Bank of Canada

For the first fifty years of its existence as an independent county, Canada did not have a true central bank. Despite the sporadic calls for creating such an institution, most felt that the private bank system adequately met the young country’s needs. It was not until the Great Depression decimated the economy that plans were adopted for the creation of the Bank of Canada.

Bank of Canada History

Canada became an independent country with the signing of the British North America Act in 1867. While still a part of the British Commonwealth, Canada was now a self-governing, sovereign nation and no longer simply a British territory.

Several large banks were already well-established before the Confederation of Canada, and each bank was permitted to continue to issue its own currency just as had been done before confederation. Located in the most important centers of commerce including Halifax, Toronto, and Montreal, these banks developed a series of branches to provide banking services to the rural population outside the main urban areas.

This branch system met the basic needs of most people. Travel between towns was limited, and international travel and commerce for the majority of people was unheard of at this time. For most citizens it mattered little which private bank issued their currency so long as the bills could be used at the local stores. But as travel and transportation grew more common, and international trade became more important in the early part of the twentieth century, the need for a single, government-backed currency became more pressing.

Canada Gets a Central Bank

The Great Depression of the 1930s provided the impetus to revisit the question of a central bank once again. The harsh economic realities of the depression contrasted sharply with the “Roaring Twenties” where credit was easily obtainable and many people were heavily mortgaged in the markets. When the stock market crash of 1929 hit, most market investors saw their accounts wiped out overnight. In an effort to preserve as much capital as possible, the banks stopped lending money thus reducing the money supply to a mere trickle.

As loans defaulted and the value of the currency plummeted, many companies closed down and households could no longer afford anything but the very basics; and in many cases, even the basics were out of reach. Unemployment reached 30% with manufacturing and agriculture – two of the country’s main employers – being the hardest hit.^[1] Given these conditions, it wasn’t long before the commercial banks were blamed for contributing to – and even prolonging – the depression and demands for a central bank to manage monetary policy grew stronger.

With concerns over how the private banks were dealing with the economic depression increasing, Prime Minister R.B. Bennett created a Royal Commission in 1933 to study the feasibility of creating a central bank for Canada. The commission concluded that a central bank was the best approach for protecting the Canadian economy and Bennett’s government quickly drafted the legislation that would become the Bank of Canada Act.^[2]

The new legislation was approved and in March 1935, the Bank of Canada was officially launched as a privately-held corporation with shares sold to the general public. In 1938, the government amended the Bank of Canada Act to privatize the bank by converting it to a crown corporation.

Bank of Canada Mandate

The mandate for the Bank of Canada can be found in the preamble to the Bank of Canada Act that explains the need for a central bank to “regulate credit and currency in the best interests of the economic life of the nation, to control and protect the external value of the national monetary unit and to mitigate by its influence, fluctuations in the general level of production, trade, prices, and employment as far as possible within the scope of monetary action, and generally to promote the economic and financial welfare of Canada.”^[3]

This rather grand paragraph can be distilled down to these essential points that summarize the bank’s mandate:

• Regulate credit and currency
• Control and protect the external value of the national monetary unit
• Mitigate fluctuations in production levels, trade, prices, and employment

Bank of Canada Accountability and Governance

The Governor of the Bank of Canada is required to meet regularly with the Minister of Finance. These meetings serve to keep the Government apprised of economic conditions and to review the effectiveness with which the Bank is meeting the mandated inflation targets. This line of accountability is enshrined in the Bank of Canada Act.

If a disagreement arises where the Bank’s Governing Council and the Minister of Finance are at an impasse with regards to monetary policy, the Minister has the final word on the matter. Protocol requires the Minister to issue a written directive to the Governor specifying a change in the monetary policy, and the Bank’s Governing Council would have no choice but to accept these changes.^[4]

Should the Governor of the Bank of Canada receive a written directive in this manner, the likely scenario is that the Governor would immediately tender their resignation. This is only speculation however, as in the entire history of the Bank of Canada, the Minister of Finance has never delivered such a directive.^[5]

Administration and Operations

While Governor Mark Carney may be the public “face” of the Bank of Canada, there are several boards and committees responsible for the critical functions performed by the Bank. These functions range from determining and implementing monetary policy to providing market liquidity and funds management for Canada’s financial system.

Board of Directors

The Board of Directors consists of twelve industry experts from outside the Bank in addition to the Governor and the Senior Deputy Governor. The Deputy Finance Minister also sits on the Board but does not participate in voting matters.

