The Consequences of the Bank of Canada's Ballooned Balance Sheet

The Bank of Canada’s balance sheet has undergone a radical transformation since the beginning of the pandemic. The Bank’s total assets more than quadrupled at their peak and still remain 3.5 times higher. The most radical change on the liabilities side has been the increase in settlement balances held by financial institutions at the Bank as part of its large-value payment system. The reason: more bonds on the Bank’s balance sheet have been matched with increases to the settlement balances of the banks who sold them.In this Commentary, we explore the consequences for the Bank of Canada of an enlarged balance sheet. Structural changes such as the introduction of new payments systems and new means of payments – Lynx, the new large-value system, the real time rail (RTR) on the retail side, and the possible introduction of a central bank digital currency – all have the potential to increase the demand for the use of settlement balances. Further, the Bank’s decision to hold its large holdings of federal debt, accumulated through asset purchases, until they mature will perpetuate excess settlement balances for the foreseeable future.As a consequence, the Bank of Canada announced that it will not return for now to its traditional corridor system around the policy rate, or target overnight 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 in the course of business each day, driving the overnight rate down to the Deposit Rate the Bank pays on settlement balances, which forms the floor.The upside of an elevated balance sheet is that it will facilitate real time settlement under the modernized payment systems since financial institutions have ample liquidity. The downside is that the Bank of Canada will necessarily hold a larger share of Government of Canada bonds on the asset side of its balance sheet. While the Bank can employ repos and security lending to limit its impact on market functioning, by following its current strategy of quantitative tightening while also holding bonds to maturity and acting as a large holder of Government of Canada debt, it will still affect equilibrium interest rates in the economy.This may raise concerns about the independence of the Bank of Canada from the government. We argue that the indemnity agreement signed by the Bank and 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 position.Such a scenario could undermine the independence of the Bank of Canada in the eyes of the public. We therefore suggest amending the Bank of Canada Act in order to allow the Bank of Canada to create a deferred asset to cover the operational losses. That way the Bank formally has no negative equity arising from operational losses and must use future profits to pay down the entire deferred asset before remitting profits to the government, thereby compensating for current losses. This will enable the Bank to credibly communicate its current strategy of quantitative tightening, in particular making clear that it is in line with its aggressive tightening of the overnight rate to achieve the 2 percent inflation target in the near future