July Monetary Policy Report have been realized. Volatility has increased, and there has been a generalized retrenchment from risk taking across markets. The combination of ongoing deleveraging by banks and households, increased fiscal austerity and declining confidence is expected to restrain growth across the advanced economies.
The bank now expects that the euro area, where these dynamics are most acute, will experience a brief recession. The bank's base case scenario nonetheless assumes that the euro area crisis will be contained, although this assumption is clearly subject to downside risks.
We welcome the agreement announced last week by euro area leaders on a comprehensive plan to address the ongoing challenges in Europe. We look forward to additional details on the modalities of the various measures announced and to their implementation in the coming weeks.
[Translation]
In the United States, real GDP growth is expected to be weak through the first half of 2012, reflecting diminished household confidence, tighter financial conditions and increased fiscal drag.
Growth in China and other emerging-market economies is projected to moderate to a more sustainable pace. These developments, combined with recent declines in commodity prices, are expected to dampen global inflationary pressures.
The outlook for the Canadian economy has weakened since July, with the significantly less favourable external environment affecting Canada through financial, confidence and trade channels. Although Canadian growth rebounded in the third quarter with the unwinding of temporary factors, underlying economic momentum has slowed and is expected to remain modest through the middle of next year.
[English]
Household expenditures in Canada are projected to grow relatively modestly as lower commodity prices and heightened volatility in financial markets weigh on the incomes, wealth and confidence of Canadian households. Business fixed investment is expected to grow solidly in response to very stimulative financial conditions and heightened competitive pressures, although it will be dampened by the weaker and more uncertain global economic environment.
Net exports are expected to remain a source of weakness owing to sluggish foreign demand and ongoing competitiveness challenges, including the persistent strength of the Canadian dollar.
Overall, the bank expects that growth in Canada will be slow through mid-2012 before picking up as the global economic environment improves, uncertainty dissipates and confidence increases.
[Translation]
The weaker economic outlook implies greater and more persistent economic slack than previously anticipated, with the Canadian economy now expected to return to full capacity by the end of 2013. As a result, core inflation is expected to be slightly softer than previously expected, declining through 2012 before returning to 2 per cent by the end of 2013.
The projection for total CPI inflation has also been revised down, reflecting the recent reversal of earlier sharp increases in world energy prices, as well as modestly weaker core inflation. Total CPI inflation is expected to trough around 1 per cent by the middle of 2012 before rising with core inflation to the 2 per cent target by the end of 2013, as excess supply in the economy is slowly absorbed.
[English]
There are several significant risks to the inflation outlook in Canada. The three main upside risks relate to the possibility of stronger-than-expected inflationary pressures in the global economy, stronger momentum in Canadian household spending, and the possibility of a faster-than-expected rebound in business and consumer confidence due to more decisive policy actions in the major advantaged economies.
The three main downside risks to inflation in Canada relate to the sovereign debt and banking crisis concerns in Europe, the increased probability of a recession in the U.S. economy, and the possibility that growth in household spending in Canada could be weaker than projected.
Reflecting all of these factors, the bank last week maintained the target for the overnight rate at 1 per cent. With the target interest rate near historic lows and our financial system functioning well, there is considerable monetary policy stimulus in Canada. The bank will continue to monitor carefully economic and financial developments in the Canadian and global economies, together with the evolution of risks, and set monetary policy consistent with achieving the 2 per cent inflation target over the medium term.
With those comments, Mr. Macklem and I will be pleased to respond to your questions.
The Chair: Thank you.
Perhaps I can lead off with something that is on everybody's minds, and that is the situation in Greece. You are on record as endorsing the democratic right of the people of that country to have a referendum on the rescue package.
Correct me if I am wrong, but I believe that yesterday you appeared to somewhat downplay what is at stake by referring to the fact that Greece has a very small economy relative to the entire eurozone. Given the real possibility that the Greek electorate may reject the agreement, what would be the consequences, not so much for Greece but for other eurozone countries and perhaps even Canada? What measures do you believe should be considered so as to contain the contagion and prevent any cascading effect, which we witnessed in the 2008 banking crisis?
Mr. Carney: Thank you for the questions.
I will start by reinforcing the words of the Minister of Finance, who said that with respect to the eurozone crisis, not just the situation in Greece but the broader steps that need to be taken in Europe, delay is the enemy. Measures have been promised, most recently at a very important summit of euro area leaders last week, which outlined a five-element comprehensive plan for Europe. As I said in my opening statement and yesterday, it is important that we quickly see the details behind those broader initiatives and that they are implemented.
One of the five elements relates to the restructuring of Greek debt and the measures that the Greek government has promised to make.
The observation I made is that there needs to be broad support for those steps, because the steps or the suite of reforms, both budgetary and structural, that the Greek government and the Greek people need to take in any circumstance will take place not just over the course of weeks but coming years. There needs to be broad support. I leave it entirely to the Greek people and the Greek government to determine how to engender and marshal that support in order to put in place absolutely necessary measures.
The second point is that as powerful as this committee is and as we are at the Bank of Canada and the people of Canada, we do not influence that outcome. Your question is what happens if there is not a satisfactory resolution and all the necessary steps are not taken in Greece? The point we would emphasize is that we would start with the relative size of this issue. It is relatively small in the context of the world's broader economy. The Greek economy is about 1.5 per cent of euro area GDP. It is absolutely necessary that all the other elements of the package are put in place — not just promised, but are put in place. That begins with a recapitalization of the European banking system.
European leaders have specified that by June of next year the capital levels of European banks be brought to 9 per cent on a common core tier 1 Basel 2.5 level measurement. Further, they specified a desire that this is not done through too much deleveraging. We would go further and suggest maybe some detail and ideally some action would be taken so that actual capital is put into the institutions as opposed to just a shedding of assets. That would have a more positive effect on the overall European situation. We leave it to the Europeans to decide exactly how to do it. That is an example of the details that need to be specified and progress made in the short term.
The third thing is progress on ensuring that the capacity of the so-called firewall, which is to say the capacity of the EFSF, which is a fund whose purpose —
The Chair: Could you tell us what the acronym means?
Mr. Carney: That is the European Financial Stability Facility, which is a pooling of European resources that can be made available and has been made available in part for Ireland, Portugal and Greece, in all of those cases in tandem with funds from the IMF. It could be made available to other European countries to ensure that they can finance their government debt at sustainable levels of interest rates. The Europeans have indicated a desire to increase the effective capacity of that fund toward an additional trillion euros. That needs to be put in place in an effective manner so that, in effect, the substantial proportion, in our opinion — not that it is absolutely necessarily to be drawn on, but that there is the possibility or the ability for the major affected countries, in other words, Spain and Italy, to draw on the fund to ensure that they can sustainably finance the rollovers of their debt over the course of the coming couple of years.
We say that because of the time frame for the adjustments both on the budget side in these countries and on the structural side. Reforms to product markets, labour markets, increasing competitiveness, and finally adjustments to the very nature of monetary union and the refunding of monetary union — which is part of the five elements of this package and is a new governance structure and new objective for monetary union — will be measured out in years, not in weeks and months. There needs to be certainty for the markets. The markets need to be overwhelmed both on the bank capital side and the sovereign funding side.
Putting into effect the steps that have been not just promised but agreed to by European leaders will effectively isolate the core of Europe from individual situations. Now, that is in everybody's interest. We are not advocating, by any stretch of the imagination, an unfortunate outcome in Greece. We would like to see the agreement that was struck be put into place. However, it is very much possible to isolate the core from what happens there. What is required, to be absolutely sure of that, is to put the other elements of the agreement into place and implement them.
I can say that the European leaders and European central bank governors and European ministers of finance know all this, and they are working to do it. That is why we say that we look forward to details on the modalities and to implementation over the course of the coming weeks.
Senator Hervieux-Payette: Can I ask about the implementation process? How does it start if they need to do that? Is it the governor of one of the country's central bank that goes to the Minister of Finance and then to the leader of that country? What is the process?
