David Longworth: Bank of Canada liquidity facilities - past, present, and
future
Remarks by Mr David Longworth, Deputy Governor of the Bank of Canada, at the C D Howe
Institute, Toronto, 17 February 2010.
* * *
Introduction
Thank you for inviting me here today. It is a pleasure to be with you. This afternoon, I would
like to talk about liquidity and the role of the Bank of Canada. As was unmistakably brought
home by the global financial crisis, it is critically important that financial institutions recognize
and manage liquidity risk and, at the end of the day, it is essential that central banks respond
to systemic liquidity shortages. Central banks are in a unique position to do this. They can
create liquidity at virtually no cost. When they undertake liquidity support and are careful to
guard against credit risk - as the Bank of Canada is - they do not impose any cost on the
taxpayer. Furthermore, liquidity support does not imply inflationary monetary policy. This is
because central bank balance sheets can be adjusted in ways that can lead to policy interest
rates being maintained at appropriate levels and that do not lead to other sources of
inflationary pressure.
In my remarks today, I will review how the Bank of Canada's liquidity measures,1 including
new measures introduced during the crisis, were guided by principles. I will discuss how
these principles will continue to help us as we wind down our extraordinary liquidity facilities.
Elaborating on one of those principles, I will endeavour to address how the provision of
liquidity by the central bank can be done to minimize moral hazard, that is, the potential that
actions of policy-makers provide an incentive to market players to take greater risks than
they otherwise would. Finally, I will discuss what this may mean for the design and use of our
facilities going forward.
I am sure no one has forgotten that day in September 2008, when Lehman Brothers went
bankrupt, nor the messy aftermath that ensued in the days following. What was striking was
the unprecedented spike in the cost of interbank borrowing, which then spread to other
markets. Financial institutions around the world became unwilling to lend to each other,
worsening an already difficult situation. Key intermediaries began to hoard liquid assets;
some went so far as to put a stop, temporarily, to their market-making activities. At several
points, interbank lending and other short-term funding markets, including for banks, ceased
to exist for terms greater than overnight, thus making it clear that this was a shock of
systemic importance.
In response, central banks and governments around the world took unprecedented action to
stabilize the financial system and reduce the severity of the ensuing global recession. The
Bank of Canada intervened repeatedly to provide liquidity to financial market participants to
mitigate the risks of serious financial disturbances.
Going into the crisis, banks, globally, were highly leveraged2 and had overestimated the
ability of markets to provide liquidity in times of stress. They relied heavily on sources of
funding, such as securitization, that disappeared as the crisis gained momentum. At the
same time, their funding requirements were growing, because they were forced to take more
assets back onto their balance sheets and because they had to meet a surge in demand for
credit from those with bank credit lines who had previously relied on market sources of
funding.
It is important to note that the decline in the liquidity of bank funding markets and the decline
in the liquidity of asset markets in general are not unrelated. As was vividly demonstrated
during the crisis, liquidity in asset markets is tightly intertwined with the ability of financial
institutions to raise funds in money markets. Impairment in one market increased the
likelihood of impairment in others. Indeed, market liquidity and funding liquidity of banks with
trading operations are mutually reinforcing, creating the possibility of a "liquidity spiral" in a
downward or upward direction.3
Central bank liquidity measures: pre-crisis
Prior to the crisis, the tools used by the Bank to provide liquidity to the financial system as a
whole were measures designed primarily to reinforce our target for the overnight interest
rate.4 These tools were - and still are - part of the Bank of Canada's standard operating
framework for the implementation of monetary policy. The main facility we use is the
provision of settlement balances in the wholesale payments system - the Large Value
Transfer System (LVTS) - which is supplemented, when required, by open market special
purchase and resale agreements (SPRAs) and sale and repurchase agreements (SRAs).5
There are two facilities that can provide liquidity to individual financial institutions.6 First - and
also intimately linked to the implementation of monetary policy, the achievement of the
overnight rate target, and the settlement of the payments system - is our Standing Liquidity
Facility at the Bank Rate. It provides liquidity, as required, to individual LVTS participants
facing shortfalls in their end-of-day settlement balances.7 Second, our Emergency Lending
Assistance, which has rarely been put to use, provides extraordinary liquidity support to
solvent institutions that are facing serious and persistent liquidity problems.
