At a time when the supremacy of markets is under siege, Mark Carney, governor of the Bank of Canada, argues that continuously open markets are actually the key to global recovery. In the meantime though, interest rates will likely have to go lower, he says.

Speaking to the Canada-United Kingdom Chamber of Commerce in London on Wednesday, Carney said that while a recession appears inevitable, so is economic recovery. For that recovery to reach its full potential, “we all need a financial system with continuously open markets at its core,” he said.

While his remarks focused on the need to rebuild markets, Carney also indicated that interest rates are likely to go still lower in Canada to fight the effects of recession. “The global recession is deepening, with demand slowing sharply across all major regions in recent weeks. As a consequence, there have been further declines in the prices of many commodities and a deterioration in Canada’s terms of trade, which reduces Canadian incomes,” he noted. Also the consumer-driven U.S. slowdown is hurting Canadian exports.

“Thus, while domestic demand in Canada remains relatively healthy and the depreciation of the Canadian dollar will offset some of the declines in external demand, the risks to growth and inflation in Canada identified in the October Monetary Policy Report appear to have shifted to the downside,” he said. “Despite having already cut official interest rates in half over the past year and having a financial sector that is still functioning effectively, some further monetary stimulus will likely be required to achieve the inflation target over the medium term.”

As monetary policy fights the effects of the immediate turmoil, Carney also set out his views on what needs to be done to rebuild the global financial system for the future. He noted that markets have failed in the current environment due to complacency about the importance of market liquidity, a lack of transparency, and excessive leverage, so that, “A system that appeared resilient (and enormously profitable) in times of low volatility proved brittle in the face of shocks.”

With the breakdown of many markets, the pendulum is swinging away from market-based finance back towards bank-based finance, Carney observed. However, he warned that this shift has its own set of negative consequences — banks have been pushed to raise large amounts of capital, liquidity has dried up, and investors are pulling back from global markets and repatriating capital to their home markets.

“All of these risks are the consequence of relying on markets built on sand. To find the bedrock on which to rebuild open continuous markets, all of us — market participants and policy-makers alike — must learn the lessons of this crisis,” he said.

For Carney, this includes a new “macroprudential” approach to regulation that must address three significant flaws in market structure – a lack of transparency, misaligned incentives, and inadequate liquidity.

“The current situation is unacceptable. The financial system should have a number of core markets – including interbank lending, commercial paper, and repo markets for high-quality securities – that are continuously open even under stress,” he said. Along with renewed regulation achieving this will also require implementation of the G-7 Action Plan to shore up systemically important institutions so that they can be more resilient and resume their market-making role, and that central banks must act as market-maker of last resort.

There are other steps that policymakers should consider to reduce risks and make individual institutions less systemic, Carney suggested, such as shifting over-the-counter markets onto exchanges or into clearing houses, establishing higher capital requirements for securities that trade outside continuously open markets, limiting the application of fair-value accounting to securities that trade on exchanges or in continuously open markets, and reducing the procyclicality of margin requirements.

Carney said that Canada’s experience demonstrates that the G-7 strategy will work. “Given the combination of strong core institutions, the provision of exceptional term liquidity by the Bank of Canada, and the now material term funding from the Government of Canada, we expect that our major financial institutions will cascade that liquidity through the system by supporting continuous markets and extending credit,” he said.

He also called for international institutions to effectively monitor systemic risk and coordinate macroprudential and financial policy reform. “There was no effective international surveillance that identified either the nature or the scale of the financial crisis, because no international organization had yet integrated effectively macroeconomic and macrofinancial analysis. Progress on these imperatives was also made this past weekend in Washington, and they will remain a focus over the coming weeks,” he said.

@page_break@“We can never eliminate financial crises, but we can reduce their likelihood and severity. In my opinion, the key to success in this regard is to seek to build continuously open markets,” Carney concluded. “The pendulum is currently swinging back from market-dominated financing towards bank-dominated financing. We should not want the pendulum to swing too far. The capital requirements at the extreme are enormous. More fundamentally, market forces should be left to determine the relative size and boundaries of the banking and markets sectors. They will only do so if markets are built on solid foundations. We can construct a global financial system that will lead to the type of sustained and mutually beneficial prosperity that Canada and the United Kingdom have enjoyed over the centuries.”

IE