Mr. Carney: That is a fair question. There is a series of meetings at the European level. There is a summit, as everyone is aware, in Cannes this week. There will be meetings, I am sure, on the margins and progress on the margins of that summit to provide greater specifics around the capacities of these funds and the specifics around them. Then, in the following weeks, there are regularly scheduled meetings of European finance ministers, but on the agenda is exactly this issue, bringing it down from 10,000 feet, if you will, toward landing and providing more details.
Within each of the countries, for example, on the bank recapitalization, it is first and foremost the responsibility of local authorities. However, they work in tandem with the EBA, the European Banking Authority, which is the common banking regulator, in effect, to determine the effectiveness of various measures that each of the banks are taking. It is something that will roll out over the coming weeks. We look forward to those details being brought out, both at the European level and a national level.
Senator Greene: What happens if there is no implementation, for whatever reason?
Mr. Carney: There are two things. First, our forecast and the forecast that is laid before you is that our assumption is that the European crisis is contained — not resolved, but contained. By that, we mean that the level of spillovers or contagion through financial markets' overall confidence, et cetera, to North America, to broader markets, including Canada, is limited from the situation. In order to contain, we have full reason to expect European authorities to honour their commitments, which have been made at the highest political level and, in many cases, with support across the political spectrum. For example, the commitments that the German chancellor made were following consultations with the Bundestag on exactly the measures to which Germany agreed, so there is support across the board. We fully expect that these will be implemented based on the level of those commitments. We expect this will deliver containment as opposed to resolution, because resolution will take years. We further would not rule out the possibility that additional supplemental measures will be required over the course of the relatively near term and the medium term to ensure that those objectives are there.
To answer the question — maybe I should not answer the question. Would you like me to answer the question?
The Chair: Yes.
Mr. Carney: The effect if there were no containment, obviously, would be that our outlook for growth and inflation in Canada would be lower, all things being equal if there are no other impacts. The direct impact on Canada from Europe is relatively modest. We have some trading interest, but it is relatively limited. The direct impact between the financial sectors is relatively modest. The direct exposure to the affected countries of the Canadian financial institutions is relatively limited. The exposure that would be felt, in our opinion, would be felt through a generalized repricing of risk assets, credit spreads, equity values and the tightening up of funding conditions that would undoubtedly occur if there were material problems coming out of Europe. That would affect the Canadian financial sector, without question, even given its strength.
We can do many things that to help mitigate that impact, but we cannot totally remove that impact. There are lots of things Canadian financial institutions have already done to limit the impact of an event like this, but they cannot totally eliminate it either. There will be an effect through the financial channel, and undoubtedly there would also be an effect through confidence of households and businesses.
Again, in a containment scenario, which is the base case scenario in our projection, we have financial effects and confidence effects already built in. We say it is one the reasons why, when you get to the middle of 2012, our best judgment as we sit here today is that we will start to see some of the benefits of the measures that we expect the Europeans to implement to start to remove some of those confidence and financial impacts, both for Canada and, very importantly, for the United States, which is much more directly affected.
Senator Tkachuk: Thank you, governor and Mr. Macklem, for being here today.
During the economic crisis, the argument has been made that it was Canada's strong regulatory framework that protected us from some of the nastier repercussions of the recent economic downturn. People, financial writers and even yourself have pointed to the Department of Finance, the Bank of Canada, OSFI, Canada Deposit Insurance Corporation, Financial Consumer Agency of Canada and to the coordinated efforts of those regulators through various institutions such as the Financial Institutions Supervisory Committee. However, the United States, which suffered massively from the same crisis, has lots of regulations regarding safety, soundness of banks, deposit insurance and adequate capital. They have the Federal Reserve, the Financial Stability Oversight Council and their Federal Deposit Insurance Corporation. They have their Commodity Futures Trading Commission. Everybody has regulators and regulations. I would like to know what part of the regulatory framework accounts for the different result in Canada versus the United States.
Mr. Carney: Let me say a couple of things on it, and Mr. Macklem may want to supplement that.
First, related to this is the structure of our mortgage market here in Canada. There are substantial differences between the structures of the mortgage markets in Canada versus the United States. The mortgage insurance system here, while there are always ways to improve it and the government has taken steps in the past couple of years to further improve it, provided a more consistent and a higher standard of underwriting in Canada than the United States. There are a variety of reasons for that, and we can go through why that is, if that is of interest, but I will give a broader answer to your question and not dwell on that.
Second, there were some aspects of regulation here that were not fully applied in the United States. One is a very simple regulation, which is a leverage ratio. Instead of a fancy way of adjusting assets, which one does and there are many good reasons to do it under Basel II and now Basel III where you risk adjust your assets and actually shrink the apparent size of the balance sheet accordingly, and there is logic to that, we had a belt and suspenders approach. This is due to the Superintendant of Financial Institutions ensuring this was the case. That approach looked at a very simple ratio of total assets over total equity, or total capital. That protected us against risks we thought were low but in fact were high.
One of the big elements of the crisis in the United States and in the U.K. and in Europe were Triple-A securities, structured securities, so-called leveraged super senior securities, that were viewed as basically risk-free that in fact were incredibly risky. People had relatively small balance sheets on a risk-adjusted basis but very large balance sheets — 40 to 1 assets to equity, 50 to 1 in the case of some continental European banks — on an absolute basis, which you could not do in Canada. Our restrictions were 20 to 1. That is an example of simple regulation
I think it goes deeper than that in regard to three aspects. One is how you regulate and how you supervise. The approach, particularly of the superintendent, has supervisory intensity and is more principled-based as opposed to a rules-based "got you'' type of regulation. It is more iterative. I will explain what I mean.
One of the things that happens on that committee you referenced, the FISC committee on which I sit as governor and the superintendent chairs and the Deputy Minister of Finance is there and the head of CDIC is there, the deposit insurer, is that from time to time our institutions will be "staged.'' They will have done something wrong. They will have some issue in either their risk management or operational risk or some element that means that they get more intensive regulatory scrutiny. They might have to hold back a little more capital. They might have to dispose of a business or change a system, but they are in the penalty box, so to speak — and it is not public — until they sort out this issue. That is discussed around this committee. We all know about it, but it is ultimately a decision of the superintendent. The institution, the bank, let us say as an example, and their board knows that there is an issue, that they do not get out of it until they fix the issue. That is sort of the iterative approach.
I cannot tell you of the specific experiences based on the act, but I can tell you in general terms that it made a big difference in a number of cases that I am personally aware of because it caught problems early. It brought board and senior management attention early to issues around risk management and operational controls, things that can crop up and ultimately cause major problems. It is an iterative approach. You cannot legislate those types of things. You cannot anticipate everything. You have to have effective supervision on the ground.
The other two elements that do work, I think, are the accountability structure. The U.S., with all due respect, has a large number of regulators. Unfortunately, in the run-up to the crisis, it was not entirely clear who was in charge for certain entities — for example, the U.S. broker dealer sector, the investment banks, principal regulator of the SEC, some regulation on the side by the New York fed but not the principal regulator. In the run-up to the crisis, and I talked about the leverage ratio a second ago, those investment banks went from something like 12 or 13 times leverage ratio to just under 30 in the five year run-up to the crisis. Surprise, surprise. With all those types of risky assets funded on a very short term basis, the SEC did not have its eye on that aspect of the ball and the fed was not responsible for it, so there was an accountability deficit and a mismatch in terms of competencies and responsibilities in the United States. Again, I say that with all due respect. It is easy to look back and criticize. I think it is acknowledged, though, by the U.S. authorities.
Here in Canada, it is absolutely clear who regulates banks, who regulates investment bank safety and who regulates insurance companies. The principal regulator is the Superintendent of Financial Institutions. She is supplemented by the Bank of Canada, by the Department of Finance and by the deposit insurer. We all have a legislated responsibility to share information, which is my last point, the level of cooperation. We must share any material information we have in our possession.
One of the other things in the U.S. and some other jurisdictions was competition, if you will, between the agencies. The reality of regulation in Canada is if we, the bank, ever have an item that we are worried about in a certain sector, we ask the Superintendent of Financial Institutions about their information. They instantly provide it to us. They do it because we have a very good working relationship, but they also would do it because their act they have to because it could be material. You would never want to be a position where you did not provide information that was potentially material.
