Red Square
MONEY CREATION IN A BANKING SYSTEM WITH A SINGLE MONOPOLY BANK
The process of money creation is perhaps the most intriguing aspect of the economic system. It
has given rise to the most extraordinary and extravagant theories. Beyond economists, it has
attracted the attention of all sorts of people, from majors in the army to Chemistry Nobel
Laureates. Still, the process of money creation, as well as the process of money destruction, are
highly simple and can be easily understood by all. Money creation, or rather bank deposit
creation as we will analyse it here, is no alchemy. It relies mainly on three features of the banking
system: the willingness of banks to grant loans, the creditworthiness of borrowers, and the
willingness of borrowers to take on loans.
Yellow Square
The Main Money Creation Channel
To understand how money deposits are being created, it is best to start by imagining that the
banking system is made up of a single bank, that has a total monopoly on the provision of loans
and deposits in the economy, a system that 1982 Nobel Price Laureate John Hicks (1904-1989)
called a monocentric banking system. All financial transactions have to transit through this single
bank. Every economic agent has an account at this bank. Some agents have a negative account, in
which case they have outstanding loans at the bank; other agents have a positive account, in
which case they have deposits at the bank. How do new bank deposits get created? There are
basically two ways in which deposits get created. Let us start with the most obvious one.
Suppose that some individual wishes to purchase some goods or services, but without
having the funds to do so. It may be a student who desires to purchase a new car, or an
entrepreneur who is keen to hire new workers and increase production, having just received
additional orders for his or her product. To go forward with their project, both the student and the
entrepreneur have to borrow from the bank. They have to ask for a bank loan. Will the loan be
granted? The answer is yes, as long as the borrowers are creditworthy – they are worthy of credit.
The word credit comes from the Latin word credere, which means to believe or to trust.
Trustworthy people or organizations can get bank credit.
How can the borrowers demonstrate their creditworthiness? They may show that their
past credit record is impeccable, that they have paid the interest due on their previous loans, and
that they have reimbursed past loans. They may indicate that their current income is high
compared to the interest payments involved with the loan that they are asking for (such ratios are
now generated automatically by bank computer programs, which either flag the customer or tell
the loan officer how much can be lent, and at what rate). They may show proof that the goods
that they are about to produce have already been ordered by some other firm, and promised to be
paid for. They may provide some guarantee – collateral – that the bank can seize in the unlikely
case that they will be unable to pay interest and pay back the amounts due. In the case of a loan to
purchase a house – a mortgage loan – the collateral is the house being purchased. In the case of a
car loan, the collateral is likely to be the car itself. Sometimes the collateral can be financial
assets – stocks, corporate bonds, government securities. If all of this is not enough, someone else
may back the loan, the mother of the student, in which case she is the creditworthy person
prompting the bank to grant the loan.
SIDEBAR
Creditworthiness is at the core of the bank lending system. It can be demonstrated by providing
collateral, or by demonstrating the ability to face the loan obligations.
Collateral is property (car, house, inventories, government securities) that is pledged by the
borrower as guarantee for the repayment of a loan.
So let us suppose that indeed the borrower is creditworthy. What happens next? The
answer to this query is simple. A bank loan gets created ex nihilo – out of nothing – at the stroke
of a pen; or rather, in our modern world, the bank loan gets created by punching a key on the
computer. Simultaneously, as the bank loan gets created, a new bank deposit also gets created.
Let us suppose that on January 2, 2008, a creditworthy borrower is being granted a new
loan of $40,000 (for quite a nice car!). The effects on Bank-a-mythica, who holds a monopoly on
banking services, are shown in Table 3. The bank now has $40,000 more in loans on the asset
side of its balance sheet, but simultaneously, on the liability side, there is an increase of $40,000
in the bank deposits. The minute the loan has been granted, the car purchaser gets credited with a
money deposit of $40,000. This is money that the bank now owes to the car purchaser. This is
why it is on the liability side of the bank. Tables such as this one, which shows changes in
balance sheets rather than the balance sheets themselves, will help us follow the process of
money creation and destruction.
Table 3
Changes in the Balance sheet of Bank-a-mythica, January 2, 2008
Assets
Liabilities and Net Worth
Loans to car purchaser
+$40,000
Deposits of car purchaser
+$40,000
There is nothing more to money creation. Since chequable bank deposits are part of M1, the most
strictly defined money aggregate as we saw on page 234, Table 3 has shown how most money
gets created in the modern world.
{IN RED} For money creation to occur, all we need is the willingness of a bank to lend and a
creditworthy borrower who is willing to borrow. {END Of RED INK}
Box
Lines of credit
The money-creating process can be made even more efficient when banks grant lines of credit
(also called overdrafts) to their customers. As Keynes explained in 1930 in his Treatise on
Money, an overdraft is “an arrangement with the bank that an account may be in debit at any time
up to an amount not exceeding an agreed figure, interest being paid not on the agreed maximum
debit, but on the actual average debit”. There may be a fee for this line of credit.