2
The leverage of the Canadian banks was capped by the existence of the asset-to-capital multiple set by the
Office of the Superintendent of Financial Institutions. See A. Crawford, C. Graham, and É. Bordeleau,
"Regulatory Constraints on Leverage: The Canadian Experience," Bank of Canada Financial System Review
(June 2009): 45-50.
3
See M. K. Brunnermeier and L. H. Pedersen, "Market Liquidity and Funding Liquidity," Review of Financial
Studies, 22, No. 6 (June 2009): 2201-38; and Markus K. Brunnermeier, "Deciphering the Liquidity and Credit
Crunch 2007-2008," Journal of Economic Perspectives, 23, No. 1 (Winter 2009): 77-100.
4
The overnight rate is the key means for achieving the Bank's monetary policy objectives and the anchor of the
yield curve.
5
Often referred to as a "repo," or repurchase agreement, a PRA is a transaction in which the Bank of Canada
offers to purchase Government of Canada securities from designated counterparties with an agreement to
resell them at a predetermined price the next business day. Special PRAs (SPRAs) are transactions initiated
by the Bank and are used to reinforce the target rate if overnight funds are generally trading above the target;
these instruments add liquidity to the system. Alternatively, sale and repurchase agreements (SRAs) are used
when overnight funds are generally trading below the target rate; these remove liquidity from the system.
6
See Bank of Canada, 2004, "Bank of Canada Lender-of-Last-Resort Policies," Bank of Canada Financial
System Review (December): 49-55, and F. Daniel, W. Engert, and D. Maclean, 2004-2005, "The Bank of
Canada as Lender of Last Resort." Bank of Canada Review (Winter): 3-16.
7
When LVTS participants are in deficit at the end of the day, and therefore need to access the Standing
Liquidity Facility, aggregate participant deposits at the Bank of Canada will exceed the target for net
settlement balances.
BIS Review 17/2010
This simple set of facilities has long served the Bank and the financial system well and
continues to do so.
Liquidity and monetary policy
In normal times, including just prior to the crisis, the focus of the Bank's liquidity measures
was on supporting our monetary policy stance. Liquidity actions were designed and intended
to affect aggregate levels of liquidity (often just intraday) to achieve our overnight rate target,
rather than the distribution of liquidity within the system. This is because a well-functioning
financial system normally allocates liquidity efficiently, which is critical to a central bank since
it supports the effective transmission of monetary policy.
The crisis did not divert the Bank's focus from monetary policy. Just as before the crisis
began, the Bank reinforced its target overnight rate during the crisis through the intraday use
of SPRAs and SRAs, and, at the end of the day, the setting of the target for next-day
settlement balances. Early in the crisis,8 these policy tools were used aggressively.
Five principles to guide extraordinary liquidity intervention
As global financial markets became more turbulent in the summer of 2007, central banks
around the world realized that unusual measures might be necessary to provide liquidity to
support financial stability. The Bank of Canada developed and then published in the spring of
2008 a set of five principles to guide its liquidity interventions. These principles were used to
shape the design and application of our extraordinary liquidity facilities.9 Allow me to
elaborate on these five principles.
i. First, intervention should be targeted, aimed at mitigating only those market failures
of system-wide importance with macroeconomic consequence that can be rectified
by a central bank providing liquidity.
ii. Second, intervention should be graduated, or commensurate with the severity of
the problem.
iii. Third, intervention should be well designed, using the right tools for the job:
marketbased transactions, provided through auction mechanisms, should be used to deal
with market-wide liquidity problems, while loans should be used to address liquidity
shortages affecting specific institutions.
iv. Fourth, intervention should be at market-determined prices to minimize distortions
and under conditions aligned with those in the market, to limit the possibility that the
central bank will crowd out the return of markets.
v. Fifth, and finally, the Bank should mitigate the moral hazard of its intervention.
Such measures include limited, selective intervention; the promotion of the sound
supervision of liquidity-risk management; and the use of penalty rates as
appropriate.