To some extent, the cooperation is the nature of how Canada works, and we can rely on it, but it is also embedded in a legislated responsibility. Cooperation, accountability and supervisory intensity are, if you will, the soft elements of regulation here that have made a difference.
I will add a fourth, which is that it is all great this has happened and well done, and we made it through, but we cannot have complacency added to that list. We did do well but, as soon as we start resting on that, we will not do well.
Senator Tkachuk: I was going to get to that. The Americans have a highly competitive system and thousands of banks. The Congressional Research Service concluded that the Canadian financial and economic system is smaller than that in the United States. We regulate half a dozen banks and a couple other small banks. You could probably do it in one room at the Albany Club, but it is just not the same thing.
You have talked about increasing regulation. How do you get hold of a system like the Americans have? You have talked Europe also needing a stronger regulatory system. Their downfall may be for different reasons from those of the Americans. Could we have weathered a collapse in the housing market in Canada? Let us say the housing market collapsed to the same extent that the American market did. I think we would have huge problems; and all our banks are too big to bail.
Mr. Carney: There are a few issues there. First, I am afraid I cannot let stand the comment that we only regulate six banks and that is it. The experience in the 1980s with Northland Bank of Canada and the Canadian Commercial Bank basically said that what happens to small institutions matters and that we needed more effective regulation of smaller institutions as well large ones. That was the genesis of the independent Superintendent of Financial Institutions, which has served us well. At the Financial Institutions Supervisory Committee, FISC, we spend a lot of time on the smaller institutions, as does OSFI. The time is well spent. When Canadians transact with those institutions and provide deposit insurance to those institutions, which occurs in most cases, they have a right to know that those institutions are being appropriately supervised.
Second, we advocate for better regulation and better supervision. As you noted in your question, the U.S. system did not work well, which is patently clear. They have various deficiencies, which included not having implemented the Basel framework properly, but they will now implement a leverage ratio across the board; and not having an effective supervisory council, but they now have a financial stability council chaired by the U.S. Treasury. A variety of other factors come with that, which adjust appropriately, in our opinion, capital and liquidity standards in the United States. It is not exactly like the Canadian system. We, too, have learned things from what happened, but it makes the U.S. system look much more Canadian than vice versa, without question. We are an advocate of that because it is in our national interests to ensure that the U.S. system is more resilient. None of us enjoyed 2008-09.
Your final question was on housing. If we had a national calamity in the housing market such as a 30 per cent to 40 per cent fall, we would notice it. However, there are some pretty major differences between the how the Canadian housing market functions and how the U.S. one functions.
You can start with the level of equity that Canadian households have in their homes, which is just under 70 per cent, versus just north of 30 per cent under the U.S. system. The fact that we do not have mortgage deductibility of interest is one of the measures that have helped to ensure that.
Further is the fact that the majority of mortgages are on balance sheet at the banks, so they have skin in the game as opposed to warehousing the mortgages to then sell them off. About one third of our mortgages are securitized where two thirds of American mortgages were securitized before, so the incentives were different. Subprime lending in the U.S on a flow basis was about 14 per cent of the flow of mortgages pre-crisis, but in Canada they were low single digits, about 3.5 per cent. There were significant differences.
Finally, there is another difference in an adverse outcome, which we are not projecting, just to be clear. High loan- to-value mortgages require mortgage insurance. A portion of higher risk mortgages moves to CMHC or to the private insurer providing the insurance. It is mortgage insurance, so there is a much quicker resolution, or the prospect of one, than there is in the U.S. because of their order of magnitude and when people will step in. One of reasons the U.S. housing market is still under pressure longer than people would have expected is in part because of the time frame for actual resolution. There are big differences.
We are not complacent about household debt in this country or about the housing market. However, I do not think that is the same as saying we have anything like the structural deficiencies that existed in the U.S. housing market prior to their crisis.
Senator Greene: My question will be short because Senator Tkachuk took most of my questions. I will ask an open- ended question, and you can take the answer wherever you wish.
Are you happy with the progress being made in the U.S. with regard to oversight of their financial system?
The Chair: Maybe Mr. Macklem would like to answer that one.
Tiff Macklem, Senior Deputy Governor, Bank of Canada: We are paid to worry, so we are never happy; that is our disposition.
Getting back to what the governor was saying in terms of the U.S. regulatory agenda, the key elements and actual sound implementation on the ground. There is still a lot of work to be done. The rules in terms of Basel III, capital, liquidity and the leverage ratio have been agreed to, but they have not been implemented on the ground. There is a lot of work to be done there and it is critically important that there be full implementation in a way that is consistent globally, not just within the U.S. That is a big piece.
Another piece remains, and we and many others are spending increasing amounts of time on it. Often it is called the shadow banking system or market-based finance. In many respects, the easy part has been done. We have rewritten the rules for the regulated sector, where there were serious gaps. We have a lot of experience with that sector and know a lot about it.
The shadow banking sector is large. In the U.S. at the peak of the credit boom, it was double the size of the regulated sector. It has shrunk dramatically because access to funding has been restricted, but it is still 25 per cent bigger than the regulated sector. It plays an important role in their economy by providing diversification, innovation and competition. However, after strengthening the rules in the regulated sector, we do not want to see activities simply migrate to the shadow banking sector. There has been intense effort coordinated through the Financial Stability Board — the Americans have been playing a big part in this at the table — at getting a better understanding of all the activities of the shadow banking sector, how they are linked within the sector, and the links to the regulated sector. You have to follow the money. What is the chain and where can it break down?
Then they have to determine what kind of measures would be effective in providing more resiliency to that sector, which would include regulating margin requirements; looking at the links to the regulated sector; and making sure that the regulated sector is taking appropriate provisions against the risks if something goes wrong in the shadow banking sector; and, importantly, strengthening key parts of the core infrastructure, or central counter parties for over-the- counter derivatives that would limit the knock-on effects to other institutions when one institution gets into trouble.
In summary, the regulated sector rules have been rewritten and have to be implemented, and we have to deal with the shadow banking sector. Finally, we have to complete the work on "too big to fail'' so that no institution is too big to fail and that taxpayers are not on the hook. Until all of that happens we will not be happy.
The Chair: Have you anything to add to that, governor?
Mr. Carney: That is well summarized. I would add another aspect specific on the United States. They have made some institutional changes as part of the Dodd-Frank legislation, including giving the fed responsibility for systemically important financial institutions so that someone is on the hook — and in this case it is the Federal Reserve — for those institutions that are too big to fail, which is broader than just big banks. That is a welcome development and they have put that into place.
Senator Moore: To continue the earlier discussion with regard to Greece, I read in the financial pages that countries who hold their bonds are required to take a 50 per cent haircut; in other words, what was worth $100 is suddenly worth $50. How much of their bonds do we have in our international reserves?
Mr. Carney: We have none.
Senator Moore: None?
Mr. Carney: How is that?
Senator Moore: That is very good. You must have got rid of this stuff earlier, did you?
Mr. Carney: I will give you a broader answer.
The Bank of Canada acts as the federal government's agent in the management of international reserves. There is an investment policy for those reserves that is not automatically triggered off credit ratings, but if you can think in terms of various rating categories from Triple-A, Double-A and Single-A, there are various thresholds in terms of the concentrations of that portfolio into those types of bonds. We make judgments around the relative creditworthiness of those bonds and the perspective creditworthiness of those bonds and then provide those judgments. It is ultimately a decision of the government, but in the case of Greece we are not holders of their bonds.
Senator Moore: That is good. I think I asked you that last year when this first came up.
Senator Massicotte: It was the same answer.
Senator Moore: It was not the same answer last year. He would not answer me last year.
Mr. Carney: You wore me down.
Senator Moore: Last Tuesday, Joseph Stiglitz, former chief economist at the World Bank, spoke in Toronto and said:
. . . the United States and Germany and a number of other countries —
— I expect he was speaking of Canada —
— do have considerable space for stimulating their economy, and it is absolutely essential that they do that.
