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Avoiding Collateral Damage

Avoiding Collateral Damage. Collateral and the Bank of Canada’s ELA Framework. David Longworth* Bank of Canada Presentation at Norges Bank Conference on Banking Crisis Resolution 16 June 2005 * The assistance of Walter Engert is gratefully acknowledged. Overview.

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Avoiding Collateral Damage

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  1. Avoiding Collateral Damage Collateral and the Bank of Canada’s ELA Framework David Longworth* Bank of Canada Presentation at Norges Bank Conference on Banking Crisis Resolution 16 June 2005 * The assistance of Walter Engert is gratefully acknowledged

  2. Overview • Introduction: "Avoiding Collateral Damage" • Two types of lender-of-last resort loans • Avoiding inappropriate emergency lending assistance • Appropriate justification; solvency; appropriate framework • Avoiding damage to unsecured creditors, BoC • Collateral; haircuts; loan portfolio • Conclusions

  3. Introduction • Bank of Canada recently reviewed its LLR policy • One aim was to be more transparent • Another aim was to spell out what LLR can do • And what it can’t do • One wants LLR lending to be appropriate • And to “Avoid Collateral Damage“ of an inappropriate policy

  4. Two types of LLR • Standing liquidity facility (SLF) and emergency lending assistance (ELA) • SLF is routine, and facilitates settlement • This presentation is about ELA

  5. Avoiding inappropriate ELA (1) • Need appropriate justification for eligibility • BoC justification: market failure related to a “deposit-taking” institution (DTI) • Relies on liquid, fixed-value deposits to fund illiquid assets • (If large DTI involved, could also be systemic) • Difficult to assess such a market failure • Such market failure seems increasingly unlikely • Indeed, BofC ELA has been rare

  6. Avoiding inappropriate ELA (2) • BoC policy: ELA is for solvent DTIs • Minimizes moral hazard • Avoids impairing interests of unsecured creditors • Recognizes that ELA cannot correct capital deficiencies of insolvent DTIs • Public-sector capital investment in a failed DTI is a fiscal matter, requiring government decision and accountability

  7. Avoiding inappropriate ELA (3) • Have an appropriate framework for dealing with other safety-net agencies • Rely primarily on supervisor for solvency judgement, collaborate on remedial measures and work-out • Sound safety net framework is critical • Clear supervisory mandate • Adequate supervisory powers • Structured, early intervention • Bank can provide input into process and decisions • Financial Institutions Supervisory Committee • Good working relationships among safety net agencies • Bank can compel inspections, including by third parties

  8. Avoiding damage to creditors, BoC (1) • Collateral supports policy of lending to solvent institutions • Requires Bank to assess borrower’s assets, encourages due diligence • Avoids impairing interests of unsecured creditors • Collateral protects the Bank • Security required by law • ELA situations are complex and high-risk • Protracted liquidity problems, doubts about solvency

  9. Avoiding damage to creditors, BoC (2) • Must be appropriate haircuts for collateral • Based on market data for marketable securities • In ELA situation, such securities would be gone • Bank would take a broader range of collateral for ELA than for SLF • Provide ELA loans against security of discounted Canadian-dollar loan portfolio

  10. Avoiding damage to creditors, BoC (3) • Take as security a floating charge against the borrower’s loan portfolio • ELA loans would be a fraction of assessed value of loan portfolio • Fraction could rise over time • Subject to an upper limit set by the Bank, would depend on the nature of the portfolio

  11. Conclusions • Lend only to solvent institutions • Otherwise, capital injection from government • Take collateral • With appropriate haircuts • Of all kinds, in ELA situation • Ensure that inspections undertaken • To support solvency judgment • Establish framework to co-operate with other safety-net agencies

  12. For more… • The Bank has recently completed a comprehensive review of its LLR policies • Bank of Canada, “Bank of Canada Lender-of-Last-Resort Policies.” Bank of Canada Financial System Review. December 2004. • F. Daniel, W. Engert and D. Maclean, “The Bank of Canada as Lender of Last Resort.” Bank of Canada Review. Winter 2004-2005. • On safety net arrangements more generally, W. Engert, “On the Evolution of the Financial Safety Net.” Bank of Canada Financial System Review, June 2005.

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