Finance Committee on March 5th, 2009

[The Chair, Conservative, James Rajotte]

I call the 12th meeting of the Standing Committee on Finance to order.

This is our second meeting continuing our study of measures to enhance credit availability and the stability of the Canadian financial system.

We have one witness for an hour and a half here this morning. It is Mr. Pierre Duguay, Deputy Governor of the Bank of Canada.

Welcome, sir. You will have up to ten minutes for an opening statement, and then we'll go to questions from members. You may begin at any time.

[Pierre Duguay, Deputy Governor, Bank of Canada]

Thank you, Mr. Chairman.

Good morning everyone. Thank you for inviting me here to discuss the Bank of Canada's perspective on the stability of the Canadian financial system.

As we have consistently emphasized, stabilization of the global financial system is a precondition for economic recovery, both globally and in Canada. To that end, policy-makers around the globe have acted aggressively and creatively by initiating a series of unprecedented actions aimed at stabilizing the global financial system. Central banks throughout the world, including the Bank of Canada, have provided unprecedented liquidity to keep the financial system functioning.

Because the crisis we are facing is global in nature and began outside our borders, most solutions must be found at the international level. We are taking part in discussions with our international colleagues on ways to strengthen financial stability globally. I would note that there has been a great deal of interest worldwide in the resilience of Canada's financial institutions in the face of the global economic crisis. Unlike their counterparts in other major economies, Canadian banks have not been materially affected by the financial crisis. They have managed to raise capital during this troubled period to support continued lending and to make up for some of the decline in the demand for securitized products as well as the exit of non-bank lenders which had relied on securitization for financing their activities. In contrast, banks in most other major economies have suffered significant losses and have required significant capital injections from their governments.

Thus, Canada has maintained much healthier credit conditions since the onset of this global recession than have been seen in other major countries. Still, the Canadian financial sector has felt the effects of the global turmoil which has increased funding needs while at the same time raising the costs and the uncertainty of term funding. In response, the Bank of Canada has made significant efforts to support liquidity in financial markets.

Now, our actions aimed at stabilizing the Canadian financial system since the global crisis began 18 months ago have been unprecedented and significant. The Bank of Canada has moved aggressively by expanding the provision of term purchase and resale agreements to a total of $41 billion, at its peak in December, and $35 billion currently.

The term purchase and resale agreements, or PRAs, as we call them, provide liquidity to key market participants for terms of up to three months against a wide range of securities. The bank has widened the range of assets that it will accept in these operations, and it has extended the range of counterparties with whom it will transact. I should point out that these PRAs are as an auction, so there is kind of a market price to the yields on these term loans.

We've also introduced a new term-loan facility for those financial institutions that participate directly in the large value transfer system and the payment system, taking their non-mortgage loan portfolio as collateral. And that, in a sense, frees up other collateral for them.

Last week the bank announced a new term PRA facility for private sector instruments that extends on the private sector term PRA facility that we had set up last autumn for the money market instruments. The new facility is open to a broader range of participants against a broader range of eligible securities, which would include corporate bonds, and it is available for a longer term and at a lower minimum bid rate than is the facility that it replaces. The liquidity from this new facility should provide indirect support to credit growth in Canada by improving the secondary market liquidity and increasing the demand for corporate securities.

I would like to point out that these facilities have been financed not by expanding the supply of central bank money to the financial system, but rather through the sale of treasury bills, either from the bank's own portfolio or from new issues, the proceeds of which, in turn, are held on deposit at the Bank of Canada. I would note that, on a consolidated basis, the Government of Canada earns net income from these operations. That net income is represented by the spread between the yield on our own term PRAs that we offer and the yield that we could have gotten on treasury bills or that the government is paying on treasury bills. Furthermore, there is little risk to the taxpayer in these operations because we require participants to pledge collateral with a value greater than the amount of money that they borrow from us.

These liquidity operations have resulted in a significant reduction in the spreads at the short end of the market--for example the CDOR, the Canadian deposit offering rate, which is the Canadian equivalent of the LIBOR, the London interbank offering rate, which is the offered rate on bankers' acceptances, essentially. So the CDOR minus OIS, or overnight indexed swap, spreads—the OIS is the expectation of what a future Bank of Canada rate would be—have narrowed substantially since last fall, when conditions were extremely negative. The improvements are especially notable at shorter-term maturities, such as one month, and are largely attributable to the liquidity facilities that have been put in place. But there have also been improvements at the three-month spread, which peaked at about 125 basis points in Canada. This is now close to a more normal level, which is about 25 basis points. That's kind of the new normal. We don't expect to go back to the pre-August 2007 spreads that were abnormally narrow.

