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

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

2

OverviewOverview

The Crisis: causes and impacts

Central Bank Actions: the Bank of

Canada’s evolving liquidity framework

Results

Lessons Learned

3

TheThe Crisis: CausesCrisis: 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

US real estate prices stop increasing

TheThe Crisis: CausesCrisis: Causes

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

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

TheThe Crisis: ImpactsCrisis: Impacts

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The Crisis: ImpactsThe Crisis: Impacts

Globally, banks are affected

Spreads between 3-Month LIBOR and Overnight Index Swaps*

0

50

100

150

200

250

300

350

400

Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08 Jul-08 Oct-08 Jan-09 Apr-09

Basis points

Canada

United States

Euro Zone

* U.S. LIBOR, EU EURIBOR and Canada CDORSource: Bloomberg; last observation made end of day 24th April 2009

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BankBank of Canada’s Actionsof 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

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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

Bank of Canada’s Actions Bank of Canada’s Actions

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Traditional Liquidity FrameworkTraditional Liquidity Framework

Financial Stability:

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

Stigma - perceived to be precursor to supervisory intervention

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)

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BoC Revised Liquidity FrameworkBoC 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

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Bank of Canada’s ActionsBank of Canada’s Actions       

2007 2008 2009

December 2007: 1-Month term PRAs introduced Expansion of securities eligible as collateral under SLF

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 introducedTerm loan facility introduced US dollar swap facility announced

February 2009: Term PRA for private sector instruments amended

April 2009: 6 and 12-month term PRAs introduced QE/ CE framework for monetary policy

Summer 2008: US Treasury securities and ABCP accepted as collateral under SLF

Evolution of the Liquidity Framework  

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Liquidity Provision: ResultsLiquidity 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

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ResultsResults

Liquidity extension is relatively low in Canada

Total Public Sector Liquidity Extension

0%

5%

10%

15%

20%

25%

US EU UK Canada

Ratio to Banking System Assets

Ratio to GDP

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Canadian Bank Funding Costs

0

1

2

3

4

5

6

A S O N D J F M A M J J A S O N D J F M A

%

3 month OIS3 month CDOR

Senior 5yr swapped to 3m floating rate debt3 month Treasury Yield

2007 2008 2009

ResultsResults

Bank funding costs have declined

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ResultsResults

Bank of Canada Assets

0

10

20

30

40

50

60

70

80

90

C$ bln

Private Sector Term PRATLFTerm PRATreasury BillsBonds

Bank of Canada’s balance sheet has changed

Federal Reserve Assets

0

400

800

1,200

1,600

2,000

2,400

US$ bln

FX Swaps

CP Funding Facility

Repos

TAF

Securities (Treasuries, GSE, MBS)

Other*

* Includes loans to U.S. broker dealers, J P Morgan, and AIG; Primary Dealer Credit Facility; Primary Credit Facility; ABCP Money Market Mutual Fund Lending Facility; Money Market Investor Funding Facility.

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Lessons LearnedLessons 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.

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Lessons LearnedLessons 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

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Lessons LearnedLessons 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

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Appendix

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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, 2008February 23, 2009

November 12, 2008

Objective

Provide liquidity & support financial markets Reinforce the BoC’s 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 Participa

nts

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

OfferingWeekly Weekly Weekly Weekly

Loan Terms

1, 3, 6 and 12 months

2 weeks 1 and 3 months 1 month

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Outstanding Value at BoC Liquidity Facilities

0

10

20

30

40

50

De

c-0

7

Jan

-08

Fe

b-0

8

Ma

r-0

8

Ap

r-0

8

Ma

y-0

8

Jun

-08

Jul-

08

Au

g-0

8

Se

p-0

8

Oct

-08

No

v-0

8

De

c-0

8

Jan

-09

Fe

b-0

9

Ma

r-0

9

Ap

r-0

9

$CA

D (

Bill

ion

s)

Outstanding Term PRA* Outstanding Private Sector PRA*

Outstanding TLF**

Source: Bank of Canada*Cash value

**Par Value

Liquidity Provision

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Monetary Policy ResponseMonetary 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.

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Macro-prudential Regulation & Global InitiativesMacro-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