Bank of Canada

1
Bank of Canadas 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.
2
Overview

• The Crisis causes and impacts
• Central Bank Actions the Bank of Canadas
  evolving liquidity framework
• Results
• Lessons Learned

3
The Crisis 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

4
The Crisis 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

5
The Crisis 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

6
The Crisis Impacts
Globally, banks are affected
7
Bank of Canadas 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

8
Bank of Canadas 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 more dependent 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

9
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

10
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 Banks
  assessment of requirements
• New Facilities Term PRA, Term PRA for Private
  Sector Instruments, Term Loan Facility temporary
  increase to USD swap agreement

11
Bank of Canadas Actions
       
2007 2008 2009
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

12
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

13
Results
Liquidity extension is relatively low in Canada
14
Results
Bank funding costs have declined
15
Results
Bank of Canadas balance sheet has changed
16
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.

17
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

18
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

19
Appendix
20
Liquidity Facilities
  Term PRA Facility Term PRA for Private Sector Money Market Instruments Term PRA for Private Sector Instruments Term Loan Facility
Announced December 12, 2007 October 14, 2008 February 23, 2009 November 12, 2008
Objective Provide liquidity support financial markets Reinforce the BoCs conditional statement regarding the overnight rate Support liquidity in private-sector money markets (replaced by Term PRA for Private Sector Instruments) Support liquidity in markets for private-sector instruments Give LVTS participants greater flexibility in balance sheet management Improve conditions in money and credit markets
Eligible Participants Primary dealers Participants in LVTS PDs (direct basis) Firms active in the CAD private sector money markets subject to regulation (indirect basis) Institutions active in the CAD private sector money and/or bond markets and subject to regulation Direct Participants in the LVTS on an indirect basis through a PD
Frequency of Offering Weekly Weekly Weekly Weekly
Loan Terms 1, 3, 6 and 12 months 2 weeks 1 and 3 months 1 month
21
Liquidity Provision
Cash value Par Value
Source Bank of Canada
22
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.

23
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