Directors represent the various regions of Canada and have extensive industry and business experience. They provide valuable input on current economic conditions and draw upon their experience to assist the Governing Council in determining appropriate policy for the country.

Note that Directors with the Bank of Canada are not employed on a full-time basis and most Directors are still very active in their professions outside the Bank. Directors are appointed for three-year terms by the Minister of Finance and may be reappointed to additional terms.

The following table lists the Bank of Canada Directors and the regions they represent as of March 1, 2008:

Bank of Canada Governor

As the senior member of the Bank of Canada, the Governor is the Bank’s Chief Executive Officer and has full authority over the Bank’s operations. The Governor is appointed by the Minister of Finance for a seven-year term and cannot be removed by the Government.^[6] This policy was included in the original Bank of Canada Act to ensure that short-term political agendas could not override monetary policy intended for the overall well-being and stability of the Canadian economy.

In the fall of 2007, David Dodge announced that he will not seek a second term as Governor and will retire from the Bank of Canada when his term expires on January 31, 2008. His replacement – Mark Carney – was officially named by the Minister of Finance on October 4, 2007.

Governing Council

The Governing Council is responsible for all final decisions regarding monetary policy and the setting of the target for the overnight rate. The Governing Council also oversees the day-to-day management of the Bank.

Both the Governor and the Senior Deputy Governor are members of the Governing Council as are three Deputy Governors.

Executive Management Committee

The Executive Management Committee deals primarily with determining the long-term strategic direction for the Bank of Canada. Consisting of the Governor, Senior Deputy Governor and three Deputy Governors, the committee also includes representation from legal and technical departments including:

• Strategic Planning
• Risk Management
• Information Technology Services
• Corporate Services
• Financial Services

Bank of Canada Monetary Policy

The Bank of Canada relies on inflation control targets to assess the effectiveness of its monetary policy. By influencing short-term interest rates, the Bank of Canada seeks to provide the economic conditions that support sustainable economic growth.

Canada’s Floating Exchange Rate

Canada’s monetary policy is based on two fundamental components; a flexible exchange rate where the value of the dollar is determined in the forex market, and an inflation-control target. This means that the loonie is free from direct government intervention and is neither assigned a fixed-rate or pegged to another currency. Other than attempting to influence short-term interest rates – or the very rarely-used approach of buying and selling currency on the forex market – the Bank of Canada allows the dollar to fluctuate based on market demand.

Canada first adopted a floating exchange rate in 1950 and was the first major country to do so. In 1962, the country moved to a fixed-rate but in 1970, the dollar was allowed to float again. All told, the Canadian dollar has been allowed to float in all but eight years since 1950, giving Canada the most experience with a floating currency of any major economy.

In a speech delivered to the Chambre de Commerce du Montréal Métropolitain in 2000, Gordon Thiessen – the Governor of the Bank of Canada at the time – noted that for Canada, there were several advantages for a floating exchange rate.^[7] Those that have watched the Canadian dollar will no doubt recall that the dollar was valued in the mid to low $.60 USD range entering the new millennium. Even though there was a great deal of domestic pressure to increase the value of the dollar, the Bank of Canada did not waver from its floating exchange rate policy.

According to Thiessen, the falling rate of the Canadian dollar was in response to an economic shock triggered by the Asian financial crisis of 1997-1998. This reduced Canadian exports to countries affected by the crisis by over 30% and caused a rapid drop in the value of the loonie on the world markets. Compounding this was the U.S. economy which was in over-drive at the time, leading to an even greater gap between the U.S. and Canadian dollars.

However, the wider this gap grew, the more attractive Canadian goods became for U.S. buyers. In short order, Asian export losses were soon more than offset by gains in exports to the U.S. thereby “absorbing” some of the shock of the Asian crisis.^[8]

So let’s take a minute to review – the Canadian economy was struck a major blow when the Asian financial crisis drastically reduced exports to the region. Short-term pain was unavoidable as jobs relying on these sales to Asia evaporated and the dollar lost ground – particularly against the U.S. dollar – in the forex market. However, new export opportunities to the U.S. were realized based almost entirely on the fact that the weaker Canadian dollar made Canadian exports more competitive when compared to countries with stronger currencies. New money was soon flowing into Canada and jobs lost earlier were off-set by new positions thanks to increased trade with the U.S.