Liquidity measures to address the financial market turmoil
Guided by these then newly developed principles, the Bank gradually expanded its liquidity
framework in four dimensions: terms to maturity, amounts, counterparties, and eligible
11
securities.10,
The first trigger came in the latter part of 2007 when liquidity in credit markets shrank around
the world, including in Canada, with credit spreads rising dramatically on a broad range of
assets. As the normal generation of liquidity among system participants broke down, there
were implications for the broader financial system. To address these heightened pressures,
the Bank of Canada conducted term purchase and resale agreements (PRAs) in December
2007 with primary dealers against an expanded set of eligible securities, with maturities
extending past the end of the year. This marked the first time that liquidity operations
extending beyond one business day were offered in support of funding liquidity.12 Consistent
with what would become our first principle, the Bank did not intervene until it became clear
that liquidity distortions were taking on system-wide importance. With this measure, the Bank
of Canada expanded its role to provide funding liquidity directly to major market participants
to stabilize the financial system and to limit spillover effects to the broader economy.
In March 2008, in response to the pressures surrounding Bear Stearns, term PRAs were
reintroduced, this time on a biweekly basis. In addition, the Bank expanded the set of assets
acceptable as collateral to secure intraday exposures in the LVTS and, correspondingly, for
loans provided under the Standing Liquidity Facility. We allowed certain types of
assetbacked commercial paper (ABCP)13 to substitute for other, more-liquid collateral pledged in
the LVTS, which, in turn, could be used more easily by financial institutions to obtain
marketbased funding. Later, in June of that year, to provide flexibility, we also allowed U.S.
Treasury securities. These steps illustrated the second and third principles - that intervention
should be commensurate with the severity of the problem and that it should use the
appropriate tools for the job.
As the spring progressed in 2008, funding conditions in Canadian money markets had
improved relative to those in other countries. So, guided by the principle that intervention
should be commensurate with the problem, the Bank announced on July 10th that it would
not renew maturing term PRAs.
In the autumn of 2008, as you all know well, severe financial market pressures suddenly
reemerged, sparked by a series of failures and near-failures of financial institutions in the
United States and Europe. Lehman Brothers was not the only one, although it was the most
significant failure. As I described a moment ago, the ability of both financial and non-financial
borrowers to obtain market-based financing was seriously impaired. The deterioration in
Canadian financial markets was much less severe than elsewhere, although liquidity was
limited at all maturities, and trading volumes were thin.
10
For a more detailed discussion, see L. Zorn, C. Wilkins, and W. Engert, "Bank of Canada Liquidity Actions in
Response to the Financial Market Turmoil," Bank of Canada Bank of Canada Review (Autumn 2009).
11
The complementary liquidity facilities provided by the Government of Canada, such as the Insured Mortgage
Purchase Program, were also important in addressing the financial market turmoil in Canada.
12
Prior to December 2007, term PRAs had been conducted only on an occasional basis to manage the Bank's
balance sheet and address seasonal fluctuations in the demand for bank notes. In addition, the December
1999 operations provided stable funding for the primary dealers over the "Y2K" period, given the uncertainty
surrounding the ability of software to properly take into account the change to the year 2000.
13
There are strict eligibility requirements for ABCP securities, such that only those securities with minimal credit
and liquidity risk are accepted. See:
http://www.bankofcanada.ca/en/notices_fmd/2009/securities_collateral060309.pdf.
BIS Review 17/2010
The Bank's term PRA facilities were resumed, under the existing terms and conditions.14
Within a few weeks, the Bank aggressively expanded its provision of liquidity, commensurate
with the increasing severity of the crisis. The frequency of term PRAs was increased to
weekly from biweekly; eligible counterparties were expanded to include LVTS participants in
addition to primary dealers; and a 3-month term PRA maturity was added. The Bank also
temporarily broadened the list of securities eligible as assets in term PRA transactions to
include own-issued ABCP.