Take the case of our car purchaser. She may have already negotiated an agreement with the bank,
entitling her to borrow up to a certain maximum amount, say $100,000, depending on her annual
income and her existing net wealth. The bank client can then draw on her line of credit whenever
she wants, up to the indicated limit. For instance, in the present case, assuming a $100,000 line of
credit, she would draw $40,000 to pay for her new car, paying interest on that amount (the
utilized portion of the credit line). The remaining $60,000 would constitute the unused portion of
the line of credit. Because this part of the credit line is not used, no interest is charged on the
remaining $60,000. However, if the car purchaser were to need to borrow some additional
amounts, say $5000 for new kitchen major appliances, she would not need to go back to the bank
loan officer to obtain yet another loan. All she needs to do is draw on an additional $5,000 off the
unused portion of her existing credit line.
Many businesses have these lines of credit. It gives them flexibility in handling payments to
workers and suppliers, because businesses usually sell their ware after they have been produced
and paid for, so that businesses need bank advances. Lines of credit have now been generalized
to individuals, thus also providing them with more flexibility when their expenses, for whatever
reason, run (temporarily!) at a faster pace than their income. {END OF BOX}
What then happens next? Suppose that the car is being purchased the next day, on January 3rd.
The purchaser goes to the car dealer, most likely with a certified cheque in hand, and after having
given the cheque and signed all the papers, she drives off with the car. The car dealer deposits the
cheque, still at Bank-a-mythica, since we assumed that this was the one and only bank of the
country. The balance sheet of Bank-a-mythica will show the changes indicated in Table 4.
Table 4
Changes in the Balance sheet of Bank-a-mythica, January 3, 2008
Assets
Liabilities and Net Worth
Deposits of car purchaser
Deposits of car dealer
-$40,000
+$40,000
By combining Tables 3 and 4, we arrive at Table 5, which summarizes the bank’s overall
transactions for those two days. The car purchaser still owes $40,000 to the bank, but all the
money deposits are now in the account of the car dealer.
Table 5
Changes in the Balance sheet of Bank-a-mythica, January 2-3, 2008
Assets
Loans to car purchaser
Liabilities and Net Worth
+$40,000
Deposits of car dealer
+$40,000
As we pointed out in page 239, all of our balance sheet tables, such as Table 2 or 5, must
balance. In all such tables, which are called T-accounts, the two sides of the ledger must carry
equal total amounts. This balance is required because changes in assets and liabilities must be
equal if the balance sheet is to balance both before and after the transactions.
But Table 5 is unlikely to be the end of the story. Although the car dealer may be quite
happy to be loaded with a $40,000 bank deposit, it is most likely that the car dealer was forced
himself to take a loan when the car was initially brought into the dealership. Indeed, the car
dealer usually holds a large inventory of cars, the cost of which has to be financed by bank loans.
So it is most likely that the car dealer will use the proceeds of his sale to diminish the amount of
his outstanding loans at Bank-a-mythica. Thus, the following change, as shown in Table 6, is
likely to appear on the bank’s balance sheet.
Table 5
Changes in the Balance sheet of Bank-a-mythica, January 4, 2008
Assets
Liabilities and Net Worth
Loans to car dealer
-$40,000
Deposits of car dealer
-$40,000
The car dealer uses his newly acquired deposits to pay back the bank. The money gets destroyed!
When borrowers reimburse their loans, money gets destroyed. At the end of the week, adding
Tables 3, 4, and 5, we obtain Table 6. In the end, despite all the action, there has been no change
in the stock of money deposits. But the composition of the balance sheet of the bank has
changed, with car purchasers owing more funds to the bank, while car dealers owe less.
Table 6
Changes in the Balance sheet of Bank-a-mythica, January 2-5, 2008
Assets
Liabilities and Net Worth
Loans to car purchaser
+$40,000
Loans to car dealer
-$40,000
Total
No change
No change
Yellow Square
A Subsidiary Money Creation Channel
We said in the previous section that there were two main channels of money creation. The first
one is through banks granting new loans. The second channel is tied to changes in the
composition of financial portfolios. Money is not the only financial asset that agents can hold.
People can hold banknotes (about which more will be said later), chequable and non-chequable
bank deposits – these assets being defined as M1 money stock – as well as chequable deposits
from other financial institutions, certificates of deposits, stock market shares, mutual fund shares,
bonds, etc. Money is being created when non-financial economic agents, such as manufacturing
corporations or households, transform some of their non-monetary assets into deposits that are
defined as being money (M1, M1+, M2, M2+, etc.). This can occur either because these nonfinancial agents decide to hold a greater proportion of their financial wealth in the form of
deposits, or when banks wish to hold a bigger proportion of their assets in the form of securities
rather than in the form of outstanding loans. For this kind of money creation to occur, there has
to be a double coincidence of wants: on the one hand, non-financial agents wish to hold more
deposits; and on the other hand, banks wish to hold more assets beyond loans.
Table 7 shows how such a creation of money would occur. The non-financial agent, here Toy
Manufacturer, sells securities (for instance, government bills that it holds) and gets bank deposits
in exchange; Bank-a-mythica purchases the government bills, and credits the sale proceeds to the
deposit account of Toy Manufacturer. We may call this the portfolio-change process. The nonfinancial agent is no richer than it was before – its wealth does not change, only the composition
of its wealth has changed – but note that the size of the balance sheet of the banking system has
now risen by $1000. Both the assets and the liabilities of Bank-a-mythica have risen by $1000.