This is a classic example of how a floating exchange rate can absorb the shock of a major financial event. This is not to say that no one was adversely affected by the Asian crisis, but consider what could have happened if the Bank had not allowed the exchange rate to follow the market.

First off, the Bank would have raised interest rates to slow the downward pressure on the dollar. This would have reduced the money supply making credit more costly forcing some individuals and companies to postpone major expenditures. Job losses would be inevitable as employers struggled to reduce expenses and preserve operating capital. Thus, by propping up the loonie in this fashion, it is unlikely that the U.S. would have picked up the slack in exports as Canadian goods would not have been more competitive without a decrease in the value of the loonie against the U.S. dollar.

Now look at the present situation in late 2007 where the loonie has reversed course and has appreciated more than 30% against the U.S. dollar in less than a year. While this may be good news for those purchasing imported American goods, it has made for difficult times for Canadian exporters. Buyers in the United States – which accounts for roughly 85% of Canadian exports^[9] - effectively must now pay a third more due to the strength of the Canadian dollar than they did less than twelve months ago.

Unlike the situation in the late 90s however, the U.S. economy is not performing well as it is mired in its own financial crisis brought on by the subprime credit woes. Domestic pressure is once again calling for the Bank of Canada to intervene, but this time it is to decrease interest rates in a bid to weaken the dollar.

Canada’s Inflation Control Targets

Canada’s fiscal policy was changed in 1992 to adopt an inflation rate target as a means to evaluate the effectiveness of the Bank’s monetary policy. This is similar in approach to other central banks including the Bank of England and the U.S. Federal Reserve.

Inflation is a key indicator that economists watch closely as it provides insight into the overall health of an economy. Countries with inflation under one percent risk stagnation, while inflation exceeding three percent suggests that demand for goods and services may outpace the country’s ability to meet the growing demand. This results in a rapid increase in prices for high-demand goods and services.

Canada’s current inflation target is a range between one and three percent, with two percent being the ideal. Depending on the inflation results, the Bank of Canada can make adjustments to the monetary policy by influencing short-term interest rates through the overnight lending rate.

Overnight Lending Rate

Most of Canada’s major financial institutions are members of the Large Value Transfer System (LVTS). This is an electronic system whereby financial institutions conduct large transactions with each other. At the end of the day, accounts must be settled and some institutions will have excess funds, while others will need to borrow funds from the overnight market in order to settle. The overnight rate determines the interest at which Canada’s commercial banks are willing to lend funds on a one-day (i.e. overnight) basis.

The overnight rate is an important benchmark as any change in the overnight rate usually leads to changes in the commercial rates for loans and mortgages. Note that the bank of Canada does not set the overnight rate directly, but it can influence the overnight rate through its Operating Band overnight rate target.

Bank of Canada Operating Band

In 1994, the Bank of Canada introduced its Operating Band. The Operating Band is the Bank’s primary monetary tool and consists of a spread of one-half of one percent with three interest rates determined by an upper and lower boundary, as well as a mid-point.

The upper limit of the Operating Band is the bank rate – this is the rate at which the Bank of Canada will lend overnight funds to financial institutions. This means that if a financial institution requires funds to cover its LVTS transactions, it can borrow from the Bank of Canada at the bank rate, or it can borrow from other banks at the overnight rate.

The lower limit of the Operating Band is the interest rate that the Bank of Canada will pay financial institutions that deposit excess funds with the Bank. This is always one half of one percent less than the rate at which the Bank lends funds.

The mid-point of the Operating Band is the most important element of the Operating Band as this is the Bank of Canada’s target for the overnight rate. The target rate is always in the middle of the Operating Band. When the Bank of Canada changes this target rate, other rates are usually affected. It is this relationship that enables the Bank of Canada to influence short-term interest rates, which in turn, affect commercial lending rates.

Remember that the target for the overnight rate (that is, the rate that the Bank wants to see for the overnight rate) is always at the midpoint of the Operating Band and the band is always one-half of a percent wide. Therefore, if the current target for the overnight rate is at 5%, then the upper and lower limits of the band are 5.25% and 4.75% respectively. The upper limit is the rate which the Bank will lend money on the overnight market, while the lower limit is the rate the Bank will pay for deposits.