As the crisis deepened through the rest of the autumn of 2008, new measures were
introduced. In October, the Bank temporarily broadened the list of assets accepted as
collateral to include the Canadian-dollar non-mortgage loan portfolios of LVTS direct
participants.15 These assets were eligible to secure intraday exposures in the LVTS and,
correspondingly, to secure loans under the Standing Liquidity Facility. Also in October,
because the traditional liquidity transmission mechanism was not operating, and thus to
address liquidity shortages beyond our traditional counterparties, we introduced a new term
PRA facility aimed directly at large participants in the money markets. In designing and
implementing these tools, the Bank was guided in particular by the third principle, which
recommends using the right tool for the job.
In November, we introduced a term loan facility at a penalty rate for direct participants in the
LVTS, secured by their Canadian-dollar non-mortgage loan portfolios. Because this auction
facility accepted these largely non-marketable, illiquid assets as collateral, participants in the
LVTS were able to use their marketable, liquid collateral elsewhere. This loan facility was
used to make liquidity available to individual financial institutions that may have had
difficulties managing their balance sheets but whose problems were not serious enough to
warrant Emergency Lending Assistance.
Later, in February 2009, the term PRA for money market instruments was broadened to
provide liquidity to participants in Canadian private sector bond markets as well.
Correspondingly, the list of securities accepted as collateral was broadened to include
investment-grade corporate bonds.
In designing the term loan facility and the term PRA for private sector instruments, the Bank
was guided by the fourth principle, which recommends minimizing market distortions. The
facilities use an auction mechanism to allocate liquidity so that the price of liquidity is
determined competitively by participants, rather than by the Bank. Both the term PRA facility
for private sector instruments and the term loan facility were designed as backstop facilities
with appropriate minimum bid rates, which provided the Bank with a natural means to exit
from them when market sources of liquidity became a more cost-effective alternative for
potential participants. In addition, the facilities were designed to preserve the existing market
structures. Finally, intervention was aimed at mitigating liquidity risk that, in the Bank's
judgment, was not in line with fundamentals; it did not attempt to alter credit risk.
The fifth principle, that we mitigate the moral hazard of our interventions, served and
continues to serve as a guide at all levels of our liquidity program. The Bank of Canada took
several precautions to mitigate the creation of perverse incentives that could adversely
influence market behaviour. As I noted earlier, the Bank intervened only in response to
specific, extraordinary episodes of heightened liquidity pressures. Moreover, the liquidity
facilities were introduced as temporary measures in order to reduce the incentives for
participants to change their behaviour. The Bank has been working closely with the federal
Department of Finance, the Office of the Superintendent of Financial Institutions (OSFI), and
other domestic bodies to monitor the liquidity conditions of markets and financial institutions,
as well as the liquidity risk management of major financial institutions. In addition, the Bank
monitors the results of each liquidity operation. Finally, where applicable, the pricing of new
facilities was constructed to preserve incentives to transact in private sector markets.
Liquidity facilities: the present
By the spring of last year, as financial market conditions continued to improve, participation
in our liquidity operations diminished, indicating that the need for the Bank's support would
likely be declining. Indeed, the amount of liquidity support had peaked at $41 billion in
December 2008. (It is currently some $23 billion.)
It is important to note that at its April 2009 fixed announcement date, the Bank announced
that it would introduce 6-month and 12-month PRAs with a minimum bid rate of 25 basis
points and a maximum bid rate of 50 basis points to reinforce its conditional commitment to
maintain its target for the overnight rate at the effective lower bound of 1/4 per cent until the
end of June 2010. This was a new use for its term PRA facility.
At the end of June, prospective sunset dates for all of the Bank's extraordinary liquidity
operations were announced. It is important to note that just as they served to guide the
creation of our extraordinary liquidity facilities, the set of five principles was used to guide the
winding down of these facilities, particularly principles (ii) and (iii), that interventions be
commensurate with the severity of the problem and that the right tool be provided for the job.