He went on to say:
The austerity that is going on in Europe, America and so forth is effectively a suicide pact for our economies.
He is obviously encouraging stimulus spending of a serious amount, I guess. Do you have any thoughts about that? Have you considered that in your efforts in the bank to maintain our solid position?
Mr. Carney: I will say a couple of words about our assumptions on U.S. fiscal policy.
We have not included in our forecast the passage of any of the provisions of the American Jobs Act in 2012. When we talk about the possibility of more decisive policy actions, one of the aspects could be that there would be substantial portions of the American Jobs Act or different forms of fiscal stimulus passed in the United States. Obviously a whole host of other more decisive actions relate to what is going on in Europe and upside surprises.
For reference, the rough order of magnitude of the American Jobs Act by way of contribution to GDP in the United States would be in the order of 1.25 percentage points of additional GDP growth in 2012 that then would be roughly the same amount of additional GDP drag in 2013. That brings us to a bit of the issue here, namely, that at some point the private sector has to take over as the motor of growth. That is the order of magnitude.
One thing with our projection is that if components of the U.S. Jobs Act are passed, that would provide additional lift in the short term for U.S. growth, in our opinion.
Senator Moore: I am also wondering about the advancement of such a stimulus package in Canada.
Mr. Carney: I am sure the Minister of Finance would be pleased to comment on that.
Senator Moore: You do not want to comment on that.
I have been reading recently the phrase "nominal GDP'' as a technical term for trying to deal with the economy and set things on a different path rather than strictly the bank's 2 per cent inflationary target. Have you considered that? What are your thoughts about possibly implementing that?
Mr. Carney: I will give a brief answer and we can expand if senators wish.
As I believe you know, the bank has been engaged in a fairly intensive research program over the course of the last five years on potential alternatives, enhancements, improvements to the inflation targeting framework that we have practised since 1991. One of the researched topics has been not nominal GDP targeting, per se, but price level targeting. The difference between price level targeting and inflation targeting is basically, "Are bygones bygones?''
Under inflation targeting, Mr. Macklem and I wake up every day, along with the other members of the governing council and employees at the bank, and think about how to achieve that 2 per cent total CPI inflation target in a reasonable horizon given all the forces that are hitting the economy and affecting inflation. How do we conduct monetary policy to achieve that?
Under price level targeting, and then more extreme in nominal GDP targeting, the central bank would be looking at targeting a level of prices. If inflation had been relatively low for a period of time in the recent past, you would look to make up that difference. Nominal GDP targeting is looking at a level growth path for nominal GDP; in other words, the sum of real growth, which are the terms in which we always talk, and nominal GDP inflation, which is different than consumer price inflation. It gets to one of the issues around nominal GDP targeting because effectively you are looking to grow a path of GDP.
The short answer is that we have looked at this or something similar. Will we opine on that in the relatively near future when the inflation control agreement is renewed with the government?
Senator Moore: When does that come up?
Mr. Carney: It should be renewed by the end of this calendar year.
In general terms, while there are interesting aspects to nominal GDP targeting, and it might deserve consideration, which is to say that I am not advocating it, in economies that are at the zero lower bound and that have the possibility of a debt deflation, a heavy debt overlay and actual debt deflation, it might merit consideration.
Neither of those factors apply to Canada and there are a number of issues with this approach, not limited to but including the ability to execute it. If we were to do it in Canada, the vast majority of Canadians would have to agree in their expectations that we would achieve this goal in order to make it self-reinforcing, to make the transition work. You would need a very good estimate of the real underlying growth rate of the economy, the so-called potential rate of growth of the economy, or you could end up expanding the inflation portion of that nominal GDP growth over time, reducing real growth and real incomes and causing all sorts of other problems.
There are a variety of other factors. In our terminology, there is a time inconsistency risk around nominal GDP targeting. In other words, the more you need it, potentially the less credible it is that you will deliver it. In other words, if we have missed a lot on the downside, we have to deliver a very high level of nominal GDP growth to stay on that longer-term path, a high level of inflation for a sustained period of time. It is not necessarily credible that a central bank would do that, or that a government might change their mind about the wisdom of this. Therefore it makes it much less likely.
Senator Moore: That is riskier than what we are doing today, correct?
Mr. Carney: I do not have a problem with suggesting that people should not be surprised if our conclusion is that for Canada, specifically, nominal GDP targeting does not come near to the very high bar that is set by a very successful regime, which is flexible inflation targeting in Canada as an alternative.
Senator Harb: Over the past couple of months, everyone was talking doom and gloom. If the result did not come the way it came, we would still be talking doom and gloom. All of the banks, as well as a large portion of the corporate sector, reported stellar results. You look at their bottom line and it is solid. The return on investment is absolutely fantastic.
You say to yourself, what is it? What is going on here? One week you see the market going up by 2 or 3 or 4 per cent. Everything seems to be jumping and going up. Still there is the doom and gloom about Europe, their banking sector and their government debt. The following week everything goes down, yet for the fundamentals in terms of the balance sheet of these banks and corporations, nothing has happened.
Personally, I am beginning to wonder how much of this is talking down the market and talking up the market and scaring off the consumer. As we all know, economies are driven by consumption. When the consumer gets scared, things will come to a full freeze.
Mr. Carney: I will make a couple of comments and Mr. Macklem may want to supplement them.
If we look at GDP growth in Canada in the second and third quarter, and prospectively in the fourth quarter, there is a lot of volatility between the second and third. It is important to recognize that there was unrepresentative weakness in the second quarter, as measured, and unrepresentative strength in the third quarter, as measured.
Why do we say that? In the second quarter, as I think we talked about when we last met, the hit on the Japanese supply chain — post earthquake and associated events — shut down some auto plants and other things in Canada. Some weakness came directly from that. Presto, when those plants were turned back on July 1 for the third quarter, you get the upside of the growth. You have to look through those two quarters on that front.
Similarly, we had fires in Northern Alberta that affected some of the energy production. We had some other energy outages in the second quarter as well. In the second quarter, we had a very welcome investment with the import of a large natural gas platform being put in place for Nova Scotia — we have a lot of Nova Scotian representatives here for whom that was good news — but that means that your imports have gone up and your net exports have gone down, along with your GDP growth. Those are a lot of temporary factors that depressed growth in the second quarter. They come off and the third quarter is stronger.
You look through to the fourth quarter, and we have it just under 1 per cent growth, as you know; we give our quarterly forecasts in the report. In part, that is reflecting the confidence effects on business and households of what has been going on — the issues you are talking about. Some of it is financial conditions for businesses — some of the hesitation that comes there — and we see those gradually coming off into 2012.
We look through, and by the time you get to fourth quarter 2011 and first quarter 2012, that is the underlying trend rate of the economy at this point in time. Lots of things will change and we will report on our changed views when we come to that.
In terms of our informal discussions with businesses across the country and in our formal bank survey of business intentions, there has been a reduction in hiring intentions and investment intentions, but they are still quite strong — particularly investment intentions — in Canada. That is an important element of the reason why we continue to grow.
The last thing I will say before turning to my colleague is that on the market volatility, part of what is happening in markets, unfortunately, in the short term is that the so-called tail risk associated with the European situation is significant. On the question earlier from Senator Greene, "what happens if,'' there is a serious risk there.
As the market either prices that in — increases the probability of that — or takes it out, it makes a fairly large difference to the prices of a host of asset classes. That is why — from the Prime Minister, the Minister of Finance and the Bank of Canada — we have been spending a lot of time with our European colleagues trying to encourage them to address the situation, not just in terms of will to address it but also some of the details of how to most effectively address it. I am certain it will be an element of the discussions in Cannes in the next few days, where the Prime Minister and the Minister of Finance are.
Senator Harb: Perhaps Mr. Macklem wants to address that question.
Mr. Macklem: Globally, this was the deepest recession since the Great Depression, and the recovery is the slowest since the Great Depression in the United States and Europe, but not in Canada. In Canada, this has not been our deepest recession since the Great Depression, and we are back to and above our pre-recession peak.
