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

3. 3 TheCrisis: Causes 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. 4  US real estate prices stop increasing TheCrisis: Causes The Crisis: 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. 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 TheCrisis: Impacts The Crisis: Impacts

6. 6 The Crisis: Impacts Globally, banks are affected

7. 7 Bankof Canada’s Actions Bank of 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. 8 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

9. 9 Traditional 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)

10. 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. 11 Bank of Canada’s Actions 200720082009 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 introduced  Term 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

12. 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. 13 Results Liquidity extension is relatively low in Canada

14. 14Results Bank funding costs have declined

15. 15 Results Bank of Canada’s balance sheet has changed

16. 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. 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. 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. 19 Appendix

20. 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, 2007October 14, 2008February 23, 2009November 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 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 Loan Terms 1, 3, 6 and 12 months 2 weeks1 and 3 months1 month

21. 21 Source: Bank of Canada *Cash value **Par Value Liquidity Provision

22. 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. 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