“Severe and Unusual Stress” — A Definition In Search of A Situation

Well. Finally. Some clarity. Sort of. Earlier this month, Bank of Canada governor Mark Carney made appearances before the House of Commons Finance Committee and the Senate Banking, Trade and Commerce committee to discuss the Bank’s latest monetary policy report . Transcripts are now available and with a little reading-between-the-lines, they tell us a lot, I think, about the true purpose of the proposed changes to the Bank of Canada Act.

As I documented in an earlier post, the Bank of Canada is seeking changes to the Act ostensibly for the innocent purpose of expanding the range of assets it can accept as collateral in its dealings with the financial system. A close reading of the Act however suggests that the Bankalready has the power it needs to accept any type of collateral it wants in the context of a “severe and unusual stress.” From this, I suggested that the proposed changes to the Act were probably more an exercise in communications than in substantive legislative change — they effectively signal to the market that the Bank is serious about backstopping the asset-backed securities market.  Moreover, the mere act of signaling may be enough to loosen things up there and get credit flowing again.

Carney’s testimony suggests a slight twist to my interpretation. First, he acknowledges in his House of Commons meeting that, indeed, the Act already gives the Bank “tremendous flexibility, unlimited flexibility, if we declare ‘severe and unusual stress'” which he later describes as situations analogous to that of Japan: “zero interest rate policy, deflation risk, and a financial system that’s totally frozen.” According to Carney, the proposed changes are really for “intermediate” or “extraordinary” (as opposed to “extreme”) situations.  Moreover, Carney argues that the proposed changes will give the Bank a better picture of the asset-backed market — and other securities (corporate bonds for example) — by allowing it to deploy  (auction) these securities : “price discovery” is the term he uses.

While I have some sympathy with these arguments, there are still some important unanswered questions that point to the fundamental communications challenge here. First, Carney’s proposed definition of “severe and unusual stress” appears to be purely ad hoc because the legislation does not define its meaning. Moreover, as he himself admits, the Bank has never resorted to the use of this provision so there is no precedent on which to base his definition.  Finally, last I checked, “extraordinary” means roughly the same thing as “unusual” — out of the ordinary, a departure from normality.  In short, as best I can tell, Carney and the Bank seem to be making definitions up as they go along in whatever way suits their purpose.

Second, it’s hard to see how the situation last summer and through to today is not “severe and unusual” — when was the last time an entire securities market seized up, threatening to cause havoc in the banking system as a whole? When was the last time the world financial system seemed threatened, leading to massive coordinated policy across developed countries (the 1980s come to mind)? The events in the asset-backed securities market have already made the Bank’s task of managing the overnight rate much more difficult, with substantive and persistent (historically and relatively speaking) deviations from its target occurring repeatedly since last summer.

Third, and building on these last two points, it seems that the Bank’s real objective is to avoid having to use paragraph 18(g.1) altogether. Why? Because its use triggers a requirement for the Bank to notify the government, in writing, in the Canada Gazette, of its use. It could therefore contribute to the crisis atmosphere. Declaring a situation “severe and unusual” may simple ensure that the situation is “severe and unusual.” Better to call a crisis an “intermediate situation” or “extraordinary” and intervene quietly, discretely, away from the public glare and distant from the Bank’s ostensible goal of transparent communications. Le plus ca change…