Coming back to the U.S. and Europe, one of the lessons from history is that recoveries after financial crises are much slower than your normal recovery. Normally, when you get a recession, the deeper the recession, the quicker the bounce back; not so after financial crises. The fundamental reason is these deleveraging forces.
There is an impressive picture in our Monetary Policy Report. I think it is chart 30, if I remember correctly; it is somewhere around there. Do I have the number?
Mr. Carney: I will work on that; you keep going and I will find it.
Mr. Macklem: It shows that the accumulated savings that U.S. consumers have rebuilt are only about one twelfth of the lost net worth.
Mr. Carney: It is chart 6.
Mr. Macklem: It shows you the challenge. Hopefully, some of the net worth will come back by asset re-evaluation.
Mr. Carney: Sorry, it is page 5 in English.
Mr. Macklem: Some of it will come back by asset re-evaluation, but it takes a long time.
Getting back to markets, fundamentally markets have had to get used to the fact that this, in all likelihood, will be a very slow recovery. If you look at the U.S. recovery, it is about on track with the recoveries of what are called the five modern financial crises — which are Spain, the Nordics and Japan through the 1970s, 1980s and 1990s.
It already will be a slow recovery and the markets have had to get used to that. Then you overlay on that the tail risks that have become more intense as the situation in Europe has deteriorated, and that goes a long way to explaining what you are seeing. Also, yes, confidence is an important channel.
Senator Harb: I had a chance to look at the world map. It is unbelievable to see that the vast majority of the debt-to- GDP ratio happened in developed countries. The vast majority of the debts internationally are in developed countries.
Now it seems to me that the banks are under stress, the government is under stress, but someone has to be making money somewhere. From rumours that I have heard, there are a few corporations or a number of those corporations sitting on a huge amount of cash on the sidelines.
Mr. Chair, I was shocked. You would be surprised to learn that for foreign direct investment in the world, the number one country — and you can correct me, governor — is the United States, followed by China, of course. Guess which country is number three country is in terms of foreign direct investment?
The Chair: Quickly tell us.
Senator Harb: Luxembourg, a small country with $153 billion in foreign direct investment. That money sitting on the sidelines is not sitting there in banks because they are using it for anything; these corporations have decided to put that money in that jurisdiction. There are three or four other jurisdictions like that, probably with billions and billions of dollars. How can we encourage these players to come back to the game?
Mr. Carney: On the Luxembourg issue, I suspect and would be almost certain that what that is reflecting is actually a tax structure; there is a tax shell. A lot of Canadian investment is in certain jurisdictions, but it is effectively through a tax advantage route in order to ultimately go — for example in the Canadian case — to the United States.
In terms of motivating it, yes, confidence is an element. Reducing some of this overall macro uncertainty — and to bring it more closely to Canada — our message has been that Canada will be affected by events in Europe. We are being affected by them. We are obviously affected more directly by what happens in the U.S. economy. We put a figure on it. If this were what Mr. Macklem referred to as a "normal recovery'' on a chart, exports as a whole to the United States would be $30 billion higher per year, which is a big number. It is not a normal recovery and it will not be. Somewhat simplified, our message to Canadian business is to recognize that fact. Recognize that the United States is more of a market share game as opposed to a growth market game for a period of time because of the dynamics described.
There are a few other things you should recognize. First, virtually without exception you are underrepresented in major emerging markets. Second, you are not as productive as you should be. They all fight back on that one, but the macro numbers do not lie. We are not as productive as we should or could be. Third, our expectation is that because of the structure of global growth, commodity prices will be relatively high — not necessarily at their peaks — for a period of time. Lastly, we do have a strong financial sector. Part of our job is to ensure it functions in bad times as well as good. You can rely on that so you can start to draw down some of that cash. You can invest to take advantage of one or all of those three opportunities for the medium term and ultimately grow revenues. That is what you should do.
After a weak start in the recession — weaker investment performance than the United States, which is quite remarkable given that they were the epicentre of the crisis — we would say that Canadian business has come back strongly in the past 15 or 16 months. The true test is from now going forward, where the uncertainty level has come up. In our opinion, all of those factors are still there and there is still an opportunity. The question is whether business will invest.
To reiterate, those are there regardless of what happens in Europe, by and large. It will affect the overall environment, but in our view it will not change the underlying dynamics of the global economy.
Senator Gerstein: My question relates to the aging population and the unfunded liabilities in programs like social security, health and long-term care, and public and private pension plans.
My first question is that with all of the issues confronting you, is this issue on the front burner or is it still outside in the horizon?
Second, how does the bank approach this issue with regard to its monetary policy?
Mr. Carney: I will pass it to the head of our pension committee at the Bank of Canada.
Mr. Macklem: I will say a few words on that. Needless to say it is not our prime responsibility.
First, there are certainly some things to worry about. We are in better condition in this country than are some others. Our public pension plan is on a sound actuarial basis, which is an important step that we took when we had our fiscal crisis in the mid-1990s and got it on track. It gets back to the idea that crisis does create opportunity. You can fix things and you have to take advantage of those opportunities.
I think where we spend some time on it is concerns around what is called "low for long.'' Interest rates are currently very low, but they will not be this low forever. They will go back to some more normal level at some point. When you look around the world at the situations in the U.S. and Europe, interest rates in advanced countries are likely to stay low for a long time. Developments in the last couple of months would suggest they will be lower for longer than it looked a couple of months ago. If you are a pension fund or insurance company that is relying on historical rates of return to fund the payouts you need to make, you will have to make some adjustments to your business model. That is not just a concern in Canada; it is a concern globally. There is no question that there will need to be adjustments in business models.
Senator Gerstein: I take it from that response that there is not anything that you do at the present time or anticipate other than running your monetary policy. It is not specifically driven toward this issue. Is that a correct understanding on my part?
Mr. Macklem: Our monetary policy is driven around achieving 2 per cent inflation. It is something that we have to take into account when we look at the overall pressures on the economy.
Mr. Carney: I will add to the last comment in the context of "low for long'' and the impact of that ultimately on pension funds, insurance companies and potentially the impact in terms of their investment strategies and how that filters through to the financial sector. It is an issue that we have identified at a macro level. That has consequences for the degree of attention that we and others pay to risks that could develop. I am not saying those risks are present in the system, but obviously the longer the situation goes on, the more pressure there is on these types of institutions. That could result in a riskier risk profile relative to the underlying obligations. One must be cognizant of that and try to anticipate what the knock-on effects of those could be.
If it is of interest on this overall issue, there has been a report produced by the Bank of International Settlements, the BIS, that looks at this at a high level. We would be happy to circulate it. It tries to raise the implications of a "low for long'' and other regulatory environments for long-term pools of capital, and it describes the knock-on effect. That may be of interest and we would be happy to supply that.
Mr. Macklem: In a Canadian context we have looked at that and published in our financial system review where "low for long'' is identified as one of the five key risks that we are focused on.
[Translation]
Senator Massicotte: Thank you, gentlemen, for coming this afternoon. I would first like to ask a technical question, then a more general one.
You used the English term "containment'' in referring to the situation in Europe. Obviously, the situation is not clear. It will take several years to resolve the problem. Your comments indicate that you are happy with the intent announced by the European countries to manage the problem. But a number of experts seem to be saying that, although the intentions are good, they lack details and mechanisms, which risks damaging the growth of Europe and perhaps the entire world.
You mentioned the need for 9 per cent of the capital reserves. A lot of people believe that meeting this criteria will reduce the debt and, as a result, the credit available on the market. Such talk suggests that we should not hope for the debt to be reduced.
The second thing is that we are seeing enormous pressure being put on creditors to receive $0.50 on the dollar for the bonds. Unless there is a default, it is possible that the entire market of default risk agreements will be rendered useless. If this is the case, it will certainly affect the credit market the world over. If we cannot trust these agreements that are already in place, and it is possible that the problem will arise again in another country, people will be afraid of investing because of major consequences.
Some analysts say these are major problems. You are talking about "containment.'' Could you please clarify what you mean by that? Do we need to resolve some major gaps before we can have trust in a clear solution?
