Euro recession will depend on banks: Carney

The euro zone is headed for at least a brief recession, but the nature and length of the slump and the degree to which it affects other parts of the world depends on how the region's lenders choose to repair their balance sheets, Bank of Canada Governor Mark Carney warns.

Moves by the European Central Bank to backstop financial institutions mean it is unlikely there will be a "European equivalent" of the Lehman Brothers collapse in 2008 that triggered the worst global downturn since the Depression, Mr. Carney said Tuesday in a speech in the heart of London's City financial district. Still, he said, the world is once again seeing a tightening of available funds because of Europe's debt woes, and the impact both in the region and elsewhere will depend on careful management by banks, as well as policy makers.

"Measures to avoid disaster are not necessarily sufficient to promote recovery," Mr. Carney told the Canada-U.K. Chamber of Commerce, noting that the effects of a pullback in funding are "not limited" to Europe. "As global liquidity recedes, volatility is increasing and activity falling. The effect on the real economy will soon be felt."

Mr. Carney's speech, his first since becoming chairman of the Financial Stability Board – the global body co-ordinating efforts to overhaul international banking – outlined ways that European banks could meet a recently imposed June, 2012, deadline to raise their level of top-quality capital, to 9 per cent from 7 per cent, cautioning against relying exclusively on sales of risky assets.

Although the banking lobby has argued that the cost of raising new capital could restrain lending and put the economic recovery at risk, Mr. Carney said banks can best limit the impact of their debt-cutting through a mix of dipping into retained earnings, selling assets and also raising capital. Using just asset sales, for instance, could mean €2.5-trillion worth of such sales are required; at the same time, banks could drop this number to €1.4-trillion if they were to pay no dividends, he said.

Mr. Carney also said that as funding pressures increase around the world due to the European crisis, the best vehicles to ensure credit markets operate smoothly are still central banks and the steps they can take to increase liquidity, or the ability of businesses, households and governments to secure funding.

However, he said, backstopping by central banks is not a sustainable solution to the "wild fluctuations" in liquidity in recent years, and he emphasized the importance of sound regulations to make banks more able to withstand funding shocks so that credit conditions are less prone to boom-and-bust cycles.

"Although central bank measures can help address current volatility, such a situation is hardly ideal," Mr. Carney said. "Over the medium term, the continuation of such extreme liquidity cycles could ultimately threaten open capital markets and a free trading system if not better addressed."

This means there "is a premium on improved oversight and regulations that reduce the procyclicality of global liquidity and make the system more resilient," said Mr. Carney, who will lead a beefed-up FSB on a part-time basis for the next three years while continuing on as Bank of Canada chief.

At the same time, he said, improved regulation will no doubt shift some financial activity to the unregulated parts of the system, or the so-called shadow banking entities like money market funds.

During a press conference after his speech, Mr. Carney said the FSB is working "seriously" on proposals to directly regulate the "shadow" sector, or at least entities in it whose activities could threaten the overall financial system.

"The shadow banking sector is a priority going forward, not least because of the links back into the regulated sector, not least because it is a major source of finance and can be a source of both conflict and resilience in the system," he said. "We need to get this right, and that will be a focus."

In a footnote to the speech, Mr. Carney repeated the line that policy makers have stuck to in recent weeks, assuring Canadians that they are ready to take steps to ensure there is enough liquidity in the system, but saying extraordinary measures like ones taken during the recession – when the Bank of Canada almost doubled its balance sheet to keep credit flowing through the economy – are not yet needed.

At the press conference, Mr. Carney elaborated.

"The issue ultimately is about the scale of global financial contagion, spikes in risk premiums and other asset prices that begin to affect core funding markets in Canada," he said. "We have not seen that in Canada, but obviously we're watching the situation very, very closely."

With a report from Doug Saunders in London