Table 7
A subsidiary money creation channel: Changes in balance sheet composition
B
Manufacturer
Toy
a
n
k
a
m
y
t
h
i
c
a
Assets
Securities +$1000
Liabilities
Deposits +$1000
Assets
Securities -$1000
Deposits +$1000
Liabilities
No change
Of course the portfolio-change process may operate in reverse gear. Manufacturer Toy
may be unhappy about the interest rate it is getting on its bank deposits at Bank-a-mythica. It may
be want to hold more of its financial assets in the form of securities, which may be slightly less
convenient but which carry a slightly higher rate of return than the interest rate on money
deposits. In this case, Manufacturer Toy may offer to buy securities at a price that will induce
Bank-a-mythica to sell them. Money, therefore, gets destroyed. The deposits of Manufacturer
Toy diminish by $1000, while its holdings of securities rise by $1000, and the size of the balance
sheet of Bank-a-mythica diminishes by $1000.
In the rest of this chapter, we will concern ourselves with the first of these two money
creating channels. From a macroeconomic point of view, the lending channel by which money
gets created is a more interesting one as it generally involves changes in income, sales and
production., which is usually not the case of the portfolio-change process.
Yellow Square
The Limits to Money Creation
One of the most striking feature of the money-creation process, especially through the lending
channel, is that there seems to be no limit to the creation of money. In a sense this is true. The
creation of money is not limited by some scarce resource such as the amount of gold that banks
have accumulated in their vaults. It is sometimes argued that this was the case in the past, and it
may have been, although economic historians argue with each other about that, but it is certainly
not the case in modern banking systems. Nowadays banks are free to lend as much as they want.
This is certainly true of our monopoly bank, but as we shall see in the next section, it is also true
even in the general case, when there are several competing banks.
Take first the case of our monocentric banking system. What could its restrictions on
lending be? The amount that the monopoly bank can lend is only limited by the three crucial
features of the banking system that we identified earlier: the willingness of the bank to grant
loans, the creditworthiness of borrowers, and the willingness of borrowers to take on loans.
As in all economic transactions, both partners to the transaction need to be willing to
engage in the transaction. For a loan to be granted, and for bank deposits to be created as a
consequence of this new loan, both the bank and the borrower have to be willing to go ahead
with this operation. Why would economic agents refuse loans that they are being offered? The
reason is that they may be unwilling to get into debt and pay interest on this debt. They may also
see no reason to spend more, or they may be scared of going bankrupt if they borrow too much or
borrow any more. Thus borrowers, on their own, may willingly put limits on the amounts they
want to borrow. By borrowing too much, they are afraid that they may lose their entire wealth or
a large part thereof. This is sometimes called the borrower’s risk.
Why would a monopoly bank be unwilling to lend? For exactly symmetric reasons. The
bank may fear that some of its clients may be unable to reimburse their loans or make the interest
payments that are due. This is the lender’s risk. If too many of the borrowers of the bank are in
this situation, the bank may become insolvent and may be closed down, as we will explain in a
short time. This is why the bank is on the look for creditworthy customers. Unless the bank is
really pessimistic about future prospects, for instance, fearing an economic recession in the near
future, thus being reluctant to increase the size of its balance sheet, the bank is always looking for
new creditworthy borrowers, or willing to increase the size of loans granted to previous
creditworthy borrowers.
But why is the bank looking for creditworthy borrowers and not just any kind of
borrower? Why does the bank fear customers who do not make their interest payments or
reimburse their loans? First, as pointed out in page 237, banks are in the business of making
profits. Besides service fees, banks make their profits on the difference between: their revenues
– the interest payments that they receive on their assets (on their loans and the securities that they
hold) and their costs – the interest payments that they have to make on their liabilities (essentially
on the deposits that people hold at the bank) plus the costs of operating a bank (the salaries of
clerks and loan officers, rentals, the costs of running the automatic teller machines, etc.). If
borrowers don’t fulfill their interest payment obligations, banks will make losses, not profits.
Bad loans have a second, less obvious, implications. Suppose the bank, by mistake,
makes a loan of $200,000 to a non-creditworthy person, and that this person turns out to be a
crook. Instead of building a prosperous business with the borrowed money, the crook spends it
all in bars, cars, and casinos. At the end of the year, the bank manager wakes up and finds out
about all this. The borrower has defaulted on the loan and has vanished; the collateral that had
been offered to get the loan is worthless. There is no way the loan can be recovered. It has to be
considered as a “bad loan”, and thus must be entirely “written off”. While this is an extreme case,
small businesses regularly go bankrupt (as sometimes do large corporations), because of poor
planning, bad luck, or changing economic conditions. Their banks can only recover a portion of
the loans that they granted. The rest has to be written off.
How will the accountants of the bank take care of this? Table 8 shows how a $200,000
bad loan is written off. Since the loan is now worth nothing, it must be removed from the assets
of the bank on its balance sheet. A minus $200,000 entry will thus need to be recorded into the
changes of the balance sheet. But a T-account must always balance by definition. What other
change must we make for the balance sheet to balance? The answer is to be found in the bank’s
capital. The bank has suffered a $200,000 capital loss, which must be subtracted from the bank’s
own funds.