Mr. Carney: Yours is a detailed question that covers several aspects. Yes, the bank's hypothesis is that the situation in Europe will be contained. The bar is not very high. We will find volatility in other situations, but as long as the situation in Europe is contained, in other words, as long as it does not lead to a deep and persistent contagion of the Canadian financial markets. There will be no deep and persistent impact for the Canadian financial market, as previous years have shown, on the confidence of Canadian households and businesses.
With respect to a few aspects of your question — because there are a few very important aspects — yes, of course, there is a lack of detail with respect to the decisions of European leaders made last week. The details are absolutely necessary, especially when the capital of the European banks are involved and the way the capacity of this fund, the EFSF, or the European Financial Stability Facility, will be increased.
It is absolutely clear that there is now a risk, it is more than a risk: there is currently a process where European banks and the European financial system are getting out of debt. That is one of the reasons why the bank foresees a recession in Europe, starting now. That is one of the forecasts in our projection.
As for the situation in Greece, the agreement on the deletion of debts in Greece and the impact on the CDS market, yes it is a danger, because the idea is to have a voluntary reduction. But, as you say, it may create problems with the way the CDS market operates.
There are problems with this market but, at the same time, there is a need for the financial institutions and the investors to have a way to have some reassurances. If the market no longer exists, they will use other financial ways with the shorting of shares, stocks, government bonds. They will try. There will be a displacement of this volatility to other markets. In this context, yes, we agree, there is a danger.
We can have this issue and, at the same time, have a situation under control concerning the financial conditions and trust, here in Canada, in a context of persistence. That is the real issue.
Senator Massicotte: All of this is complicated for most Canadians. There is a recession in Europe, a referendum in Greece and perhaps even a recession in the United States. There have been a lot of changes in the last 12 months. Your own projections have changed several times because there is turbulence, changes on the markets.
What economic scenario do you foresee three years from now, if everything goes well? And if it does not go well, what will the difference for Canadians be in terms of economic growth?
Mr. Carney: I will try to answer your question, but it is a bit dangerous. We have a forecast, but it is the most probable situation for the Bank of Canada. There is one very important thing: the Americans lowered the level of their GDP by 1.6 per cent. That is an enormous amount. That for a large part indicates the differences between the two projections. This is an historic revision, and it shows the lack of momentum in the American market and especially in American consumption.
But the better forecast for the future of the Canadian economy is, of course, the MPR of the Bank of Canada. The MPR is a forecast that includes significant risks, and we have detailed them.
Senator Massicotte: If things are going well in three years, what will the growth be like? Optimistically?
Mr. Carney: We will have 2.1 this year, 1.9 next year, and 2.9 in 2013.
Senator Massicotte: If things do not go so well?
Mr. Carney: Less.
Senator Massicotte: How much less?
Mr. Carney: Oh no. . . .
Senator Massicotte: An unemployment rate of how much? Will the unemployment rate change?
Mr. Carney: As you know, we never make any official forecasts regarding the unemployment rate in Canada.
The Chair: Thank you, Senator Massicotte. We will now move on to Senator Ringuette, followed by Senator Smith.
Senator Ringuette: Thank you. I have two questions about Canada's situation.
[English]
I am concerned about the Canadian economy. We have a certain distance in regard to the eurozone, but that is not the case in regard to the U.S. economy. Most of our exports are destined for the U.S.A. If they have a stimulus program, it seems that it will be with a Buy America caveat. In Canada right now, our economy relies so much on our energy output, which fluctuates, and if the American recession is on, as you indicate, then there is going to be a lower demand for energy and less investment in our Canadian energy sector. That is my first concern in regard to the Canadian economy.
My second concern relates to our banking sector. Yes, we have some regulations and some supervisory control in place, but many of them rely on the banking sector being "self risk-evaluating.'' We have had a phenomenon in Canada in recent years where the commercial banking aspect and the investment or the highly risky banking sector have practically merged. I see that as adding to the risk for our banks. I guess I am looking for some assurance that all of these concerns regarding our financial institutions can rest at ease.
Also, you say that despite a brief recession in the euro area and also in the U.S., Canada should be okay. I do not feel at ease with that. We cannot make the statement that the U.S. will be in a recession but Canada will not be affected drastically.
Mr. Carney: That is one of the reasons why we did not make that statement. Our expectation, in our projection, is that there will be a brief recession in Europe. Obviously the depth and the length of that recession will be a function of how well the European authorities address the considerable issues we have been discussing this afternoon.
Our expectation is not, at this point, that the U.S. economy will go into recession. Our expectation is that the U.S. economy will have a period of modest growth. U.S. growth in the third quarter, which was just reported subsequent to the publication of this report, was exactly what we expected it to be. They are Americans, so they will revise it differently. Full disclosure might not always be the case. However, at this stage it is consistent and consistent with momentum. We do see that momentum slowing from the pace in the third quarter, similar to the dynamics in Canada.
We further say that one the risks is that there could be a recession. One of the risks to the down side is that there could be a recession in the United States. These risks are not independent. In other words, further problems in Europe, ongoing challenges in the global financial sector, retrenchment of corporate activity, less hiring and already relatively modest growth in the United States could tip them over. Without question, that is a risk to the down side for the U.S, which would affect Canada directly. I think we have been clear in stressing that. There is no question that there are risks and that this is a delicate time in the global economy.
I have a couple of quick comments, if I may, on some of the specific sectors because there are important issues to raise.
First, on energy, there is, as you are aware, a longer scale, quite sizable investment program in various aspects of the Canadian energy industry. The most prominent is the oil sands, but there is also considerable investment in conventional and unconventional gas in Western Canada, including British Columbia, in offshore oil and gas in Atlantic Canada, and in hydro and other forms of energy in this country. We expect this to persist well beyond our forecast horizon.
I will sneak this next point into my answer. As for global oil prices, one of the things that has happened is that the U.S. is not the marginal pricer of oil in the global market. They are for certain grades of oil because of pipeline and other capacity constraints, but in effect Chinese industrial production and growth is the tightest correlation to global oil prices. That is not surprising because China has a much more energy-intensive economy. Chinese consumption of oil has gone up by over 6 million barrels over the last decade, while U.S. net consumption since 2002 has fallen. The dynamics have changed in the global oil market.
The second point is important from both a consumer and a producer perspective in Canada, but I will speak from a consumer perspective. A reasonably wide gap has opened up between the price of West Texas Intermediate, or WTI, crude and Brent crude. There are a variety of other crude pricing indices, such as North Sea oil and North American oil, off of which certain Canadian crude is based, but the point is that WTI has fallen more than Brent has since the global economy has slowed. However, because Canadian refineries, particularly in Eastern Canada, get a blend of those crudes, gas prices have not fallen as much as WTI prices have.
The other reason for that is that margins have expanded as well. We go into some detail on that. Part of it has to do with capacity dynamics in the U.S. market, but it is an important factor to highlight because in our job, on the monetary policy side, we need to understand these types of dynamics as we forecast inflation and set monetary policy. Therefore, we have set that out in some detail. What matters for Canadians is the price they pay at the pump, and we take that into account.
As for the financial sector, in the interests of time I will refer to my earlier answer on the effectiveness of the supervisory and regulatory construct here in Canada. I will supplement and reinforce that by saying that the one thing we cannot be is complacent. Pride goes before the fall. As soon as you start believing that you have everything sorted out there will be problems. We live in a dangerous global environment.
My last point on the financial side is that this system, which came through the biggest financial shock since 1929, did so very well. That system has added billions of dollars of additional capital and tens of billions of dollars of additional liquidity since that time. They have further buttressed their own defences, as they should — it is their responsibility — since then. Obviously, we and the regulator, the Superintendent of Financial Institutions, watch the situation very closely.
Senator Ringuette: That leads me to my final question, which is about Basel and its acceptance of self risk-evaluation of capital. I understand that there are two reams, but I find it strange that, after the global financial crisis, the world would still accept this self risk-analysis evaluation for financial institutions. I think it still provides too much of a minefield for global financial markets. I truly believe that.
