Bank of Canada’s Response to the Financial Market Turmoil

1. 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.

2. Overview • The Crisis: causes and impacts • Central Bank Actions: the Bank of Canada’s evolving liquidity framework • Results • Lessons Learned

3. 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

4. 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

5. 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

6. The Crisis: Impacts Globally, banks are affected

7. 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

8. 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

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 Bank’s 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 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

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

14. Results Bank funding costs have declined

15. Results

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

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