In this case, the Operating Band appears as follows:

If the Bank of Canada changes the target overnight rate, the entire Operating Band moves to reflect the change. Using the example above, a 25 point increase in the target overnight rate results in the following Operating Band:

Monetary Policy Deliberations

Starting in 2000, the Bank of Canada introduced a system whereby eight pre-determined dates are set each year for key policy announcements regarding overnight target rates. The announcement dates are always on a Tuesday and the meetings follow a carefully structured timetable of events leading up to the release of policy rate details. Several Bank of Canada departments are involved in preparing for each of the rate announcements and the tasks they complete are described below.

Staff Economic Projection

The Staff Economic Projection is the first statistical analysis report made available to the Governing Council. It takes into account the most recent data available on the Canadian economy and provides a recommendation for the overnight rate that will keep inflation growth on track to meet the two percent ideal of the inflation target range. The Staff Economic Projection report includes international economic factors, a look at current conditions of Canada’s economy, and an economic model based on all the information contained in the projection report.

International Development

The Bank’s International Department produces a report for the Governing Council that assesses global economic conditions. The state of global markets is an important consideration as Canada is a major exporter and the ability of foreign nations to continue buying Canadian goods must be factored in as part of any projection for future growth.

Near-Term Aspects for Canada’s Economy

This report provides a detailed analysis of the current conditions of the Canadian economy. This report takes into account the high-frequency indicators including car sales, housing starts, employment, manufacturer’s shipments, retail sales, and merchandise trade. Given the volatile nature of these indicators, the resulting data is also volatile and factors including severe weather and labor disruptions for example, can all impact the calculations. In essence, this report is treated as a “snap-shot” of the current conditions that can provide insight into the formation of possible trends.

The Economic Model

The purpose of the economic model is to input the data and projections obtained above, into a macroeconomic model of the Canadian economy. The model shows how changes in the key policy rate will affect the Canadian economy including the expected inflation rate. This provides a realistic case study of the economy and assists the Governing Council in determining an appropriate interest rate target.

Economic Projection Report Briefings

Armed with the Staff Economic Projection report and the most recent modeling results, the Governing Council then undergoes a series of briefings about one week prior to the key rate announcement date. The briefings are centered on four topics and are performed by four dedicated departments:

1. Risks and Alternatives

The Staff Projection report is just what its name implies – it is a projection of the future condition of the Canadian economy based on an assessment of current conditions. Like any work of this nature, there is a very real risk that the projections could be inaccurate based on anything from faulty analysis to a major, unexpected economic shock rendering the conclusions irrelevant. Therefore, the staff also prepare alternative policy scenarios for the Governing Council to consider.

2. Regional Survey and Forecast

In order to take into account the various regions of the country and to ensure a policy that reflects the diversity of the Canadian economy, regional representatives of the Bank conduct surveys four times a year. These surveys involve over one hundred different companies and gather information on company expansion plans and market data. This information is compiled into a single national forecast that incorporates all areas of the country.

3. Money and Credit

The economic model used in the staff projections shows the link between interest rates and expected changes in spending by households and firms should the interest rate change. The other aspect to be considered when determining future spending patterns is savings and credit expenditures. The Bank of Canada’s Department of Monetary and Financial Analysis monitors credit levels and reviews lending to firms and households to determine changes in the money supply brought about by a possible change in the interest rate.

4. Financial Market Expectations

The Financial Markets Department of the Bank of Canada assesses the “mood” of the markets with respect to what the market is expecting the Bank to do with interest rates. An expected change in interest rates causes much less upheaval than a change that is not expected.

By having a clear feel for what the market is expecting, the Bank can pinpoint issues that need to be addressed when interest rate decisions are communicated. The goal is to deliver a message with sound reasoning to reduce public anxiety over interest rates.

Final Briefing and Recommendations

This final session usually takes place on the Friday before the key policy rate announcement date. In this briefing, the Governing Council meets with the other members of the Monetary Policy Review Committee, the chiefs of the four departments providing briefing notes, and the directors of the financial divisions located in Montreal and Toronto.

Governing Council Deliberations

Based on the information provided in this final briefing, the Governing Council must then reach a consensus regarding the most likely future path for the economy as well as the underlying trend for inflation. They determine the risks regarding this outlook and begin deliberations on the appropriate level for the key policy rate taking into account the projections for the economy and all possible risks.

The Council reconvenes on the Monday morning and by the end of the day, will have decided on the course of action for the policy rate. The statement is prepared for release the following morning at 9:00 AM.

Follow-Up Communications

The Bank releases either the Monetary Policy Report or a Monetary Policy Report Update four times a year. This report provides additional insight into the Governing Council’s outlook for economic activity and inflation, as well as the risks that may make the outlook invalid. Anyone intending to trade Canadian dollars in the forex markets would be well advised to review these documents on the Bank of Canada website.

