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Ottawa — Credit-rating agencies, investors and dealers need to change their ways so that they can get a grip on the complexity of today's financial markets, Bank of Canada Governor David Dodge says.
“Investors should not rely simply on the pronouncements of rating agencies to deliver their seal of approval!” Mr. Dodge said in a speech in London that detailed how Canada's central bank saw the credit crunch unfold and seize capital markets around the world.
Mr. Dodge characterized the problems as “a fairly major bump in the road,” and blamed the credit problems on a widespread lack of knowledge about the risks involved in the trading of increasingly complex securities.
“One lesson, which I hope will be clear to everyone, is the absolute importance of transparency if markets are to function properly,” he said.
“Investors should not rely simply on the pronouncements of rating agencies to deliver their seal of approval!” Mr. Dodge said in a speech in London, England, that detailed how Canada’s central bank saw the credit crunch unfold and seize capital markets around the world. (Reuters)
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Vendors of financial instruments need to start structuring these complex securities in a way that the buyers can clearly understand how risky the underlying assets are, Mr. Dodge said.
Credit-rating agencies need to separate their ratings of complex securities from their more straightforward ratings of conventional debt instruments.
And investors shouldn't depend just on the agencies' ratings to make their decisions, Mr. Dodge told the Canada-U.K. Chamber of Commerce.
“However, this process can be successful only if they have access to all the information they need,” he added.
Mr. Dodge said he was confident that Canadian financial institutions have the wherewithal to withstand the credit crunch.
“They have not been immune to both global and local problems,” he said, but added that “the major banks appear to be well placed to deal with the current dislocations.”
And he warned that the troubles that began in August are far from over. Canada's central bank has managed to smooth out its overnight money market, but other short-term markets remain out of whack, he said.
“While the overnight market in Canada is well on its way back to normal operations, this does not mean that all of the problems in money markets have been resolved.”
Mr. Dodge also suggested the need for hedge funds to be more forthcoming about their operations. While he stopped short of calling for regulation of the burgeoning, unregulated market, he argued that there is “a clear case for increased transparency, at least with respect to their objectives, operating procedures and governance.”
The Group of Eight rich countries is divided on whether hedge funds should face tighter regulations, or merely encouraged by government leaders to do a better job at self-regulation. Two days ago, Bank of Canada researchers argued against tighter enforced government regulations, saying such rules could pose a moral hazard, and may also stifle the dispersion of risk that hedge funds bring to capital markets.
Mr. Dodge also took a shot at sovereign wealth funds — aggressive pools of capital backed by state money that have been buying assets around the world.
Canada's public pension funds are well behaved, and adhere to high standards of transparency, he said, but that's not the case for all countries' funds. (He did not name countries.) “Too often, the objectives behind these funds are not clearly defined, and this can lead to misconceptions about their motives, particularly those that have their origins in foreign exchange reserves,” he said.
Mr. Dodge reiterated statements made by the central bank last week that the Canadian economy is running at full tilt, but that the risks to the economy are “significant.”
The U.S. downturn could be deeper and more protracted than expected, he said. Or, on the other hand, Canadian household demand, already robust, could actually be stronger than expected.
That's why the central bank has decided to keep its key interest rate on hold for now, he said. (The bank had indicated in July that the rate would need to rise.)
Generally, the speech detailed how Mr. Dodge and the central bank saw the credit crunch take hold, and had a tone of “I told ya so.”
“Central bankers had been worried for quite some time that credit spreads were not appropriately reflecting risk,” he said. “So we welcomed the re-pricing of risk that began in the spring of this year.”
But the re-pricing became unruly in August, he said, because the complex credit instruments in play were so opaque that market players could not trade them with confidence.
“Even supposedly sophisticated investors became extremely uncertain, and that, in turn, led to fear,” he said. “The ‘wall of liqudity' evaporated under the summer sun.”
He recognized that Canada's money market problems were exacerbated by the fact that provisions to backstop some asset-backed commercial paper here were more lax than elsewhere in the world. But he said he was “hopeful” that the Montreal discussions between investors and liquidity providers would resolve the made-in-Canada problem.
