Policy makers should be wary of imposing new regulations on financial institutions and credit agencies in the aftermath of this summer's credit crunch and just let market forces improve transparency, outgoing Bank of Canada Governor David Dodge said on Sunday.
In a speech to the Institute of International Finance in Washington, Dodge said the responsibility for improving market transparency is shared by investors, sellers of complex financial products and credit rating agencies.
He also laid out some ideas on how central banks might expand their provision of liquidity to commercial banks in certain instances of market instability.
"The best route to increased transparency is the use of market forces, rather than detailed, prescriptive, and potentially burdensome regulations," Dodge said, according to the prepared text of his speech.
When investors demand much higher rates of return for complex securities like those at the heart of the recent financial market turbulence, then vendors will have an incentive to provide more detailed information on the assets underlying these products, he argued.
"However, markets will work only if issuers follow the basic principles of providing clear, straightforward, pertinent information about the security they are selling," he said. "Just as food companies are required to list all ingredients on their labels, so should issuers list the 'ingredients' of a security."
Dodge took a shot at Canada's credit rating agency, DBRS, as an example of an agency that wrongly used the same rating system for both conventional securities and the highly structured securities that were at the heart of the financial market dislocation, where the risks associated with the underlying assets are unclear.
"It seems likely that those credit-rating agencies that do not work harder to ensure that users understand the nature of their ratings will soon have fewer clients willing to pay for their services," he said.
Market players should be "encouraged" to take steps to ensure more liquidity in the asset-backed securities market. "It may be possible, for example, for asset-backed securities to carry some manner of 'branding' or 'certificate of origination' that would provide a clear incentive for the loan originator to exercise due diligence in extending the loan before it is securitized," Dodge said.
Central banks likewise have to re-examine some of their own policies as ultimate providers of liquidity to the financial system in times of crisis, Dodge said. As central banks have done elsewhere, the Bank of Canada has injected funds into the overnight money market at intervals since August to add liquidity.
"But are there principles that would suggest that some market failures would be best dealt with if we had a readily accessible facility that would provide liquidity to banks at terms longer than overnight, collateralized with a possibly wider range of securities?" he asked.
Policy makers would have to clearly define what kind of market disruption would warrant use of such a liquidity provision, he said.
"Such a facility would be designed to help to mitigate system-wide tightness. And such a facility would have to be set up so that it is clear that the Bank would not use it as a backdoor route to easing monetary policy."