Investors Scrutinizing the Regulators

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Monetary buck-passing

Terence Corcoran

Friday, March 14, 2008

Canadians got their first look at their new central bank governor yesterday. Judging by Mark Carney's maiden speech, at the Toronto Board of Trade, what we have in Mr. Carney is a bank governor of a very different sort than we've had in the past. Whether he is the bank governor we need is another matter.

At the announcement of Mr. Carney's appointment late last year, some skeptics wondered at the wisdom of parachuting in a man with no particular expertise in monetary policy, or even a history of scholarly interest in the subject. The thesis for his PhD, acquired relatively late in life, looked at issues of corporate competition and the role of national champions, a simple subject compared with monetary policy. He was also an outsider. Monetary purists, however, tended to downplay the central banking gap in his background, and instead took comfort in the fact that Mr. Carney, a Goldman Sachs man before he joined government, would bring to the central bank something it had lacked: street smarts.

As might have been expected, Mr. Carney yesterday delivered a speech that was heavy on street smarts but thin on monetary policy. Experience also suggests investment bankers who make it to the big time in government often turn out to be heavy-duty regulators and interventionists. A good example is another Goldman Sachs alumnus, current U.S. Treasury Secretary Henry Paulson, who yesterday unveiled plans for tighter regulation of the U.S. mortgage and banking industry so as to better align "incentives" and regulation.

Mr. Carney played right into that game. "Even though most of the practices that contributed to the crisis took place beyond our borders ... Canada is not isolated from global events." Canadian markets will be judged, he said, "by new standards of liquidity, transparency, and the greater integrity that comes from properly aligned incentives."

As to the causes of the "current turbulence," Mr. Carney recited a long list of prospects -- not one of which happened to be monetary policy. We've got "overdue repricing of risk" and "flaws in the financial system." There has been "overconfidence" in risk models behind the repackaging of asset-backed securities and mortgages. Inadequate "transparency" was also a factor in the breakdown of trust in the credit-rating agencies. Some investors didn't play close attention to their investments.

On "misaligned incentives," Mr. Carney dug deep down into the banking system. He said there were "mismatches between the timing of trader compensation and the realization of profits from their trades, an insufficient recognition and compensation of risk-management professionals, and provision of funding at risk-free rates to trading desks that placed risky bets."

There's a lot more of this kind of stuff in Mr. Carney's speech, including musings about accounting issues and, in particular, the policy of requiring financial institutions to mark assets and liabilities to market value. The impact of the requirement is a banking system that is radically writing down assets on the basis of market values that have been driven down by panic. "The point can be made," Mr. Carney said, "that in the current circumstances, existing accounting rules provide a degree of precision that is not warranted."

All this is very interesting and probably true, but what does it have to do with monetary policy? At one point, Mr. Carney even dips into the business of bank executive compensation. "Many financial institutions have pay structures that reward short-term results and encourage potentially excessive risk taking." The authority for this bit of conventional theory is the Financial Times' registered bank basher, Martin Wolf, whose column "Why regulators should intervene in bankers' pay" is footnoted in the advance copy of Mr. Carney's speech.

When he got around to talking about monetary policy, in Canada and abroad, Mr. Carney did what central bankers do best: pass the buck. It's all the fault of market participants who got "overly confident," a condition brought on by "low and relatively stable long-run interest rates." Gosh, where did they come from? And, come to think of it, where did those stable long-term interest rates go? That they came and went at the hands of central banks isn't something central bankers like to talk about.

Mr. Carney seems particularly confident that the co-ordinated "liquidity" initiatives orchestrated by the U.S. Federal Reserve and other central banks, including the Bank of Canada, will help Canada and the world financial system turn the corner. It might have been better had Mr. Carney spent more time explaining how the latest liquidity moves will fix the markets, as opposed to what they actually seems to be doing, which is boosting commodity prices and increasing the risk of inflation.

Copyright 2007 CanWest Interactive, a division of CanWest MediaWorks Publications, Inc.. All rights reserved.

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