Table 8
Writing-off a bad loan, Changes in the Balance sheet of Bank-a-mythica
Assets
Liabilities and Net Worth
Assets
Liabilities
Securities
no change
Chequable deposits
no change
Loans outstanding
-$200,000
Total
-$200,000
Net Worth
Bank’s capital
-$200,000
Total
-$200,000
Table 9
Balance sheet of Bank-a-mythica, December 31, 2007, after accounting for bad loan
Assets
Liabilities and Net Worth
Assets
Liabilities
Currency
$100,000
Chequable deposits
$5,000,000
Securities
$1,000,000
Loans outstanding
$4,200,000
Net Worth
Bank’s capital
$300,000
Total
$5,300,000
Total
$5,300,000
The new balance sheet of Bank-a-mythica, once the loan loss has been taken into proper
account, will thus look like Table 9, with Table 9 being the sum of Table 2, before the loss was
recorded, and Table 8, which records the change induced by the loss. In Table 9, compared to
Table 2, Bank-a-mythica has a smaller net worth, but this net worth is still positive, standing at
$300,000. Although Bank-a-mythica is not in as good a shape as it appeared in Table 2, it is still
solvent. In other words, despite the bad loan, the bank’s capital is still positive, as its assets are
still larger than its liabilities. The bank could still face a string of bad loans. Nonetheless, most
likely, the bank would be concerned about the decline in its own funds and would make an effort
to increase its capital (for instance by issuing new shares), or by being more prudent in its future
dealings and in the choice of its borrowers.
Sidebar
A solvent bank is a bank that has positive net worth. The bank’s capital is positive, so that its
assets are larger than its liabilities. An insolvent bank has negative net worth.
Suppose however that more borrowers have defaulted on their loans, for instance because
their businesses did much more poorly than what was predicted in the marketing plan. Suppose
that $900,000 worth of loans turned out to be bad loans that year. $900,000 worth of loans must
thus be subtracted from the asset side of the balance sheet of Bank-a-mythica, as shown in Table
10, and $900,000 must be subtracted from the bank’s capital. But wait! The own funds of the
bank, the bank’s capital, were only $500,000. What happens now? The net worth of the bank
becomes negative, standing at -$400,000. The bank is insolvent. Its liabilities – the deposits of
its customers – are not covered by enough assets (the sum of the securities and loans). The bank
must go under and declare bankruptcy, or its assets and liabilities have to be taken over by some
other bank.
To try to avoid such bank failures, there are minimum requirements that are applied
world-wide regarding the size of bank capital relative to the value of assets (especially the value
of risky loans). These requirements are known as capital adequacy requirements, and their
generalization to banks of many countries has been spearheaded by the Bank for International
Settlements (BIS), an international organization located in Basel, Switzerland.
Table 10
Balance sheet of Bank-a-mythica, December 31, 2007, after accounting for huge bad loans
Assets
Liabilities and Net Worth
Assets
Liabilities
Currency
$100,000
Chequable deposits
$5,000,000
Securities
$1,000,000
Loans outstanding $4,200,000 - $900,000 Net Worth
= $3,500,000
Bank’s capital
= -$400,000
Total
$4,500,000
Total
$500,000 - $900,000
$4,500,000
The lesson to be drawn from this is that Bank-a-mythica faces no limit as to the amount
of loans it can make, and therefore to the amount of money it can create, save for its own fear of
making losses and failing. What limits the creation of money is the number of creditworthy
borrowers and the willingness of these potential borrowers to borrow. If no one is willing to go
into debt, no new loan will be granted and bank deposits will not grow. As the saying goes, you
can bring a horse to water, but you cannot force it to drink!
It should also be clear that monetary relations are based on conventions – on customs.
The definition of a creditworthy borrower will not be the same in all time and space. Someone
classified as a creditworthy person today in Canada may not have been in the past or in some
other country. For instance, criteria to obtain mortgage loans are now much less stringent than
they were in the past. Also, different banks may have different opinions with regard to the
creditworthiness of the same person. Since we are talking about different banks, this is a good
time to consider the limits of money creation when several banks are operating within the
monetary system.
Box
Bank Failures
Thousands of American banks failed during the Great Depression, as they became insolvent
when the value of their assets plummeted with the downfall in economic activity, with other
banks refusing to make transactions with them when insolvency was suspected, and with these
banks often being subjected to bank runs. The surviving banks became overly cautious during the
Great Depression, denying loan demands and recalling loans that had been previously made. This
made the recession even worse, as producers lacked the financial means to produce, thus
reducing production and paid wages. As wages received diminished, household consumption also
fell. In addition, when banks went under, depositors lost the money that they had in these banks,
further reducing consumption and hence economic activity.
In Canada, not a single bank failed during the Great Depression. Still, in Canada as
elsewhere, many bank loans to companies and entrepreneurs must have turned bad, becoming
worthless as these companies and individuals went bankrupt. Most probably, some Canadian
banks, as many other surviving banks in the rest of the world, were insolvent then – a point that
was made by Keynes himself in 1931. But as long as nobody takes notice, or as long as everyone
turns a blind eye, the bank can continue to operate. This shows once more that monetary systems
rely on trust and conventions.