While the Bank of Canada's liquidity operations have focused on the short-term financing, I would like to note that the Government of Canada has introduced measures aimed at supporting the long-term financing for businesses and consumers, and I would like to highlight two among the numerous measures.

One measure is the insured mortgage purchase program, which allows financial institutions to fund new financing by selling pools of insured residential mortgages to Canada Mortgage and Housing Corporation. Another is the Canadian secured credit facility, under which the Business Development Bank of Canada will buy term asset-backed securities, which are securities that are backed by loans and leases on vehicles and equipment. It will essentially target this segment of the market, for which financing is unavailable now.

All these measures together are certainly helping to meet the rising demand from businesses and individuals who have been finding it very difficult in this environment to raise adequate funds. We have all heard reports of ongoing tightening in both the availability and pricing of credit. We've heard anecdotes. Our own surveys of businesses and surveys of senior lending officers confirm that. Nevertheless, when you look at the data, our latest figures show continued strong growth in total household credit--9.6% in January--compared with the same period one year earlier. In part, we've seen limited deceleration in the growth of total business credit, although this was more pronounced in January. There is volatility in these numbers from month to month. Total business credit, overall, stood at 4.2% in January compared with the same period one year earlier. What we've seen is accelerating growth in bank lending that has helped offset, or at least partially offset, a contraction in market financing. We will continue to closely monitor credit growth and credit conditions in Canada. We just got the January numbers last week. We are monitoring that very closely.

In conclusion, as we are all well aware, the Canadian economy is feeling the effects of the global turmoil and recession. The authorities, of course, have put a lot of fiscal and monetary stimulus in place in Canada and globally to support the recovery. However, as I noted at the outset, stabilization of the global financial system remains a precondition of the global and Canadian economic recoveries.

Investor and public confidence has been badly shaken. It will recover with the timely implementation of the ambitious plans in some major countries to address their toxic assets and to recapitalize financial institutions. However, if these national and multilateral measures are not timely, bold, and well executed, Canada's economic recovery will be both attenuated and delayed.

I would now be pleased to answer your questions, Mr. Chairman.

[The Chair, Conservative, James Rajotte]

Thank you very much for your presentation, Mr. Duguay.

We'll go to Mr. McCallum, for seven minutes.

[John McCallum, Liberal, Markham—Unionville, ON]

Good morning, Mr. Duguay.

Unfortunately, it seems that the economic situation continues to deteriorate. When the Governor of the Bank of Canada appeared recently before this committee, I told him that he was optimistic. He answered that he was not optimistic, but realistic.

To be fair to the governor, his fairly optimistic forecast, he made very clear, was predicated on the situation in the United States improving and on everything working. It seems that there is little confidence in the United States, at this moment, that the crisis of the banking system will be fixed expeditiously.

You probably don't want to come out with a number, but compared with the earlier view that we would snap back and have 3.8% growth in 2010, how would you characterize your current position? How has it evolved since that time?

[Pierre Duguay]

Thank you, Mr. McCallum.

As we pointed out in our latest interest rate announcement when we lowered rates by another 50 basis points, the data has been weaker than expected. We knew that in the first half of this year there would be a string of bad news--we mentioned that. As you point out, the recovery that we projected starting in the second half of this year is very much predicated on confidence rebounding as the financial situation improves and is resolved. That's a precondition to recovery and the recovery of confidence that comes with it.

We said in our report that the first half of this year would be weaker than expected and the contraction of output would be stronger. Potential delays in stabilizing the global financial system, together with larger than anticipated confidence and wealth effect on domestic demand in Canada, could mean that the output gap will not begin to close until early in 2010.

In our monetary policy report update we had growth above potential output, as you may remember, starting in the fourth quarter of this year. I think we're delaying that. We're saying it won't happen until the beginning of 2010.

We don't have a complete projection at this point. We will have a complete projection. We will be coming out with the monetary policy report in mid-April.

[John McCallum, Liberal, Markham—Unionville, ON]

Thank you.

Some Canadians have the impression that with the interest rate now approaching zero, monetary policy has become powerless. I know that monetary policy is not necessarily powerless, because the central bank can acquire assets like corporate bonds and commercial paper market--direct actions of that kind. I know you've started on that path.

I'd like you to perhaps reassure Canadians that monetary policy is not totally weak or powerless, and describe the nature of other things monetary policy can do and additional measures you could do if necessary.

