Canada’s current regulatory framework focused on just keeping individual banks safe without looking at the overall economy will not be able to cope with a sudden correction of the housing market or personal debt levels, according to a paper released today by the University of Calgary’s The School of Public Policy.

Authors Mahdi Ebrahimi Kahou and Alfred Lehar argue that in the aftermath of the recession caused by the 2007 financial crisis, there is a growing consensus about the need to change the regulatory framework towards a macroprudential perspective – an approach to financial regulation that aims to reduce the risk of the financial system as a whole.

The researchers highlight the existing regulatory framework’s pure micro-based nature which is focused at protecting the individual financial institutions – keeping individual banks safe ensures the safety of the system as a whole.

Addressing the link between the system and the performance of the overall economy has become a mandate for policymakers and scholars, the authors argue.

In particular, the report identifies two key challenges for macroprudential stability in Canada.

First being that housing prices and personal debt levels of Canadians are at a high level. Any sudden corrections might pose a challenge for the financial system and policymakers should continue to address this type of systemic risk.

Second, while the Canadian banking system was not severely implicated in the recent financial crisis, stronger linkages may pose a larger threat to Canadian financial stability in the future.

According to the paper, the frequent occurrence of financial crises and their consequences has led many to suspect that the existing financial regulatory framework is not sufficient to insure the stability of the financial system as a whole and by looking at individual institutions in isolation, risks are overlooked that are only visible at the system level.

“Macroprudential regulation is the correct approach to ensure the long run stability of the financial system,” Kahou and Lehar state. “Instead of focusing only on the individual bank as a standalone entity, regulators must see the system as a whole and limit threats to financial stability.”

While we now know substantially more about systemic risk than just 10 years ago, many questions remain to be addressed.

Macroprudential policy, as an attempt to address this concern, must remain a mandate for policymakers, the researchers conclude.

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