By contrast, as was mentioned earlier and listed in Table 1, in 1985 two Alberta-based
banks failed – the Canadian Commercial Bank and the Northland Bank, causing a bank run on at
least three other small Canadian banks. The big recession of 1981-1982, the slowdown in the oil
and gas sectors, and the concomitant large increase in interest rates are sometimes blamed for
these two failures, as the two Alberta banks were heavily involved in the regional real estate
market in Western Canada. The Estey Commission, which, as noted on page 238 was set up by
the Canadian federal government to investigate the causes of the failures, concluded that bank
management pursued imprudent lending policies and bizarre banking procedures, along with
misleading financial statements. Indeed, the failures of these two Canadian banks show some
similarities with the Savings and Loans (S&L) debacle in the United States, also in the 1980s.
S&L institutions were financial institutions similar to our credit unions or Caisses populaires.
The cause of the failure of S&Ls is well-documented. Besides difficulties caused by a mismatch
between short-term liabilities and short-term assets at a time of rising interest rates, evidence of
fraud and insider abuse, tied in particular to real estate swindles, has been uncovered, leading to
convictions of fraud and racketeering.
Regulation and bank supervision is needed, not only to restrict overly enthusiastic
bankers, but also to create an environment where financial fraud is more difficult, just like
banknotes issued by the Bank of Canada are made in such a way that they are difficult to
reproduce, to avoid counterfeiting. {End of Box}
Red Square
MONEY CREATION IN A BANKING SYSTEM WITH SEVERAL BANKS
We have seen that loans made to individuals or corporations, and hence money creation, depend
on trust. The same is true of the relations between banks. Whenever they engage in transactions
with each other, banks must trust each other, otherwise the banking system would grind to a halt,
or the banks which are not trusted by the other banks would quickly be unable to operate and
their clients would suffer great inconvenience. Well-functioning banking systems have
institutions that allow banks to make their transactions with each other with great confidence. In
Canada, transactions between banks are regulated through the Payment Clearing and Settlement
Act, which was proclaimed in 1996, and through the by-law of the Canadian Payments
Association. The Bank of Canada is a key player in this institutional setup, in particular it
oversees the payment system, but its role will be mainly discussed in the next chapter.
As is the case for individuals, the transactions between banks are closely monitored with
the help of credit ratios. These ratios depend on the amount of collateral that each bank is willing
to provide to the LVTS, and on the amount of bilateral credit limits that participants grant to each
other. The purpose of these controls is to insure that the troubles of one bank will not snowball
into other banks running into trouble – the issue of systemic risk. Collateral and trust, or
creditworthiness, are thus the kingpin of a monetary system.
Sidebar:
There is systemic risk in a payment system when the failure of one bank to meet its obligations
could lead to the failure of other banks to meet their obligations, thus jeopardizing the
functioning of the entire payment system.
Yellow Square
The Canadian Clearing and Settlement System
To understand the functioning of a banking system with multiple banks – a polycentric banking
system as Hicks would call it – let us go back to a situation which is very similar to that of our
initial example. Let us suppose that a Chevrolet car dealer must now pay for an allotment of cars
that was sent to him by the car producing company. Suppose that in order to do so the car dealer
must draw on his line of credit (See the earlier Box, “Lines of Credit”), for an amount of
$400,000, thus increasing the amounts borrowed from his bank, say the Bank of Montreal, by an
amount of $400,000, and ordering his bank to pay this amount to GM Canada. Let us suppose
that GM Canada does business with another bank, say, the Toronto Dominion Bank.
Sidebar
A line of credit is an arrangement with the bank that allows someone to borrow freely up to an
amount not exceeding an agreed figure, interest being paid not on the agreed maximum, but on
the actual average loan.
Because the amount involved is large, the payment will go through an electronic-only
payment system (instead of a paper payment system, such as is the case with ordinary cheques).
In Canada, this electronic-only wire system is called the large-value transfer system (LVTS). It
has been operating since 1999. This is a clearing and settlement system, in which banks and a
few other participants in the LVTS, such as the Fédération des caisses Desjardins and more
importantly the Bank of Canada, clear their payments and settle their accounts. About 90 percent
of the value of bank payments go through the LVTS. From now on, the participants to the LVTS,
save the Bank of Canada, will simply be referred to as “banks”.
SIDEBAR
Clearing is the continuous daily process by which banks exchange and deposit payment items
for their clients, and determine the net amounts owed to each.
Settlement is the end-of-day procedure by which banks use borrowing and deposit facilities at
the Bank of Canada to fulfill their net obligations to all other banks.
Before any large transaction goes through between two banks (before it clears), a
computerized system verifies that the debit position of the paying bank is not too large. Once the
controls within the system are all satisfied, the transaction clears and the payment is irrevocable.
It cannot be reversed. If a bank were to fail by the end of the day, before final settlement, the
collateral pledged by the failing bank or the collateral pledged to the LVTS by the remaining
banks would be enough to cover any amount due by the failing bank. In our car dealer example,
as soon as the $400,000 payment from the Bank of Montreal to the Toronto Dominion bank is
cleared, a $400,000 amount is deposited in the bank account of the car producer, GM Canada,
and that payment is final. It cannot be revoked.
