The size of the Bank of Canada's balance sheet has significantly increased since the beginning of the COVID-19 pandemic, and ongoing and upcoming pressures will keep it oversized for the foreseeable future, according to a new C.D. Howe Institute report.
In The Consequences of the Bank of Canada's Ballooned Balance Sheet, authors Steve Ambler, Thorsten Koeppl and Jeremy M. Kronick examine the challenges of this enlarged balance sheet as well as the issues that will drive its size in the short-, medium- and long-term.
The Bank of Canada's balance sheet ballooned from just over $120 billion in early March 2020 to a peak of $575 billion in March 2021, largely a consequence of the Bank's quantitative easing (QE) program that saw it buy Government of Canada debt to provide further stimulus to the economy. On the liabilities side, settlement balances, the interest-bearing deposits belonging to Canadian financial institutions such as banks, increased by three orders of magnitude (from $250 million to approximately $260 billion), implying a massive excess supply of short-term liquidity for Canada's financial system.
When the Bank of Canada buys Government of Canada bonds from commercial banks, it adds them to the asset side of its balance sheet, paying for them by adding to the banks' deposits (settlement balances) on the liability side of its balance sheet. Amid rising interest rates, the variable interest it pays banks on those deposits exceeds the average of the fixed rate it earns on government bonds.
In the short run, the Bank's balance sheet will stay oversized because its quantitative tightening (QT) strategy to rein in high inflation involves simply letting maturing government debt roll off its balance sheet rather than actively selling it to the market, write Ambler, Koeppl and Kronick. Therefore, its balance sheet will only gradually decline and settlement balances will remain large in the future. "About $140 billion of debt will mature within the next two years with an additional amount of roughly $200 billion by 2030," says Ambler. "The bonds with the longest maturity will not mature until 2064, leaving roughly $70 billion on the balance sheet in the coming decades."
In the medium-term, the authors explain there are two fundamental changes likely to increase the Bank's balance sheet size: the new large-value payment system Lynx and the soon-to-launch real time rail (RTR) on the retail side; and the potential introduction of a central bank digital currency (CBDC).
"The main challenge for the Bank is to figure out what the appropriate size of its balance sheet will be in the medium run given the implications of holding a large share of Government of Canada debt," says Koeppl. This involves two main research questions: i) what will the demand for settlement balances be as a consequence of the introduction of Lynx and RTR? and ii) if a CBDC is introduced, how much will the net demand for the Bank's liabilities increase?
Long-term, the Bank of Canada has announced that for now it will not return to its traditional corridor system around the policy rate, but will instead continue to run a floor system to implement monetary policy. With excess settlement balances in their Bank of Canada accounts, financial institutions have little need to lend to each other over a business day, driving the overnight rate down to the Deposit Rate the Bank pays on settlement balances, which forms the floor.
The immediate benefit of this is that it gives the Bank of Canada an additional policy tool in the form of QE or QT, the authors explain. Additionally, it makes it easier to settle transactions in real-time – necessary with the introduction of Lynx and the RTR.
The key to moving forward will be to find ways to minimize the risks for the Bank of Canada of holding a large balance sheet, according to the authors. "First, holding a larger balance sheet means playing a more significant role in the market for Government of Canada debt and potentially affecting rates of return that influence other market interest rates," says Kronick. "Second, a hold-QT strategy invokes independence concerns if the reasons for its use are tied to the fact that selling bonds at a loss would increase expenses on the Government of Canada's statement of operations, which could trigger the need for more debt."
Ambler, Koeppl and Kronick argue the indemnity agreement signed by the Bank of Canada and the government in early 2020 protects the Bank from a negative equity position due to valuation losses on the bonds. It is not, however, applicable to the Bank's operational losses as a result of the sharp rise in the policy interest rate that by now means that the interest the Bank is paying on settlement balances exceeds the interest earned on the Government of Canada debt it owns. "These losses are likely to leave the Bank in a negative equity situation," says Kronick.
The authors recommend a change to the Bank of Canada Act to allow the Bank of Canada to create a deferred asset to cover operational losses and to help it credibly communicate its current QT strategy.
Steve Ambler is Professor of Economics, Université du Québec à Montréal. He is the David Dodge Chair in Monetary Policy at the C.D. Howe Institute.
Thorsten Koeppl is Professor, Robert McIntosh Fellow and RBC Fellow, Queen's University and also is a Fellow in Residence, C.D. Howe Institute.
Jeremy Kronick is Director, Monetary and Financial Services Research, C.D. Howe Institute.