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Bank of Canada’s Response to the Financial Market Turmoil. Conference on Business, Banking, and Finance 28-29 May 2009. Ron Allenby, Assistant Director Financial Markets Department Bank of Canada.

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Bank of Canada’s Response to the Financial Market Turmoil

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Bank of Canada’s Response to the Financial Market Turmoil

Conference on Business, Banking, and Finance

28-29 May 2009

Ron Allenby, Assistant Director

Financial Markets Department

Bank of Canada

* The views expressed here are my own, and do not necessarily reflect the views of the Bank's Governing Council.


Overview

  • The Crisis: causes and impacts

  • Central Bank Actions: the Bank of Canada’s evolving liquidity framework

  • Results

  • Lessons Learned


TheCrisis: Causes

  • Low US interest rates for extended period

  • US banking system deregulation

  • Search for higher yield: growth in securitization; increased leverage; increased risk taking

  • Real estate boom: ease of lending standards


TheCrisis: Causes

  • US real estate prices stop increasing

  • Poor performance of subprime mortgages: concerns with asset-backed securities

  • ABCP market freeze in Canada

  • Reduced confidence in structured products: increased awareness of risk


TheCrisis: Impacts

  • Uncertainty in banking sector re: future funding needs and distribution of losses related to mortgages and structured products

  • More cautious liquidity and credit management: tensions in money markets; bank funding costs rise

  • Spill-over of credit market turmoil into asset prices: decline in equities; impact on financial institutions

  • Several waves over 2007-2008


The Crisis: Impacts

Globally, banks are affected


Bankof Canada’s Actions

Strategy:

  • Continued focus on monetary policy objective – reinforcing target rate during periods of stress; aggressive reductions in overnight interest rate.

  • Provision of extraordinary liquidity to core market participants.

  • Support of global initiatives – central bank cooperation and communication; leadership in creating a sounder financial system


Bank of Canada’s Actions

Importance of Liquidity:

  • Liquidity required for efficient pricing – banking and market-making are key functions, but endogenous liquidity generation had broken down

  • Financial system stability moredependent on efficient pricing – in large part because of securitization and mark-to-market accounting

  • Traditional central bank liquidity framework insufficient – altering liquidity through monetary policy, or in the core payments systems, or through a reallocation of liquidity to banks insufficient when markets centre of storm


Traditional Liquidity Framework

  • Monetary Policy:

    • Intervene at one-day, with a limited set of highly regulated counterparties, against only the most liquid of collateral

    • Standing Liquidity Facility: at target +/- 25 basis points

    • Buyback operations (at target rate)

Financial Stability:

Emergency Lending Assistance (restricted to core financial institutions, broad collateral)

  • Stigma - perceived to be precursor to supervisory intervention


BoC Revised Liquidity Framework

Margins of Change to Liquidity Framework:

  • Term: lending beyond one day

  • Collateral: wider range of eligible securities

  • Counterparties: wider range of financial institutions

  • Size: value of operations evolve with Bank’s assessment of requirements

  • New Facilities: Term PRA, Term PRA for Private Sector Instruments, Term Loan Facility; temporary increase to USD swap agreement


Bank of Canada’s Actions

Evolution of the Liquidity Framework

  • Summer 2008:

  • US Treasury securities and ABCP accepted as collateral under SLF

  • February 2009:

  • Term PRA for private sector instruments amended

  • Autumn 2008:

  • 1 and 3-month term PRAs introduced. Frequency & size of operations increased and list of eligible counterparties expanded

  • Term PRA for private sector money market instruments introduced

  • Term loan facility introduced

  • US dollar swap facility announced

  • April 2009:

  • 6 and 12-month term PRAs introduced

  • QE/ CE framework for monetary policy

  • December 2007:

  • 1-Month term PRAs introduced

  • Expansion of securities eligible as collateral under SLF


Liquidity Provision: Results

  • Liquidity extensions, as a percentage of banking system assets and GDP, is relatively low in Canada

  • Changes in the Bank of Canada balance sheet: assets have grown; holding a broader range of assets

  • Bank funding costs have declined

  • But, some markets have not recovered: significant decline in outstanding ABCP


Results


Results

Bank funding costs have declined


Results


Lessons Learned

  • Central banks have a role in liquidity provision, from both a monetary policy and financial system stability perspective

  • Monetary policy transmission is affected by asset-market liquidity; support of the inter-bank market may be required to maintain control over overnight rates

  • Intervention may be required when liquidity problems have a system-wide significance; but, must be reasonable assurance that action can mitigate the problem and contribute to stability.


Lessons Learned

Principles of Intervention:

  • Target intervention to problems with system-wide importance

  • Intervention should be graduated and commensurate with the severity of the problem

  • Tailor the response/tools to the problem

    • Capability to transact with extensive set of counterparties and collateral

    • Capability of aiding cross-border liquidity distribution


Lessons Learned

Principles of Intervention, continued:

  • Intervention should not be distortionary

    • Reduce potential stigma problems through design of liquidity facility

    • Encourage usage of central bank programs, but as a back-stop

    • Mitigate moral hazard by clarifying objectives and principles

    • Exit strategy should be considered along with design of facility


Appendix


Liquidity Facilities


Liquidity Provision

*Cash value

**Par Value

Source: Bank of Canada


Monetary Policy Response

  • Since December 2007, the BoC has lowered the policy rate from 4.50% to 0.25%.

  • The Bank is committed to hold the target overnight rate at the effective lower bound of 0.25% until the second quarter of 2010 conditional on the inflation outlook.


Macro-prudential Regulation & Global Initiatives

Macro-prudential Regulation:

  • In cooperation with domestic partners, focus on system-wide issues and appropriate regulatory responses

    • Examine how to best coordinate management of both risks to individuals (depositors, investors) and risks to the system

      Global Objectives:

  • Coordinate on international regulatory frameworks

    • Standards of transparency, infrastructure

  • Examine role for central banks not only as providers of liquidity to institutions, but to markets


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