Mr. Carney: I will say a couple of things on that issue. It is an important issue in terms of the effectiveness and the appropriateness of internally rating base models or doing, to use your term, self risk-assessment, which is part of both the Basel II Accord and the Basel III Accord.
A couple of things have changed with the Bassel III Accord. The first and most important change is importing a Canadian innovation, the leverage ratio, which throws all of that out of the window. Instead, it says, "What is your level of assets relative to underlying capital?'' That level is capped. That will be phased in for the middle of this decade, and that is a Canadian contribution to global regulatory reform.
The second thing is that the risk ratios have been adjusted. On average, they go up by 20 per cent. The amount of capital, just because of the adjustment for risk, goes up 20 per cent on average, across jurisdictions. It is actually slightly higher, but it is roughly 20 per cent for Canada. However, the underlying amount of capital that these institutions have to carry relative to those risk ratios is on the order of seven times higher. It is not the case for Canadian banks because they were holding real capital, but, in many other jurisdictions, they were holding quasi- capital. Then, on the asset side of the balance sheet, they had assets that did not exist when they needed them.
I will give you a classic example. Deferred taxes is an asset that is worth something if your business is a going concern. However, the fact that you have deferred your taxes is not worth anything if you are going bankrupt because you will not pay any taxes.
You would not have thought it had to come to this, but it took three tries to say, "You have to net that off of your capital because it is not real capital.'' There are a host of other things that have been netted off. Even though the absolute level of capital has gone up on a ratio basis, the measurement change in that ratio has gone up substantially.
One thing that should make you more comfortable is that one of the differences between Canada and other jurisdictions — and the superintendent is the best person to speak to this — is in regard the Basel III adjustments on capital that come into place between 2013 and 2019. They get phased in, so all of those things — particularly those asset things, the deferred taxes — gradually adjust between 2013 and 2019. The intention of the superintendent is that Canadian banks meet the new higher, tougher standard in 2013, based on the 2019 definitions, so we start at the end. That is a big difference. That is an example of Canada's system starting stronger, going into the adjustment to the new regime and ending stronger. I trust you are reassured.
The Chair: Senator Ringuette looks a little bit happier. Maybe we could ask the same thing to the Superintendent of Financial Institutions when she appears before us in a couple of weeks.
Senator L. Smith: The issues are complex in regard to the boomers and the young generation. For the average person, you play a key role in messaging confidence, along with the Prime Minister and Mr. Flaherty; various people play key roles.
With the volatility in the markets, you have done a great job of communicating your plan. What do we tell the boomer generation who are getting a little anxious and will work longer, and the young generation that is wondering about the lifestyle they will have? Do we talk about 6 months or 12 months? How can we craft messaging so people can have hope?
Mr. Carney: The first hour and half did not do it for you.
It is a very good question. Let me take the easier bit, which is the young generation. Even though the experience globally has been higher unemployment for young people and, in some countries, a sense that prospects have crested and are diminished in some of the advanced economies, with respect to Canada the opportunities are major emerging markets.
Just to give one figure, the share of our exports that goes to the BRIC countries has been halved in the last decade. These are the fastest growing parts of the world and we have been doing well, but we have not been fully taking advantage of these big opportunities. That can change with dedicated focus of our businesses and with trade agreements. The government has an active trade strategy that starts to open to up some of these markets. Over the course of the working lifetime of younger Canadians, there is a tremendous opportunity for Canada to build into these markets and take advantage of our strengths.
Yes, they are in natural resources; yes, they are in financial services; but they are also in media, in entertainment and in a range of manufacturing and globalizing services, where we can be very strong — including some the emerging industries where things that previously were not tradeable become so, particularly around the service side.
That is a tremendous opportunity that we have not exploited and we have the opportunity to exploit for a couple of reasons. The first is the nature of Canada and the ties that we have with many of these areas. Second, we have a reputational advantage among the advanced economies. It may sound like bragging, but to say you have a reputation for competence should not be bragging. That is basically the Canadian reputation, which matters.
Again, not to belabour it, but we do have the wherewithal from a financial sector perspective and corporate balance sheet perspective to take advantage of the opportunities. There is a tremendous range of opportunities that we have not exploited, first and foremost.
Second, and this crosses over to the boomer generation, we do have flexibility on the macroeconomic side. We have sound fiscals; we have delivered on the inflation target and we intend to continue to do so.
It is a volatile world, without question. We cannot control what happens outside our borders, but we can dampen the impacts here in Canada. We probably can dampen it more than other major economies can because we do have that flexibility, and it is our job to use that flexibility appropriately.
The other element on the boomer side is that one of the concerns often is the soundness of the financial system. People have worked hard and built up retirement nest eggs; what is going to happen to those? Are they safe?
To be clear, we do not guarantee people's investments, but we can provide that greater level of financial stability and resilience so that the scale of accidents we are seeing elsewhere in the world is less likely to happen here in Canada. That is incredibly important.
If I look at my mailbag or email in-tray, one of the things that is difficult for the boomer generation as they move to retirement is this "low for long'' interest rate environment. We fully recognize that. Unfortunately, we have to manage monetary policy for the entire economy, all Canadians, and we have to make sure that we do not destroy the savings of Canadians by high inflation or push Canadians into bankruptcy in huge numbers because of deflation. We have to hit that sweet spot, that 2 per cent, and that is what we will do, along with ensuring the financial system continues to work and pointing out where the opportunities are. That is effectively what we can do to help both of those generations and all Canadians.
Senator Oliver: I would like to thank you both for the excellence of your presentations today.
I must say that Senator Moore asked the two questions that I had planned to ask; one is Joseph Stiglitz's report in Toronto and the second is the inflation targets and what will happen by the end of year. I appreciate your answers to both of those.
I do have a quote, Mr. Carney, that you made earlier about the importance of good supervision. We all know that the World Bank, the IMF and the OECD have continued to say wonderful things about Canada's financial system, but they have criticized one thing.
In one of your speeches to the Institute of International Finance in September, you said:
It is also important not to lose sight of the limitations of regulation. New and better rules are necessary, but not sufficient. People will always try to find ways around them. Some may succeed, for a while. That is why good supervision is paramount.
The IMF, the OECD and many others have said that one of our weaknesses in Canada is that we do not have a national securities regulator. Indeed, Canada is the only institutionalized nation without a common or a national securities regulator. When you state that we need good supervision, what effect does our failure to have a national regulator have?
[Translation]
The Chair: You may answer in French, if you like.
Senator Hervieux-Payette: It is the same question.
Mr. Carney: It is the same question.
[English]
Let me say two things. First, with respect to supervision and the approach that the superintendent has taken, that is one issue you could raise with her. She has chaired a very effective international group that has developed principles of supervisory effectiveness. It is not all the lessons from Canada; it is global lessons, but many of the lessons are from Canada.
They have produced a report that has been submitted to G20 leaders for the Cannes summit. It has been endorsed by finance ministers and governors, and I commend it. It will come out in the fullness of time, I am very confident, after the summit in Cannes. It really gets into this issue in detail.
Of course, the issue, which then gets slightly handed over to my left, is Mr. Macklem's role at the FSB. One of his roles is to chair an implementation committee for all of these reforms to ensure that they are effectively implemented. With these types of approaches, one of the country review type issues would be how well better supervisory principles will be put into place over time. He may say a word about that in a moment. This is to try to export it.
In terms of the specific issue that you asked about, it is absolutely important, and we have stressed it many times, that we have a common approach to regulation and a consistent approach to securities regulation across the country. We have to work with the system that is in place. We are all aware that the federal government has a proposal that is before the Supreme Court of Canada. In the normal course, in the not-too-distant future, one would expect the court to opine on that. We, with others, look forward to the views of our highest judges on that issue.
Whatever the facts on the ground in terms of securities regulation, it is our job to work with those regulators as effectively as possible to ensure that those supervisory objectives are met.
Mr. Macklem: I would add on the last point that there is the issue of form, but there is also the important issue of content. In regulation, it will be just as important to get the content right as to deal with the form.
I spoke to implementation earlier in response to Senator Greene's question. To go back to Senator Greene's question, we will not be happy until it is fully implemented. It will be critically important that it is fully and consistently implemented.