[Pierre Duguay]

Those are very good questions.

As we said in our press release, we are refining our approach to how we provide additional monetary stimulus, if required, through credit and quantitative easing--the sorts of things you've been talking about.

At this point I'm not really in a position to give details. In our April monetary policy report we will outline the framework for the possible use of such measures. It would be premature at this point to give an indication of what we will be doing.

[The Chair, Conservative, James Rajotte]

You may ask one last question.

[John McCallum, Liberal, Markham—Unionville, ON]

We had BDC here this week, and the budget says that some $8 billion is authorized to flow in credit through BDC and EDC. At the time I said that a number of people in the business community had expressed concern that nothing much was happening and there was little sense of urgency in this money getting out of the door. I tried to get BDC to give us some idea of how long it would take to get the $8 billion out the door. I didn't really get anywhere.

I don't expect you to criticize BDC or comment directly, but would you agree, given the overall credit situation in Canada, that there is a degree of urgency for funding that was allocated in the budget to move expeditiously? If you are saying the recovery's going to be under way in 2010, then surely the money is needed in 2009, and therefore it's not business as usual. There should be a sense of urgency by both BDC and EDC to actually use the money they have been allocated.

[The Chair, Conservative, James Rajotte]

Very briefly, Mr. Duguay.

[Pierre Duguay]

Very briefly.

I would agree that there is a sense of urgency. Very clearly, we will be hit by a string of bad news in the coming months. What is absolutely critical is to maintain business and public confidence, and clearly, access to credit is essential in that situation. So yes, I would say that there is a sense of urgency. It will not speak for BDC, of course.

[The Chair, Conservative, James Rajotte]

Thank you.

Thank you, Mr. McCallum.

Monsieur Laforest.

[Jean-Yves Laforest, Bloc, Saint-Maurice—Champlain, QC]

Thank you, Mr. Chair.

Good morning, Mr. Duguay.

We are experiencing an economic crisis that began with a financial crisis. I wish to discuss, among a few other things, the Caisse de dépôt et placement du Québec, which has suffered colossal losses. In Quebec, these losses have been the only thing people are talking about for the last two weeks. One of the factors that led to these losses was the purchase of commercial paper by the Caisse. Of course, one cannot know everything that really happened. Many people bought commercial paper and were relying on ratings issued by special agencies such as the DBRS, and various other securities rating agencies. We do know that many types of commercial paper were given a high rating. All of this looks like a scam. People were told that this paper would yield a good return. Some people were perhaps too gullible in believing this, but the agencies do nonetheless share part of the responsibility.

What kind of assessment does the Bank of Canada give these ratings agencies?

[Pierre Duguay]

Obviously, we are not directly responsible for ratings agencies. Generally speaking, as regards the commercial paper crisis, there were problems with ratings agencies. Commercial paper was greatly lacking in transparency. Certain structured products were very opaque, and few people knew what they truly were. Ratings agencies were specifically assessing what we call credit risk, and not liquidity. After the losses, investors who were buying up ABCP like hot cakes suddenly decided that they did not want any of it anymore.

As concerns the Caisse de dépôt, their ABCP was issued by third parties, and not banks. These ABCP were structured in a particular way. In this specific Canadian case, the credit margins accompanying this ABCP were very imperfect. In fact, several ratings agencies simply refused to rate those securities. In a certain way, investors understood that they were only using one highly subjective rating. It is always preferable to have two credit ratings.

[Jean-Yves Laforest, Bloc, Saint-Maurice—Champlain, QC]

The Bank of Canada was in a position to observe everything that was going on. Your job is to conduct monetary policy, but you also have to observe everything that is going on in financial markets. The Bank of Canada takes action based on the state of the markets.

Why were you not able to issue any warnings?

[Pierre Duguay]

We issued warnings, specifically in our Financial System Review. That was in 2005, I believe. We indicated that there were difficulties and risks associated with the liquidity of this ABCP. Ultimately, however, the decision is made by investors, who have the responsibility of doing their homework. In the case of the Caisse de dépôt et placement du Québec, their investors are very sophisticated.

[Jean-Yves Laforest, Bloc, Saint-Maurice—Champlain, QC]

You are saying then that you issued a warning, but that people did not listen to it.

[Pierre Duguay]

Exactly.