Blackout Guidelines

Prior to any of the eight scheduled key policy rate announcement dates, members of the Bank’s Governing Council must observe a communications “blackout”. This blackout – or no comment period – requires that all members of the Governing Council refrain from making comments or delivering speeches about the economic outlook in order to prevent any unnecessary speculation about monetary policy actions.

The blackout goes into effect on the Wednesday of the week preceding the interest rate announcement and ends once the announcement has been made official. There is also a similar blackout for the scheduled Monetary Policy announcements as well.

Canada’s Financial System

Canada’s financial system consists of a number of large banks (The so-called Big Five Banks, a series of smaller banks, credit unions, and other financial institutions. The Bank of Canada works with other federal and provincial agencies as well as commercial institutions to ensure the safety and efficiency of Canada’s financial system, but the Bank does not directly regulate the financial system. At the federal level, consumer and regulatory issues are handled primarily by the Office of the Superintendent of Financial Institutions.

Lender of Last Resort

To ensure liquidity for Canada’s financial system, the Bank of Canada provides funds to financial institutions through the overnight lending system. This is the most common way for the Bank to provide liquidity but there are other less common situations that may arise for which the Bank of Canada may act as a lender of last resort should a financial institution require direct assistance. For example:^[10]

1. The Bank of Canada provides operating credit to solvent financial institutions through the Emergency Lending Assistance (ELA) program. This initiative is intended to cover institutions that have significant liabilities in the form of deposits, but their assets are invested in securities that are difficult to liquidate and they are in danger of not meeting their liabilities. The ELA is essentially a bridge loan provided by the Bank of Canada that covers liabilities until the institution can convert the necessary assets to meet client commitments.

1. In the most extreme case, the Bank of Canada has the authority to provide liquidity by purchasing various securities issued by any Canadian or foreign institution.

Currency and Funds Management

The Bank of Canada has the exclusive responsibility for all facets of the design, production, and distribution of Canadian bank notes.^[11] As the only provider of bank notes, the Bank must be able to supply the country’s financial institutions with enough bank notes to satisfy the demand. Banks and other financial institutions receive the notes via the Bank Note Distribution System, which also collects and destroys old notes no longer fit for circulation.

Government Banker and Treasury Manager

The Receiver General of Canada collects most of the government’s revenue from corporate and individual taxes, and also oversees most of the country’s expenditures. It is the responsibility of the Bank of Canada to ensure that the operating accounts of the Receiver General have sufficient funds to meet daily cash requirements and to ensure that any surpluses are invested in term deposits.

Foreign Exchange Reserves

The government keeps foreign exchange reserves in order to buy and sell currencies on the open market. In some cases, the Bank may buy or sell Canadian dollars directly through the FX markets to help stabilize the dollar’s value in an attempt to address unusual and potentially disruptive movements in the dollar. Note that direct intervention in this manner is relatively rare but it is sometimes necessary to provide a more immediate effect on the dollar than can be accomplished with the longer-term strategy based on the setting of interest rates.

Debt Management

The Bank provides advice and expertise to the government with regards to the servicing and management of the national debt. Debt is mostly in the form of treasury bills and marketable bonds which the government sells at auction on the market. The Bank of Canada assists with the transactions and seeks to provide stable and low-cost funding to the government.

Retail Debt

Retail debt in Canada exists mostly as Canada Savings Bonds and other bond issues that the government sells through a network of sales agents and directly through government websites. The Bank is responsible for advising the government and for implementing and managing the operations and support service for the selling of the government bonds.

Related Links

Governor Mark Carney

Bank of Canada website

References

1. ↑ Encyclopedia of Saskatchewan - University of Regina
2. ↑ Bank of Canada website
3. ↑ Bank of Canada Act - Preamble
4. ↑ Bank of Canada Act - 1934
5. ↑ Bank of Canada Act - 1934
6. ↑ Bank of Canada Act - 1934
7. ↑ Speech to the Chambre de Commerce du Montréal Métropolitain by Bank of Canada Governor Gordon Thiessen, 2000
8. ↑ Speech to the Chambre de Commerce du Montréal Métropolitain by Bank of Canada Governor Gordon Thiessen, 2000
9. ↑ Canadian Manufacturers and Exporters website
10. ↑ Bank of Canada website
11. ↑ Bank of Canada website