At the end of July, the Bank lowered its pre-announced minimum amounts for the regular
term PRA auctions as well as for the term PRA for private sector instruments and the term
loan facility. At the end of October, the term loan facility and the term PRA facility for private
sector instruments were terminated. The frequency of regular term PRA auctions was
reduced from weekly to biweekly and, subsequently, to monthly. At the beginning of this
month, we began to reduce the eligibility of non-mortgage loans as collateral for the Standing
Liquidity Facility from 100 per cent to 20 per cent.16
The financial crisis has subsided, and financial conditions have improved significantly over
the past ten months, both globally and in Canada. Through the crisis, the Bank's regular term
PRA facility was used heavily and appears to have contributed to reduced market stress and
a return to well-functioning money markets. In contrast, there was relatively little demand or
need for funding from the term PRA facility for money market instruments, the term PRA
facility for private sector instruments, and the term loan facility, which were all designed as
backstops. That said, the presence of these facilities - including the latter two until the end of
October 2009 - helped to mitigate uncertainty among market participants about the
availability of liquidity.
Future: dealing with moral hazard and the provision of liquidity
I would now like to return to the issue of moral hazard. Recall that our fifth principle is the
mitigation of the moral hazard associated with our interventions. Having gone through a
financial crisis, we can be even more clear on how to do this. How can we minimize the
potential that our actions provide incentives to market players to take increased risks?
There are three basic things a central bank can do to mitigate the moral hazard associated
with its crisis interventions: (i) limit crisis intervention to significant systemic events, as we
have done; (ii) encourage infrastructure development and regulatory reform that make the
financial system more resilient to systemic shocks, thereby reducing the frequency and
repetition of patterns leading to systemic events; and (iii) maintain a flexible intervention
strategy that can deal with specific types of systemic problems as they evolve. This flexibility,
which acknowledges the inherent uncertainty surrounding the timing and magnitude of
systemic crises, means that individual system participants will not know in advance how to
transfer risk to the central bank at artificially low prices.17 The use of auctions to price and
distribute liquidity can be helpful in this regard.
I'd like to expand on the second element, making the financial system more resilient to
shocks. To reduce the probability of a crisis, there are actions that can be taken by the
central bank and by the prudential supervisor. The actions that the Bank of Canada has
taken or is taking include:

Encouraging and overseeing the implementation of liquidity-generating
infrastructure, such as a central counterparty for repo trades, that help market
participants self-insure against idiosyncratic
shocks;18.

Maintaining standing facilities - our Standing Liquidity Facility and Emergency
Lending Assistance - with either penalty rates or with stigma even in non-crisis
times, which allow key institutions to determine when to approach the Bank as the
lender of last resort for funds.19 This could stop large idiosyncratic shocks from
cascading into systemic events;20, 21, and,

Monitoring financial institution liquidity against tighter criteria (together with OSFI).
On the part of prudential supervisors, the following are actions that are under way or have
been proposed and that can also help make the financial system more resilient and thus
mitigate moral hazard:

Establishing standards that encourage financial institutions to maintain sufficient
liquidity to deal with the idiosyncratic or small systemic shocks they can expect to
face and to have policies for sound liquidity management practices in place;22
17
This is consistent with the advice developed in 2008, except for the element of co-insurance, which was
considered to be a possible measure in the first iteration of the principles guiding the Bank's extraordinary
liquidity interventions. The concept of co-insurance has been replaced by the idea that financial institutions
self-insure against idiosyncratic shocks and that the central bank provides insurance only for systemic liquidity
shocks. This change should be more effective in limiting moral hazard because it focuses more on containing
the cause of moral hazard.
18
Other examples include standardized transparent securitization and through-the-cycle margining.
19
The Standing Liquidity Facility has a penalty rate (Bank Rate) and the Emergency Lending Assistance has
stigma.
20
Allowing key institutions to determine when to borrow from the central bank would reduce information
collection and monitoring costs for the central bank, while the penalty rate and stigma would control the moral
hazard associated with inappropriate use of the facility.
21
The terms and conditions of the Bank's collateral policy, including the size of haircuts, can also help to contain
moral hazard.
