The Bank of Canada is ready to defend Canadian banks from a global financial meltdown if the current banking crisis in the U.S. and Europe spills into Canada, but the central bank does not think they will have to step in.
Speaking on Wednesday at the National Bank Financial Services Conference, Bank of Canada deputy governor Toni Gravelle declared that the bank was “ready to act in the event of severe market-wide stress and provide liquidity support to the financial system.”
He specifically referred to the near-collapse of the British pension system last September following disruptive tax cuts by then Prime Minister Liz Truss, and said the Bank of Canada would be better prepared for such a crisis, allowing it to offer liquidity not just to banks, but pension funds and others facing financial stress.
Learning from pandemic crash
Gravelle said the central bank had learned many lessons from the COVID-19 crisis and would do things more efficiently if a similar major crisis arose and markets stopped functioning.
In that light, the bank released a fresh discussion paper about how the Bank of Canada responded to “an unparalleled level of financial market disruption” when the pandemic virtually halted the entire Canadian economy.
After the fact, many critics complained that the bank had acted too forcefully, cutting interest rates and promising they would stay low, but analysis by central bankers around the world showed how close the economic system was to crumbling.
“Investors sought liquidity by selling financial assets and drawing down loans and credit lines,” says a summary of the new report.
“The speed, scale and one-way nature of these transactions caused an almost complete breakdown of market functioning.”
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As well as cutting interest rates, the central bank pumped money into the economy by buying not just Government of Canada bonds but other assets, pouring money into the economy to prevent a systemic financial breakdown.
Gravelle, one of the bank’s top specialists in managing market stability, what you might call the wonkier side of central banking, said that while the bank stands ready to pull out the stops and defend the financial system using its extraordinary tools, “the bar is very high” for the bank to do so.
Credit Suisse a ‘wake up call’
Gravelle said that while many at the Bank of Canada found the collapse of Silicon Valley Bank earlier this month worrying, “more importantly the Credit Suisse takeover by UBS was a bit more of a wake up call,” leading officials in his financial stability division to bush off their contingency plans.
In a post-speech question and answer session with National Bank’s leading economist Warren Lovely, Gravelle was quizzed on how seriously we should take the danger to Canada and its banks.
“You mentioned that you are monitoring the current situation closely, you’re ready to act if necessary, we’re not immune to spillovers,” said Lovely. “So can you give us some sense of how nervous are you right now?”
Its track record may mean not all Canadians will trust the assessment of the Bank of Canada, but Gravelle’s response was categorically reassuring.
“The Canadian banking sector is in a quite different place than the regional banks in the U.S.,” he said. “But just in terms of the current crisis, our current assessment, although we are keeping a close eye, we don’t feel anywhere close to concerned in terms of financial system stress.”
While media reports focus mostly on interest rates, central banking has a lot of moving parts and those who still think the Bank of Canada’s job is easy and they could do better would be wise to listen to Gravelle’s speech and discussion first.
Avoiding moral hazard
Gravelle also said that any buying of assets to protect financial institutions would be formulated to avoid moral hazard, “when investors or market players feel they can take unusual risks without bearing the consequences if things go wrong.”
“In other words, they come to expect that since the central bank stepped in once, it will step in again — at any sign of market stress, even a modest one,” he said.
To mitigate the effects of moral hazard, the central bank will limit its action to the most extreme cases, meaning that investors could suffer significant losses before the bank steps in. It will also make the bailed-out investors buy back the securities from the Bank of Canada as soon as the crisis is over.
