David Dodge, governor of the Bank of Canada, says markets have not yet returned to normal after the summer’s credit market disruption, and the extent of the dislocation will impact monetary policy.

Speaking to the Vancouver Board of Trade in Vancouver today, Dodge explained that the market turmoil is being caused by a necessary repricing of risk, the advent of widespread securitization, and the lack of a secondary market for the structured products created by securitizations.

“The re-pricing of credit risk is an ongoing process, and the events of this summer represent a bump in the road. Unfortunately, that bump means that it may take a while to achieve an appropriate pricing of risk,” Dodge noted. “This is because it will take time to unravel some of these complex and opaque instruments to get to the underlying assets, and then to find values for the assets themselves.”

Dodge noted that there is uncertainty about the extent and duration of the tightening of credit conditions in Canada and, hence, about the tempering effect this will have on the growth of domestic demand. “Gauging the effects of the financial market turbulence on credit conditions, and the implications for the Canadian economy, will be one of the Bank’s most pressing tasks over the coming months,” he concluded.

In the meantime, he says there are lessons to be learned. The first lesson is the importance of transparency in financial markets. “Investors should demand greater transparency where it is now lacking. Vendors of financial instruments will then need to structure them in such a way that market players can clearly see what they are buying,” he noted. “More fundamentally, investors must take on more responsibility for diligent research, so that they can better understand the nature of their investments. Put another way, investors must do their own homework instead of simply relying on the word of credit-rating agencies.”

He downplayed the need for regulatory intervention to achieve these outcomes, noting that natural market forces should be enough to get there. “I would caution against any knee-jerk regulatory response,” he said.

A second emerging lesson is that there’s a need to pursue the right incentives for loan originators, so that credit quality is maintained and credit is appropriately priced. “The creation of loans for immediate securitization reduced the incentive for originators to maintain credit standards,” he said. “It may be that natural market forces will go a long way towards rebalancing incentives, but there may also be an active role for policy-makers in this regard.”

“Another issue related to securitization concerns the capitalization of banks. If banks are moving securitized loans off their balance sheets, but still providing liquidity guarantees for these securities, how much capital should they be required to set aside? The authorities at the Basel Committee may need to revisit this issue in light of recent experiences,” he added.

Dodge said that the overnight market is now well on its way back to normal operations in Canada, however problems in other areas of the money markets have not yet been resolved.
“Although the spreads between bank-sponsored ABCP and treasury bills have narrowed a bit in recent days, it is somewhat surprising that they have not narrowed further and more quickly, given the strong balance sheets of Canadian banks,” Dodge said. He also called on investors and liquidity providers to continue to cooperate in the restructuring of third-party ABCP.

The most important lesson that central bankers can learn from these events, Dodge said is, how the degree of securitization affects credit conditions. “If securitization led to the creation of loans that would not otherwise have been made, then this was a source of demand in the economy that we as central bankers likely did not fully take into account,” he said. “Any given policy rate would thus be less restrictive than was earlier judged, implying that interest rates globally might have been lower than would have been optimal.”

A reduction in securitization now seems likely, leading to a higher cost of credit relative to the overnight interest rate, Dodge said. This may affect monetary policy.