22
The Basel Committee on Banking Supervision's press release of 17 December 2009 entitled, "Consultative
proposals to strengthen the resilience of the banking sector announced by the Basel Committee" covers the
introduction of "a global minimum liquidity standard for internationally active banks." See also C. A. Northcott
and M. Zelmer, "Liquidity Standards in a Macroprudential Context," Bank of Canada Financial System Review
(December 2009): 35-40; and "International framework for liquidity risk measurement, standards and
monitoring," a consultative document issued by the Bank for International Settlements, December 2009.
BIS Review 17/2010

Strengthening capital regulations to ensure that risk is appropriately mitigated
without imposing an excess regulatory burden on financial institutions or generating
additional moral hazard from "not allowed to fail" policies;23

Ensuring that there are meaningful consequences to financial institution
stakeholders who have responsibility for mitigating risk when mitigation strategies
fail by, among other things, having a clear and transparent resolution mechanism
25
and "living wills," which can allow institutions to fail or to be quickly restructured;24,
and,

Requiring the use of contingent capital or convertible capital instruments, perhaps in
the form of a specific type of subordinated debt, to help ensure loss absorbency and
thus reduce the likelihood of failure of a systemically important institution.26
These are also the building blocks that can be used to reduce the probability of a crisis. The
goal is to reach a destination where financial institutions, markets, and infrastructure play
critical - and complementary - roles to support long-term economic prosperity.
As we move forward, it is important that financial system participants do not believe that our
intervention in times of crisis implies a willingness to intervene in normal times. It is also
important that we retain considerable flexibility about when and how to intervene in the next
crisis to fulfill our mandate to be liquidity lender of last resort to the financial system in the
event of a systemic shock.
For the Bank, the primary facilities used during the crisis, the term PRA and the term loan
facility, should continue to be a part of the Bank's toolkit, as is our Emergency Lending
Assistance. In a crisis with a shortage of good quality collateral, the Bank would also
consider a term securities lending facility to exchange good collateral for lower quality
collateral - at the appropriate price - in order to support the functioning of core funding
markets. Given potential changes to core market infrastructure (the implementation of central
counterparties, for example), further study will also be important to determine the appropriate
tools to address future liquidity issues.
23
The Basel Committee on Banking Supervision press release of 17 December 2009 covers "raising the quality,
consistency and transparency of the capital base" and "strengthening the risk coverage of the capital
framework."
24
The Financial Stability Board (FSB) is working on "a package of measures to address the "too big to fail"
problems associated with systemically important financial institutions," which includes "improving the capacity
to undertake an orderly resolution of a failing firm," including one that operates cross-border. See the FSB
press release of 9 January 2010 entitled, "Financial Stability Board meets on the financial reform agenda."
25
Canada has clear and transparent resolution mechanisms for federally regulated, deposit-taking financial
institutions, which are periodically reviewed and enhanced as needed. For example, the Canada Deposit
Insurance Corporation (CDIC) has long had powers to restructure and resolve troubled deposit-taking
institutions, and in 1996 federal legislation was amended to give the Superintendent of Financial Institutions
the authority to temporarily take control of an institution, and if necessary, request a winding-up order, subject
to certain prescribed conditions and approval of the Minister of Finance. More recently, CDIC was granted the
authority in 2008 to establish bridge banks to facilitate the restructuring of federally-regulated deposit-taking
institutions.
26
The BCBS press release of 11 January 2010 entitled, "Group of Central Bank Governors and Heads of
Supervision reinforces Basel Committee reform package," announces that the "Basel Committee is reviewing
the role that contingent capital and convertible capital instruments could play in the regulatory capital
framework." See also "Considerations along the Path to Financial Regulatory Reform," remarks by
Superintendent Julie Dickson, Office of the Superintendent of Financial Institutions, 28 October 2009.
BIS Review 17/2010
Conclusion
To conclude, the principles developed as the crisis began have served the Bank and, more
importantly, the financial system well. Throughout the crisis, the Bank has been innovative
and nimble.27 In this period of winding down our temporary facilities, we are acting
deliberately and thoughtfully, for example, by providing advance notice and by only gradually
reducing both the amounts and frequencies of the auctions. We will continue to act in this
manner as we move to reinforce the stability and resilience of the financial system - and,
both in the near and longer term, we will continue to employ these principles to guide our
actions.