(Adds comments on government role)
By Leah Schnurr
OTTAWA, May 6 (Reuters) - The Bank of Canada plans to develop a framework for stress tests that will incorporate different sectors of the financial system to enhance its contribution to macroprudential oversight in Canada, Deputy Governor Lawrence Schembri said on Friday.
In a speech focused on what central banks can do to contribute to financial stability, Schembri said the system-wide framework would cover banking, insurance and investment funds, as well as financial markets and financial infrastructures.
Central banks must rethink their role in financial stability in light of the severity of the global financial crisis, he said.
Although the best contribution central banks can make to financial stability is stability in inflation and the economy, Schembri noted, "this is a necessary, but not sufficient, condition for financial stability."
While Canada emerged relatively unscathed from the credit crisis, the subsequent housing boom has raised concerns that overly hot prices and heavily indebted homeowners pose a risk to the system.
Asked about how much responsibility the Bank of Canada bears, Schembri said the Canadian government is ultimately responsible for financial system stability, though the central bank plays an important role through the advisory committees it sits on.
"The level of cooperation is relatively high and we're able to respond fairly nimbly to situations where vulnerabilities are cropping up," Schembri said, pointing to last year's mortgage changes by the government to cool the housing sector.
Among measures Schembri suggested central banks can take to aid financial stability are encouraging prudence among borrowers and lenders, and increasing transparency to create market awareness of potential vulnerabilities.
Central banks can improve their contribution to financial stability by using their two key strengths, which are their broad system-wide perspective and their analytical capacity, he said.
"Although central banks don't themselves have a broad set of instruments to mitigate financial vulnerabilities, they do have that system-wide view, which they can and do use to promote financial stability by making public their analyses of financial vulnerabilities and risks and making recommendations for preventive policy actions," Schembri said.
Schembri also said the Bank of Canada aims to improve its models to better understand the interactions between monetary and macroprudential policy. He described the bank's plans as "aspirations", and did not suggest a timeline. (Reporting by Leah Schnurr; Editing by Chizu Nomiyama and James Dalgleish)