I see that Senator Ringuette has left, but plans are being put in place by the Basel committee to assess consistent implementation. One of them addresses the issue that Senator Ringuette raised, which is the internal rating or internal assessment of risk.
Senator Moore: Self-assessment?
Mr. Macklem: Yes, self-assessment. Obviously, the first line is the institutions themselves. They have to have good models, they have to be well applied and they have to have appropriate controls in place. The supervisors in countries need to test those both in terms of the process and to assess that the processes are being followed.
The other aspect at the global level, through the Basel committee, is to ensure that the risk weighting, which is central to this exercise, is being carried out on a consistent basis across jurisdictions. There are plans, but they are not fully developed yet as to how to do that. Roughly, they would probably involve having something like a test portfolio and then looking at how that is risk weighted in different countries and ensuring there is consistent application.
[Translation]
Senator Hervieux-Payette: This will allow me to speak to a high-ranking official in our country who is bilingual.
In the beginning, you said that you have quite a unique mechanism in place for Canada's various agencies to coordinate and share information, and that you always discuss risk analysis. Is it a formal or informal mechanism?
Mr. Carney: It is a formal mechanism, known as a financial institution supervisory committee. I believe it is set out in the Office of the Superintendent of Financial Institutions Act, but it is specifically laid out for the Governor of the Bank of Canada, the Deputy Minister of Finance, and the President and CEO of CDIC.
Senator Hervieux-Payette: The Canada Deposit and Insurance Corporation?
Mr. Carney: Yes, and the superintendent. It is an official committee with official responsibilities.
Senator Hervieux-Payette: I have two questions that go hand in hand. When you saw the risks on the horizon in terms of structured products, you analyzed the situation in Canada. Did you notify your colleagues outside Canada that this could put the entire economy at risk, since you are in contact with international agencies? Did you and your colleagues discuss the fact that a colossal number of structured products, almost all of them issued by the United States, were coming onto the market?
Mr. Carney: Yes, once the difficulties or the global financial crisis began — in other words, July 2007 — we initiated discussions with the Americans and the Europeans regarding the risk posed by structured products, given the problems with asset-backed commercial paper or the non-bank ABCP market here in Canada, which was truly a vehicle for structured products. Unfortunately, or fortunately in some respects, but unfortunately at that time, we had a chance to see the amount of leverage in those markets and were therefore able to get an idea of the amount of leverage in the structured derivative product market. I had several discussions on the subject — I was at Finance, and I know the Minister of Finance also had discussions — with U.S. Treasury officials.
Senator Hervieux-Payette: After this crisis, will international mechanisms look like our national mechanism? In other words, will stakeholders look to engage in discussion at the international level, thus ensuring they intervene before the damage is done? Ultimately, when you intervene after the fact, all you are doing is crisis management.
Mr. Carney: That is an excellent question. We consider the international mechanisms; the Financial Stability Board, or FSB, has a committee that I, Mr. Macklem and others around the world — other central bankers and supervisors — belong to and that committee is tasked with identifying and pinpointing financial instability around the world, as well as recommending solutions. It is a subcommittee of financial stability advisors. That is one of the Financial Stability Board's responsibilities. There is also the Basel committee, which is made up of central bank governors and which I chair. The committee is known as CGFS. There is a committee of governors. Now, as of 2009, G20 finance ministers, G20 central bank governors and other financial centre representatives hold formal talks during IMF meetings every spring and fall. So there are a number of mechanisms working to identify risks in the markets.
I would like to give you an example of where we have seen success in this area. It has to do with exchange-traded funds or ETFs. I am not sure what they are called in French.
There are two types of ETFs. One is the plain vanilla variety, an example of which would simply be some sort of exposure for an index such as the TSX. There are structured ETFs and leverage types that are very similar to non-bank ABCP, and that situation was identified by the Financial Stability Board. It is a problem in Europe.
European authorities have started taking steps to address this problem. So, although the situation is improving, it is not perfect. Clearly, the situation is far from perfect, but it is improving. There are mechanisms.
In Canada, things are done in a formal manner. We have obligations under the law. Globally, that is not the case. Things are done informally. We have responsibilities, but they are less formalized. So, in that setting, things are more difficult.
Senator Hervieux-Payette: You started with Greece. The Europeans are dealing with a pretty major problem right now. The fact is that when they assessed the risk of allowing Greece into the eurozone, they based their assessment on reports on Greece and its ability to comply with the rules governing the euro zone. Those reports, however, were distorted.
Going forward, whatever action is taken, when you belong to a group, the rest of the group has to be able to analyze the membership issue. Under normal circumstances — had the truth been told and had Greece's financial statements not been doctored — Greece would not even be in the euro zone, because it did not comply with the euro when you get right down to it. This situation has dragged on until now. It took time to discover what happened. The fact remains that the group within the eurozone also made an error.
There is often a temptation to blame everything on the Americans. However, the problem is also due to a deficient risk analysis by the Europeans when allowing partners that did not comply with euro zone requirements to join the group. Would you agree with that theory?
Mr. Carney: The President of France expressed a similar view. He did, however, say that Greece was a member of the eurozone and it was therefore necessary to provide the country with assistance.
Senator Hervieux-Payette: Now.
Mr. Carney: It is now necessary to provide assistance. There is a problem and it has to be solved. We respect, then, the attitude that France, Germany and our European partners have adopted.
The Chair: Before I thank you, on behalf of the committee, I would like to ask you a question.
If memory serves me correctly, the last time you were here, in the spring, you were very concerned about household debt.
Mr. Carney: Yes.
The Chair: I was wondering whether you are still just as concerned about the issue or, quite the opposite, whether the situation has improved and you are sleeping better at night.
Mr. Carney: The risks surrounding Canadian households still exist. The level of household debt remains high. It is actually a bit higher than it was in the spring. However, the rate at which that debt is growing has dropped, as we predicted in the spring. That drop is partly the result of measures taken by the Government of Canada to address mortgage insurance. Certain measures taken by the Superintendent of Financial Institutions to raise the quantity of Canadian bank capital with respect to Basel III also helped the situation, as did warnings to Canadians from the Bank of Canada and the Government of Canada. The drop can also be attributed to a natural adjustment in household debt.
There is no doubt that the growth rate has dropped. Nevertheless, some risks remain, and those risks are on the rise. As Mr. Macklem indicated, it is possible in this kind of environment to see household debt increase further. That is an upside risk for inflation in Canada. Given the level of debt and the debt burden households are carrying, there is a risk that, if Canada's economy were to experience another shock, the country's consumption growth rate would slow down more significantly than in the past. However, both risks exist, and we are keeping a close eye on the situation. We are working closely with the superintendent and the Department of Finance on the matter.
Mr. Macklem: Chart 23 on page 26 shows that the household credit growth rate has dropped. It was approximately 12 per cent in 2007. The historical average is about 8 per cent. Today, it is just below 5 per cent. This data is recent. So the situation is encouraging. However, a few quarters do not a trend make. We are not out of the woods yet, but there is reason to be optimistic.
[English]
Senator Massicotte: The chart on American consumers is much improved. How much of that improvement relates to debt writeoff?
Mr. Carney: It is the old-fashioned way; it is largely default.
I will go back to Mr. Macklem's earlier point. It is understandable and unfortunate the scale of net worth gain that American households still have to make relative to their savings. Of course, they will end up getting most of that gain once the economy stabilizes, partly through saving and reinvestment but eventually through asset price appreciation of housing and equities as the situation stabilizes and growth returns. That is an important caveat.
Senator Harb: Chair, on behalf of the committee, could you thank the governor, his deputy and team on a report well done? It simplifies a complex problem in simple language that even the average Joe can understand.
The Chair: I could not say it better than you said it.
Senator Massicotte: They do a report every quarter.
The Chair: With those compliments ringing in your ears, Mr. Carney and Mr. Macklem, it is my happy lot to thank you very much for appearing before the Standing Senate Committee on Banking, Trade and Commerce. It has been a great exchange tonight, as it always is. We look forward to the next occasion.
(The committee adjourned.)