What is the impact of the Bank of Canada’s balance sheet on the banking system?

Introduction

The COVID‑19 pandemic has caused severe stress in fixed income markets. In response, in April 2020, the Bank of Canada launched the Government of Canada (GC) Bond Purchase Program. Initially, the program focused on restoring the functioning of the Government of Canada bond market. In July 2020, this focus shifted to additional monetary stimulus through quantitative easing (QE).

As part of QE, the Bank purchased government bonds in exchange for settlement balances and as a result, its balance sheet expanded., Settlement balances (or reserves) are deposits that major Canadian banks hold at the Bank (Chu et al. 2022).

The Bank’s quantitative tightening (QT) program, which began in April 2022, is the reverse process. Through QT, the Bank allows its holdings of GC bonds to mature and ceases to reinvest the proceeds of principal and coupon repayments. Consequently, the Bank’s balance sheet will shrink over time.

In this note, we describe how QE and QT affect the Bank’s balance sheets and the Canadian banking system as a whole. We show that the direct effects on the size, composition, and liquidity of the banking system’s balance sheet during QE and QT depend on who sells (during QE) or buys (during QT) Government of Canada bonds in the financial system: banks or non-bank participants. (such as households, companies or investment funds). During the quarter, the effect will be greater if non-bank participants replace the Bank as the marginal buyer of Government of Canada bonds. This is the most likely scenario since, historically, non-bank participants have held a significant share of the Government of Canada bond market. In addition, during quantitative easing, the Bank primarily displaced these entities in terms of Government of Canada holdings.

This analysis focuses exclusively on the mechanical impacts of QE and QT. Other factors that can affect the size and composition of commercial bank balance sheets, including the natural growth of bank deposits, loan growth, and changes in the level of government bond issuance, are held constant.

The Bank’s footprint in the government bond market will shrink as quantitative tightening continues

The Bank held a total of approximately $430 billion in GC bonds before ending QE and entering the reinvestment phase in November 2021. During this period, the Bank maintained its holdings of GC bonds. GC roughly constant (graph 1). QT, launched in April 2022, began to reduce holdings of Government of Canada bonds on the Bank’s balance sheet by not replacing maturing Government of Canada bonds. Therefore, the size of the Bank’s balance sheet will decrease over time in a predictable manner.

About Ruben V. Albin

Check Also

COLUMBIA BANKING SYSTEM ANNOUNCES AGREEMENT TO SELL THREE BRANCHES IN NORTHERN CALIFORNIA TO FIRST NORTHERN BANK

Branches are divested to meet US Department of Justice (DOJ) requirements for Columbia Ongoing merger …