Thus a loan is initially granted by the Bank of Montreal, with deposit money created
therein, but the deposit eventually ends up in an account at the Toronto Dominion Bank. How
will all this be entered in the balance sheets of the two banks at the moment that the transfer to
the account of GM Canada occurs? Let us look at Table 11.
Table 11
The money creation channel with two different banks: Intraday Changes in balance sheets
Bank of Montreal
Assets
Liabilities
Loans to Chevrolet car
dealer +$400,000
Toronto Dominion Bank (TD)
Assets
Liabilities
LVTS balances
Deposits of GM
+$400,000
Canada
+$400,000
LVTS balances
-$400,000
Assets
LVTS
Liabilities and Net Worth
Balances of Toronto Dominion Bank
+$400,000
Balances of Bank of Montreal
-$400,000
The trick to understand what is going on is to remember that all balance sheets must
balance. If the Bank of Montreal has made more loans than it has collected deposits, and if the
Toronto Dominion Bank has collected more deposits than it has made loans, as is the case in our
instance illustrated by Table 11, there has to be some adjustment mechanism that will make the
T-accounts balance.
The Chevrolet car dealer has ordered his bank to transfer $400,000 of his newly acquired
money to the deposit account of GM Canada at the Toronto Dominion Bank. Now, as shown in
the bottom part of Table 11, once the transfer is recorded through the LVTS, the Bank of
Montreal owes this $400,000 amount to the clearing system – it is said to have a negative LVTS
balance or to have a debit LVTS position – while the Toronto Dominion Bank is said to hold a
positive LVTS balance or to have a credit LVTS position. The system owes the Toronto
Dominion Bank $400,000.
SIDEBAR
The LVTS balance of a bank is the multilateral clearing position that the bank has accumulated
within the large-value transfer system in the course of the day. When the bank is in a net credit
position, the balances are positive; when the bank is in a net debit position, the balances are
negative.
Things may change quite rapidly however. During the same day, it may be that GM
Canada has to pay its suppliers, producers of metals or plastics, several of whom may be holding
accounts at the Bank of Montreal. In that event, payments will have to flow from the Toronto
Dominion Bank towards the Bank of Montreal, and the positive LVTS balances of the Toronto
Dominion Bank may get reduced close to zero, or may even become negative. And as further
payment orders come in during the day, there will be further changes to the net position of each
of bank. These changes can be quite large, so that each morning each participant decides how big
a bilateral credit line it grants to each of the other participants, on the basis of their credit
assessment. In addition, a central computer calculates the position of each participant on a
payment-by-payment basis, so that each bank is aware of its overall position and that of every
other bank. The net amount that each participating financial institution is permitted to owe is
subject to bilateral and multilateral limits. Various whistles go off when one bank goes too far in
a negative position. In that case, the bank with the excessive negative position will have to wait
till it receives transfers from the other banks before it can go ahead with the payments ordered by
its depositors .
Box
Gross Flows of Payments and Net Balances in the Large-Value Transfer System
The Canadian LVTS is unique among clearing and settlement systems in the world, and is highly
cost efficient. In other countries, to insure payment finality, large-value payments involve an
immediate transfer of funds on the settlement accounts of banks, on the books of the central
bank. But each clearer must hold central bank deposits that are sufficiently large to cover any
possible outgoing payment. In Canada, settlement only occurs at the end of the day, on a
multilateral basis, but payment finality is guaranteed as soon as the payment is being accepted by
the system and thus clears, thanks to the collateral arrangements mentioned above.
The following numerical example may help to explain how the main Canadian clearing
and settlement system – the LVTS – works. Suppose the following transactions occur between
three banks that participate in the LVTS during the day (the numbers are not unreasonable, given
that on average, in 2006, no less than $166 billion worth of payments did transit through the
LVTS every day – about one ninth of Canada’s annual GDP!)
The Bank of Montreal (BMO) makes payments of $30 billion to depositors of the Toronto
Dominion Bank (TDB).
The Bank of Montreal (BMO) makes payments of $30 billion to depositors of the Canadian
Imperial Bank of Commerce (CIBC).
The Toronto Dominion Bank makes payments of $22 billion to depositors of the Bank of
Montreal.
The Toronto Dominion Bank makes payments of $20 billion to depositors of the Canadian
Imperial Bank of Commerce.
The Canadian Imperial Bank of Commerce makes payments of $40 billion to depositors of
the Bank of Montreal.
The Canadian Imperial Bank of Commerce makes payments of $18 billion to depositors of
the Toronto Dominion Bank.
The following table sums up these transactions and their implications with regards to the
settlement balances of the three banks.
