Financial system could face difficult adjustment to higher interest rates, BoC governor says

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The financial system could face a difficult adjustment to higher interest rates, Bank of Canada governor Tiff Macklem said Friday, arguing that banks and regulators need to be highly attuned to risks following the recent turmoil in the U.S. and European banking sectors.

Speaking to reporters from Washington, where he is attending the spring meeting of the International Monetary Fund, Mr. Macklem said that the risk of financial contagion from the collapse of Silicon Valley Bank and the crisis at Credit Suisse appears to have been contained.

However, there could be further jitters as banks and financial markets around the world work through the massive rise in interest rates over the past year. And regulators may need to tweak some of the tools they put in place following the 2008 global financial crisis, Mr. Macklem said.

“The financial system does need to adjust to higher interest rates,” Mr. Macklem said. “It can be difficult for Canadians to adjust to higher interest rates, and it can also be difficult for the financial system.”

The historic rise in interest rates has increased bank funding costs and strained many borrowers. It has also resulted in large balance-sheet losses at many financial institutions, given that bond prices drop when interest rates rise.

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These mark-to-market losses aren’t necessarily a problem, so long as banks aren’t forced to sell their bond portfolios. However, concerns about asset valuations can lead to deposit withdrawals and even outright bank runs, as happened with Silicon Valley Bank.

The sudden repricing of assets can also strain other parts of the financial system. This happened in Britain last fall when a swing in government bond prices squeezed poorly hedged pension funds and nearly sparked a firesale in the gilt market.

Mr. Macklem said that Canadian banks were mostly unaffected by the recent U.S. and European banking stress.

In the days and weeks after the failure of Silicon Valley Bank and the emergency sale of Credit Suisse, the Bank of Canada was in frequent communication with the CEOs, treasurers and risk officers of Canada’s large and mid-sized banks, Mr. Macklem said.

“What we saw was really a very muted effect in Canada,” he said. “We did see some decline in equity prices of banks in Canada – they were considerably smaller than what you saw in Europe and the U.S. – and some widening of spreads. Since then, the situation has largely normalized or stabilized.”

He credited the swift response by U.S. and Swiss central bankers and regulators for containing the crisis. After the collapse of Silicon Valley Bank, the U.S. Federal Reserve started pumping liquidity to regional banks to fend off further bank runs while the U.S. government expanded deposit guarantees.

Meanwhile, the Swiss central bank backstopped Credit Suisse until regulators could orchestrate a shotgun wedding with rival UBS Group. In both cases, the central banks were acting in their traditional role as lenders of last resort.

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Canadian banks have a long-standing reputation for stability, and banks around the world have generally strengthened their risk-management practices since 2008, increasing capital and liquidity buffers and reducing leverage.

Still, Mr. Macklem said that financial institutions need to be “very diligent and vigilant in their own risk management” and added that there is a “premium on sound supervision” from regulators.

“The financial system and the economy is adjusting to higher interest rates. We can’t rule out that there won’t be some renewed stresses, and certainly in the event of extreme liquidity stress … central banks stand ready to provide emergency liquidity, if needed,” he said.

Financial regulators are trying to learn from the recent tumult, Mr. Macklem said. He said the Basel Committee, which oversees global banking regulation, is looking at the treatment of interest-rate risk on bank balance sheets. They are also looking at how digital banking and social media may have increased the speed of the run on Silicon Valley Bank.

“They had a very concentrated customer base; they were communicating on social media. And then digital banking is a lot more convenient, but that also means that money can be withdrawn much more quickly,” Mr. Macklem said.

“This was a very extreme situation, but new technology, social media are out there. And does that suggest we need to look at the calibration of the runoff assumptions on deposits that are built into liquidity buffers? The Basel Committee is reflecting on those sorts of questions,” he said.