Bank of Canada ‘ready to act’ if financial turmoil spreads

The Bank of Canada is prepared to support the financial system if the banking-sector turmoil in the U.S. spills across the border and hits Canadian banks and markets, deputy governor Toni Gravelle said Wednesday.

In a speech in Montreal, Mr. Gravelle said that the Canadian banking system remains strong and financial markets are functioning. But he said the central bank was “ready to act in the event of severe market-wide stress and provide liquidity support to the financial system.”

Mr. Gravelle’s remarks were the Bank of Canada’s first direct comments since the failure of Silicon Valley Bank on March 10 sent shockwaves through the global banking system. Two other U.S. regional banks have failed in recent weeks, and Swiss lending giant Credit Suisse was forced into an emergency sale to rival UBS Group – a series of events reminiscent of the financial crisis of 2007 and 2008.

“Canadian banks weathered the global financial crisis well, and, since then, their resilience has been further strengthened with the implementation of new, higher global standards,” Mr. Gravelle told a conference organized by National Bank of Canada.

“But we know we’re not immune to spillovers from what’s happening elsewhere. The financial system is highly globally integrated, so when financial stresses arise outside of Canada, they can negatively affect things here at home.”

In a question and answer session after the speech, Mr. Gravelle said that the recent banking debacles were a “wake-up call” and that Bank of Canada officials were “polishing off our contingency plans.”

The crisis in the banking system has forced central bankers in the U.S. and Europe back into their role as lenders of last resort. After the failure of Silicon Valley Bank, the U.S. Federal Reserve announced a US$25-billion lending facility that allows regional banks to swap their non-liquid assets for cash in the event of a bank run. It also began lending hundreds of billions of dollars to banks through its discount window.

The Swiss National Bank offered Credit Suisse 50 billion Swiss francs ($74-billion) in emergency liquidity to keep it going until its shotgun wedding with UBS could be finalized.

After the Credit Suisse sale, the Bank of Canada, the Fed and four other central banks stepped up efforts to keep U.S. dollars flowing through the financial system by enhancing their swap lines. These allow central banks to trade their own currency with one another, giving non-U.S. financial institutions access to U.S. dollars in the event of a sudden liquidity crunch.

Mr. Gravelle’s speech was mostly a retrospective look at how the Bank of Canada responded to market stresses in the early months of the COVID-19 pandemic. However, the history lesson offered a roadmap for how the central bank might respond to future crises.

Liquidity crises can occur if investors and depositors get nervous and dash to access cash, but banks and other financial institutions don’t have enough on hand to meet withdrawals, and are unable to sell their longer-dated assets because of market dysfunction.

The Bank of Canada’s main line of defence in the event of a liquidity crunch is its “term repo” facility, which lends cash to banks in return for high quality collateral.

“Our go-to game plan to relieve severe market dysfunction focuses on providing collateralized lending in the form of repos to banks. We then rely on the banks to pass this funding into the broader financial system,” Mr. Gravelle said.

In more extreme situations, the central bank can also lend directly to asset managers such as pension funds.

“This would be invaluable if we were ever faced with an event like the pension fund-related stresses in the U.K. gilt market in autumn 2022,” Mr. Gravelle said.

During the market breakdown in March and April of 2020, the central bank also began buying Government of Canada bonds from market participants to prevent this crucial market from seizing up. This program later morphed into the bank’s quantitative-easing (QE) program, aimed at holding down interest rates. The bank purchased roughly $330-billion worth of federal government bonds as part of its market stabilization and QE efforts in 2020 and 2021.

Mr. Gravelle said “the bar is very high” for the bank to launch another government bond-purchase program. He said that overuse of emergency-response programs can lead to “moral hazard,” where financial institutions take greater risks because they expect to be saved by the central bank.

“We will be offering extraordinary liquidity like we did in the pandemic only in extreme market-wide situations, when the entire financial system faces funding constraints,” he said.

Mr. Gravelle also used the speech to lay out the bank’s timeline for reducing the size of its balance sheet, which expanded massively as a result of the QE program. The bank is currently letting the bonds it owns mature without replacing them, a process known as quantitative tightening, or QT.

Mr. Gravelle said he expected that QT would be complete sometime around the end of 2024 or the first half of 2025. The central bank does not envision shrinking its balance sheet all the way back to prepandemic levels, because its new “floor” system for conducting monetary policy requires banks to hold more reserves at the central bank.

“We know [the size of the BoC balance sheet] will be well below our current level of roughly $200-billion. Our best estimate is somewhere in the range of $20-billion to $60-billion,” he said.

The Bank of Canada’s next interest-rate decision is on April 12. After eight consecutive increases, the bank paused its rate hikes earlier this month, leaving the overnight rate at 4.5 per cent. Mr. Gravelle said central-bank officials would be looking at the impact of the U.S. and European banking troubles on the Canadian economy as they prepare for the coming rate decision and update their quarterly economic forecasts.

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