Benefits Canada recently spoke to the deputy governor of the Bank of Canada, David Longworth, about what’s being done to stabilize tumultuous financial markets and lessons learned from the credit crisis.

There’s been a lot of talk about the need for more transparency in financial markets to avoid another credit crunch. Where will this transparency come from?

DL: First, market forces themselves will play an important role in bringing this about. People have seen what has happened. Issuers have realized that some of the less transparent instruments can’t be issued unless the transparency is improved, and investors won’t invest in them unless they understand more fully than they did in this most recent episode what they are actually investing in.

Second, the credit rating agencies will take to heart the fact that there are some improvements that they can make. I think a number of them are looking hard at whether they should distinguish between ratings for plain vanilla corporate bonds and some of the more complicated products. And many credit rating agencies also plan to carry out more of an education program of what credit ratings mean and what they don’t mean.

I think regulators will have to look at the so-called “exempt market” where there are essentially no requirements for transparency, and will have to say whether there has to be an overarching principle of transparency for all these complex products.

What is Bank of Canada’s role?

DL: With respect to the Bank of Canada, this isn’t ultimately our responsibility; it’s the responsibility of securities market regulators. But when there’s something we feel we can usefully do, for example, what we require in terms of the collateral we take [as with asset-backed commercial paper], then we’ll do something ourselves.

How significant was the Bank of Canada’s recent auctions of emergency term lending? What impact has this had?

DL: Of the four [auctions] we’ve done—two in December and two in the recent period—the $2 billion is the largest size we have done for term against a wide range of collateral. So it has some historic significance. What we have seen is that, together with the fact that it was coordinated with other major central banks, there’s been a beneficial effect on the term-funding market. It’s to reassure institutions that liquidity is there. With respect to the last two operations, we’re doing this against a background where the Canadian problem is not as significant as it had been in December.

The House of Commons is currently considering a proposed amendment to The Bank of Canada Act that would expand the list of collateral the Bank will accept in open market buyback operations. How much would it increase the Bank’s ability to stabilize markets or bail them out?

DL: First of all, it would be used to avoid or mitigate significant financial instability and to help us implement monetary policy. “Bail out” is not a term that I would use in this context. We don’t know how the current situation is going to evolve. Nor can we fully contemplate what might be situations that would arise in the distant future. What we want to do is have the powers there so that we could be ready in case we ever had to use them. We had an act that needed to be modernized. Some of the references to money market instruments were anachronistic and it needed to be brought up to date so that we could transact buy-back operations against the broad range of instruments that are relevant.

Bank of Canada Governor Mark Carney recently referred to “a series of misaligned incentives that encouraged excessive risk-taking,” as being among the main causes of the current market turbulence. What is wrong with the incentives in financial markets?

DL: So I’ll start with the originate and distribute model because I think that’s the one that people are most concerned with. You want the originators to have the incentives to do due diligence so that when things get packaged into asset-backed securities, that people know what their nature is and what they’re buying. So the appropriate credit checks, for example, have been done on customers who get involved in a mortgage. So, I think that’s the most important one. You need to make sure that, either by them retaining an interest in those mortgages or through other mechanisms, their incentives are aligned so that other people who end up with an interest in those mortgages can count on a proper job being done from Day One.

Another thing the governor and others have talked about is the remuneration of traders and risk managers. Traders seem to be sometimes remunerated on the short-term return strategies, not the return over the life of the position that they originally took. And there may not have been a high enough profile given to the remuneration of risk managers who are people that ultimately help to protect a bank from getting into serious difficulties.

Another item that’s been mentioned is the way banks allocate funds to the desks that take on risky positions. Sometimes that funding is in internal accounting allocated at risk-free rate of interest rather than at an interest rate that reflects the fact that the traders are taking on risky positions.

The other is a whole series of things that people refer to as “cliff risk” which is that regulations, whether these be government regulations or investment policies of whatever kind of financial institutions, are sometimes written based on specific credit ratings. And when that credit rating changes, it sometimes requires that people have to get out of or significantly reduce their positions. This is going to be like pushing things off a cliff and leading to stronger reaction in the markets than might be there if the distinctions weren’t so sharply drawn in the regulations, again whether those are public or private.

How much long can we expect turbulence in financial markets as a result of the liquidity crisis? How long will the process of re-pricing of credit risk take?

DL: What’s been happening is going to have an impact for some time to come. We really don’t know when or how this turmoil will be ultimately resolved.

How lasting an impact will the credit crunch have on financial markets?

DL: On the financial side, we may have seen some complex financial instruments that will never come back. There may be some of these markets that are dead forever. And there are others that will come back only when issuers find a way to make the assets transparent enough that they can entice investors who will be carrying out their due diligence very carefully before they put their toe back in the bathtub.

Have those in the financial world learned any lessons from this?

DL: I think they have. One hopes that they will be remembered for a long, long time. Those people who can’t sell complex financial instruments know that they have to find a way to be more transparent. Credit rating agencies have learned that they need to make changes and are thinking hard about those changes. Financial institutions are realizing that they need improve their risk management and their liquidity management. We’re seeing signs of all these things to some extent.

Earlier this decade, pension funds experienced a “perfect storm” of low interest rates and falling capital markets that led to many into deficits. Are we in the midst of another “perfect storm?”

DL: Obviously there’s a clear challenge from the fact that we have low interest rates and that there’s been weakness in credit markets. But I think there was significant learning from the earlier episode and some pension funds are in much better shape to deal with these challenges now. I don’t think pension funds have been caught off guard this time as much as they were with the previous episode.

Can we expect as much exchange rate volatility this year as we did last year?

DL: I think globally there’s a significant tie-in between exchange rate volatility and the volatility in other financial markets. Given that we don’t know just when or how long the volatility in the other markets is going to go on, it’s very difficult to say with respect to the exchange rate. With respect to the Canadian dollar, in addition to the kind of volatility in other financial markets, the volatility in the Canadian dollar will depend on the volatility in commodity prices and the volatility of views about the evolution of the U.S. and Canadian economies.

Don Bisch is editor of Benefits Canada.

For a PDF of the original article that appeared in the magazine, click here.

© Copyright 2008 Rogers Publishing Ltd. A shorter version of this article first appeared in the May 2008 edition of BENEFITS CANADA magazine.