The time for decisive action on financial reform has come, and banks need to prepare for it, Bank of Canada governor Mark Carney says.

Bank of Canada governor Mark Carney says banks should prepare for radical reforms to the world financial system. (Sean Kilpatrick/Canadian Press)

Canada's top banker told a Montreal business audience Thursday that the reforms to be discussed by the G20 at the upcoming summit in Toronto are hugely important. "Recent tensions in Europe have underscored this urgency," he said.

The changes to the world system are "radical, not incremental" but will end up looking a lot like what is already practised in Canada, with a few add-ons, Carney said.

"The rigour of Canadian capital regulation was an important — although far from exclusive — reason why the Canadian system fared so well during the crisis," Carney said.

There is little question reform is needed, he said, dismissing notions that reforms would put a lid on growth. And failure to act is not an option: "We are awash in moral hazard," he said. "If left unchecked, this will distort private behaviour and inflate public costs."

The 2008-09 financial crisis in the United States and several major European economies "exposed the fallacy" that strong financial institutions would collectively act to ensure the soundness of the system for their own preservation.

Reform will aid growth

Although the coming changes will be significant, Carney dismissed critics who believe the requirement for more capital reserves will limit banks' ability to lend and slow down economic activity.

In fact, the opposite will happen, he said. "The point is not to pile up so much capital in our institutions that they are never heard from again," he said.

The reforms will cause banks to shift focus away from trading risky financial instruments and more to conventional lending to businesses and individuals that spur growth, he argued.

And he noted that banks will be given plenty of lead time to meet new standards, since the implementation date of key reforms won't be until the end of 2012. "We should not sacrifice our ambition for these measures to speed of implementation, nor the economic recovery to an arbitrary timeline," he said.

Carney's speech was prepared for the International Organization of Securities Commissions meeting in Montreal.

The Canadian central banker said he welcomed that last weekend's meeting of G20 finance ministers in South Korea had refocused discussions on the core reform agenda, and eliminated such distractions as a global bank tax supported by the United States and several European countries.

On Wednesday, Finance Minister Jim Flaherty released a letter that he sent to his G20 colleagues again proposing that instead of a universal levy, key individual banks be forced to create a rainy-day fund to be used during a time of crisis.

This is known as embedded contingent capital. Carney voiced support for the plan Thursday because it's aimed at leaving the banks themselves responsible for losses — not taxpayers.

"Its presence would also serve as a useful disciplinary device on management since common shareholders would be incented to act prudently and avoid having their stake in the institution diluted away," Carney told the audience.

"The risk of insolvency should, fundamentally, be a private concern," he said.

While voicing cautious support for the options already on the table, he also proposed that banks should develop “living wills,” or plans to unwind themselves in an orderly fashion if they were to fail.

With files from The Canadian Press