Owed to 6
Owed by
BMO
TD
CIBC
Ó Amounts
owed to
BMO
22
40
62
TD
CIBC
30
30
20
18
48
50
Ó amounts
owed by
(debits)
60
42
58
150
Ó amounts
owed to
(credits)
62
48
50
150
LVTS
balances
+2
+6
-8
0
Although there have been transactions reaching a total gross amount of $150 billion, the net
amounts involved are much smaller, with the Bank of Montreal being left with $2 billion of
positive LVTS balances. In other words, the Bank of Montreal is here in a net credit LVTS
position. The Toronto Dominion Bank has a LVTS positive balance of $6 billion, while the
Canadian Imperial Bank of Commerce holds the difference, a $8 billion negative LVTS
balance (a net debit LVTS position). It would be easy to build other examples where the total
amount of positive balances is even smaller, despite actual daily transactions being of a larger
size. Thus the size of positive LVTS balances is only very indirectly related to the amount of
monetary transactions or the volume of economic activity. It is a random number that
depends on the relative size of incoming and outgoing payments for each LVTS participant.
{END OF BOX}
But suppose now that we have reached the end of the day, and that the situation is that
described by Table 11, with the Bank of Montreal still being in a $400,000 debit LVTS position
(a negative LVTS balance). Can such a situation last? As we will see in the next chapter, in a
sense it could. But there are economic incentives for this situation to be reversed. The banks that
have positive LVTS balances will usually lend them to the banks that have negative balances!
This will occur on a segment of the overnight market – the interbank market – where banks
make loans to each other. In the present case, at the end of the day, the Toronto Dominion Bank
can grant a one-night loan of $400,000 at the overnight rate of interest to the Bank of Montreal.
This generates a LVTS credit (positive) flow of $400,000 for the Bank of Montreal, and a
negative LVTS flow of $400,000 for the Toronto Dominion Bank, as shown in Table 12, thus
allowing both banks to bring their LVTS balances to zero (when Tables 11 and 12 are added).
The end result for the balance sheet of each bank is shown in Table 13.
SIDEBAR
The interbank market is the financial market where banks lend and borrow surplus funds
between themselves for one night.
The overnight market is the financial market where banks and other financial market
participants (investment dealers, pension funds, large corporations, trust companies, the
Government of Canada) lend and borrow surplus funds for one night. The overnight market has
three components, one of which is the interbank market.
Table 12
The Toronto Dominion Bank Grants an Overnight Loan to the Bank of Montreal: Change
in LVTS balances
LVTS
Assets
Liabilities and Net Worth
Balances of Toronto Dominion Bank
-$400,000
Balances of Bank of Montreal
+$400,000
Table 13
The Money Creation Channel with two Different Banks: Overnight Changes in balance
Sheets
Bank of Montreal (BMO)
Toronto Dominion Bank (TD)
Assets
Liabilities
Assets
Liabilities
Loans to Chevrolet car Funds borrowed from Advances made to
Deposits of GM
dealer +$400,000
TD
Bank of Montreal
Canada
+$400,000
+400,000
+$400,000
LVTS balances
LVTS balances
$0
$0
Once again we can draw lessons from this example. First, it is clear that the polycentric
banking system relies on trust and creditworthiness. Banks have to be sufficiently confident in
other banks and in the clearing and settlement system to accept that other LVTS participants run
temporary negative balance positions during the day, and to grant overnight loans to banks that
end the day with a deficit LVTS position. Indeed, as we noted earlier, institutions have been set
up so that transactions can be carried with very little risk. In addition, as long as all banking
institutions are “moving in step”, granting loans and collecting deposits at approximately the
same pace, the situation of a polycentric banking system is not very much different from a
monocentric one, because on average, over a period of weeks, the positive and negative positions
will compensate each other for each bank, although they will not on an hour per hour basis.
When some banks are growing faster than others, with their loans growing faster than
those of other banks, things are more complicated, as these fast-growing banks will show net
debit LVTS positions systematically, unless they find other means to compensate for the
discrepancy between loans and deposits. In the United States, New York City banks
systematically run deficit clearing positions, and so do some banks in Europe. There are basically
two ways through which banks that run systematic clearing deficits avoid borrowing extensively
from other banks. First, they can offer certificates of deposits, at attractive interest rates, that are
purchased by the banks or other financial market institutions that have surplus funds. This is
called liability management. This often involves another segment of the overnight market – the
market for overnight wholesale deposits. Second, once they have granted new loans, they can sell
bunches of loans to banks or financial institutions that are in a surplus position. This is an
instance of securitisation, whereby a loan is transformed into a financial vehicle that can be sold,
just like a security.
SIDEBAR
Liability management is the process through which banks attempt to obtain funds, for instance
by offering certificates of deposits at attractive interest rates, and hence attracting wholesale
deposits.
Securitisation is the process through which illiquid financial assets – assets that cannot be sold
easily, such as mortgages – are transformed into marketable instruments – financial assets that
can easily be sold and purchased.
At this stage it should be clear that, in a modern monetary system such as the Canadian
one, nothing, besides the prudence of bankers and the self-restraint of borrowers, limits the
creation of credit and that of money. This feature of our monetary system, the fact that the
creation of money is essentially endogenous, has advantages. It provides flexibility to the
monetary system: monetary units get easily created when the economy is expanding and there is a
need for additional units of money for production and transaction purposes. However, as for most
things, there is a downside to this flexibility.
