By Steve Ambler, Thorsten Koeppl and Jeremy Kronick
The Bank of Canada’s ballooning balance sheet has received lots of attention lately. From $120 billion in early March 2020 it grew over the next 12 months to $575 billion and it still stands at $414 billion today, more than three times what it was. That happened because in response to the pandemic the Bank purchased Government of Canada bonds from commercial banks. It added the bonds to the asset side of its balance sheet and paid for them by boosting “settlement balances” — basically, the commercial banks’ bank accounts with it — on the liability side. Voilà, a ballooned balance sheet.
Three factors suggest the Bank’s larger balance sheet may be with us for a while.
First, although in response to surging inflation it has aggressively raised its policy rate, it is not selling the bonds it purchased. Instead, it is letting them roll off its balance sheet as they mature.
Second, Canada is modernizing its systems for clearing both retail payments (those from you to a business) and wholesale payments (those between large financial institutions). Transactions will now settle in real time, which means financial institutions will want to hold larger settlement balances at the Bank to facilitate these payments — which in turn means a larger Bank balance sheet.
Third, there may be a Bank of Canada digital currency in our future. If people hold more of it than they do cash today — for example, because they no longer need an ATM — the Bank’s liabilities will increase. The result? A larger Bank balance sheet.
With these factors suggesting the Bank will continue to hold more assets, primarily in the form of federal government debt, does that mean inflation will stay high? No, the Bank’s main policy instrument is the target for the overnight interest rate. If it manages that appropriately, its balance sheet is a secondary concern.
Is it a problem that the Bank will hold more government debt? The Bank is a large player in the government bond market so if it buys more, that will affect bond prices and therefore yields, which in turn will affect yields on all other debt. But the Bank can ease this concern through repurchase agreements, in which it sells government bonds while agreeing to buy them back later at a pre-agreed price, thereby shrinking settlement balances accordingly.
Does holding more debt create greater interest rate risk for the Bank of Canada? Yes, certainly. When the Bank buys bonds it locks in the prevailing interest rate and therefore what those bonds pay it until they mature. But on the settlement balances it uses to purchase the bonds it pays the “deposit rate,” which is variable. When the interest on the bonds the Bank of Canada holds is less than the interest it pays on the settlement balances, as it is today, the Bank loses money.
To cover its losses, the Bank can draw down its reserve funds and equity — even allowing equity to go negative. Because the Bank is a crown corporation, a negative equity position will not directly impede its ability to conduct monetary policy. However, the public may not see it that way. They may perceive the Bank as being under pressure from government to set interest rates lower — and hence pay less on settlement balances — than may be necessary to achieve the inflation target. This could reduce the Bank’s credibility when deciding monetary policy.
In our view, the way to solve this problem is to enter the Bank’s losses as a deferred asset on its balance sheet and a deferred liability on the government’s balance sheet. That means no negative equity for the Bank — though it also needs to be clear the Bank must eliminate its deferred asset position before again remitting profits to the government.
This solution would mean amending the Bank of Canada Act, which currently requires the Bank to split any profits between replenishing its reserves and remitting funds to the government. But what we propose would be transparent, would make it easier to convince the public and would better safeguard the Bank’s independence.
The Bank of Canada’s balance sheet is likely to stay large. Though not an operational problem, it does carry the risk of government intervention and interference with the Bank’s independence. A small change in law would go a long way to reducing this concern.
Steve Ambler is an economist at l’Université du Québec à Montréal, Thorsten Koeppl an economist at Queen’s University and Jeremy Kronick director of monetary and financial services research at the C. D. Howe Institute, which has just published their paper: “The Consequences of the Bank of Canada’s Ballooned Balance Sheet.”