[Jean-Yves Laforest, Bloc, Saint-Maurice—Champlain, QC]

On the first page of your document, you say that Canadian banks have managed to raise capital during this troubled period to support continued lending and to make up for some of the decline in the demand. You are drawing a comparison with what is happening elsewhere, specifically in the United States. You state that we are doing rather well, but I still feel that you are providing a rosy outlook. Credit conditions have tightened significantly in the past year for both consumers and businesses.

Don't you find this slightly contradictory? In the last paragraph of your statement, it reads, and I quote:

Investor and public confidence has been badly shaken, but will recover with the timely implementation of ambitious plans in some major countries to address toxic assets and recapitalize financial institutions.

If countries are recapitalizing their financial institutions, it is because their balance sheets have taken a huge hit. Are you excluding Canada from this trend?

[Pierre Duguay]

Yes, absolutely, because Canadian banks are very well capitalized. It is the main reason why our system is the envy of the world. Significant losses were suffered mainly in the United States and in Europe. As I said in my opening statement, this crisis began abroad and most solutions must be applied at the international level. In the United States and in Europe, there is a clear and distinct need to recapitalize institutions, including public funds; however, this is not the case in Canada.

[The Chair, Conservative, James Rajotte]

Merci.

We'll go to Mr. Menzies, please.

[Ted Menzies, Conservative, Macleod, AB]

Thank you, Mr. Chair.

Thank you, Mr. Duguay. You're a brave man to come all by yourself to appear in front of this distinguished committee, which, I might add, actually has female representatives on both sides of the table today, which is a great thing in this old boys' club, where it's refreshing to have some women here with us.

Anyway, thank you for your comments and your reflections today. One comment of yours that I picked up on was that a precondition for recovery is improvement in the world's economic stability. If I can follow up on that, we had finance department officials here who talked about the role Canada is playing in this G-20 leaders' action plan. I know that the Governor of the Bank of Canada, and I'm not sure who else, takes part in these G-20 conferences.

Can you share with us, as much as you can, what role the Bank of Canada plays with other central banks in the G-20, and are you part of this leaders' action plan as well?

[Pierre Duguay]

The G-20 has what is called the ministers and governors, who meet before the leaders. And of course the ministers and governors, having discussed the situation, will be informing their leaders individually and probably making a recommendation. And the leaders will be deciding in early April on a course of action.

What we are doing, in a sense, is preparing the ground. Below the governors and the ministers, of course, there are meetings of the deputies. One of our deputy governors, John Murray, and Tiff Macklem, from the Department of Finance, who was here yesterday, are G-20 deputies.

As Tiff told you yesterday, there is a diversity of opinion. There are a wide range of solutions that have been contemplated. There are two issues. In the short term, what more do we do, given that the situation has deteriorated. I think the plans to resolve the financial crisis are just about the right plans, and the question here is the execution and the timeliness, so it is imperative to go forward on that.

The second part is that once you win the war, you have to think about the reconstruction and how you prevent something like that from happening again, talking about the regulation of the financial system. That's where, in a sense, there are a variety of views. But I think there is a coming together that some things are important, such as macro provincial regulation and having capital regulations where capital is built up during the upside of the cycle so there is a buffer that can be used to absorb shocks when they happen.

We also want to avoid pro-cyclicality. There is a sense in financial systems that things tend to get amplified by the reactions of people. So we're asking if there is anything that can be done from a regulatory point of view to limit this amplification, which is a part of nature. When things are good, you're optimistic; you understate risk. When things turn bad, all of a sudden the irrational exuberance gives rise to panic. So just as the risk is understated in one case, when you get a string of bad news, risk gets overstated. So how do you try to set a financial system that would be robust to that?

And the third point that's important is, in a sense, the alignment of incentives. Regulation always sets incentives to bypass it, so ensuring that there is a system-wide approach so that the incentives are aligned.... For example, in the ABCP there was a misalignment of incentives because of the original distribution model: the people who were making the loans did not keep any. They were just making loans, sending them, and had no incentive to do a verification of the credit quality of the loan. So alignment of incentive is important, and of course transparency and clear disclosure.

In the context of the ABCP crisis, one of the big problems, as we discussed earlier with Monsieur Laforest, is that disclosure was not adequate.

[Ted Menzies, Conservative, Macleod, AB]

The point I wanted to make--and I think you said it earlier in answering a question--is that Canada is viewed in a leadership role, and I think that Canadians need to hear that again, that our system is sound and that other countries are coming to us, looking to us as a leader.

Thank you for your answer.

[The Chair, Conservative, James Rajotte]

Okay. Thank you.

We'll go to Mr. Mulcair.