In all likelihood, when the economic perspectives are bad, bankers and their customers
will tend to be extra prudent. However, when economic perspectives look good, both bankers
and their clients may become overly enthusiastic. Demand for credit may quickly rise and
bankers are likely to grant new loans at an accelerating pace, attributing creditworthy status to
nearly all income earners. With loans increasing, so will the stock of money. On the basis of
supply and demand analysis, one could then argue that this process ought to lead to rising interest
rates – the cost of loans – and that this would then somewhat restrain the demand for loans and
the growth of the money supply. But what happens is that both the demand for and the supply of
loans increase in tandem, as bankers are just too happy to finance the expenditures that their
customers desire. Hence, with demand and supply growing together, under these circumstances
there is no inherent market force pushing interest rates upwards.
If such a process persists, at some stage the rising demand for credit and money will
outpace the growth of potential output. An inflationary gap will appear, and the inflation rate
will start rising. In addition, as has happened in the past, speculative bubbles may erupt, leading
to fast-rising prices in the stock market or in the real estate market which may further disrupt the
economy. Some outside intervention is necessary.
THE BANK OF CANADA: MONETARY POLICY IMPLEMENTATION
Monetary policy can be conceptually divided into two components: monetary policy strategy
and monetary policy implementation. Monetary policy strategy is closely tied to monetary
macroeconomics. It deals with the macroeconomic goals of the central bank, for instance
achieving a target inflation rate or a given growth rate of economic activity, and how best to
achieve them, especially when goals may be conflicting over the short run. It also deals with the
monetary stance and the transmission mechanism of monetary policy – the decision to change the
value of some monetary variable under the control of the central bank and how this change will
impact the macroeconomic objectives. In other words, monetary policy strategy depends on the
macroeconomic model that lies behind the actions of the central bank.
SIDEBAR: Monetary policy strategy is the decision that the central bank takes about some
monetary variable that constitutes its operational target, for instance a short-term rate of interest
that it can control, with the view of influencing or achieving some macroeconomic outcome or
target, for instance a certain rate of inflation.
Monetary policy implementation is the set of rules, instruments and day-to-day actions
that allow the central bank to implement its operational target.
By contrast monetary policy implementation deals with the day-to-day, or even the hourper-hour, operations of the central bank. We can say that it corresponds to the nitty-gritty aspects
of monetary policy. Monetary policy implementation is made up of two elements – the
operational target and the operational instruments – both of which must be under the control of
the central bank if monetary policy implementation is to be successful. Today, there is a wide
consensus among central bankers that the operational target ought to be a short-term interest rate.
In Canada, this operational target is the overnight interest rate on collateralized transactions.
This is the rate of interest that arises from the overnight market, which we already encountered in
Chapter 12 when discussing the clearing and settlement system of Canadian banking. It is the rate
at which banks and other financial market participants lend and borrow from each other for one
night, using or searching for surplus funds fully secured by acceptable collateral. The operational
target of the Bank of Canada is thus the target overnight interest rate.
SIDEBAR: The overnight interest rate is the interest rate that banks and other financial market
participants pay and receive when they borrow and lend surplus funds from each other for one
day, in particular when banks borrow and lend LVTS balances from one another.
The target overnight interest rate is the operational target of the Bank of Canada; it is
the overnight rate that the central bank would like to see realized.
In what follows we examine the operational framework – the technical instruments that
allow the Bank of Canada to achieve its operational target. In other words, we first deal with
monetary policy implementation. Monetary policy strategy – the choice of the value taken by the
operational target – will be studied once we know how the central bank implements its decisions.
Yellow Square
The Corridor System
How the operational target gets implemented in the Canadian monetary system is a simple story.
Unless there are special circumstances, the Bank of Canada makes an announcement eight times
a year, in the early morning at specific dates, as to what its target overnight interest rate will be
until the next announcement. Et voilà!
The Bank of Canada accompanies its new rate announcement with an explanation of its
decision to decrease, increase or keep constant the target overnight rate (See the Box “Bank of
Canada Press Release”). These justifications have more to do with monetary policy strategy, and
hence they will be dealt with later. In the meantime what must be noted is that the target
overnight rate is accompanied by an operating band, which is made up of two additional interest
rates that stand below and above the target overnight rate. These two rates are respectively the
interest rate on deposits at the central bank and the interest rate on advances made by the
Bank of Canada to the banks that participate in the Large Value Transfer System (the LVTS, as
we called it in Chapter 12). This latter rate is also called the Bank rate. These two interest rates
thus determine the operating band. This band looks like a corridor – a channel or a tunnel – thus
leading this operating framework to be called the corridor system, as shown in Figure 1.
SIDEBAR
The Bank rate is the interest rate charged to banks that still have negative LVTS balances at the
end of the day, and hence that must take advances (borrow funds) for one night from the Bank of
Canada in order to settle with the LVTS.
The interest rate on deposits at the central bank is the rate of interest that banks get on their
deposits at the Bank of Canada as a result of the operation of the LVTS. Banks with positive
LVTS balances must deposit them in their account at the Bank of Canada when settlement occurs
at the end of the day.
The operating band is the zone of overnight rates comprised between the Bank rate and the
interest rate on bank deposits at the central bank.
The corridor system is the operating framework adopted by the Bank of Canada which forces
the overnight interest rate to remain within the operating band and close to the midpoint of the
band, as defined by the target overnight rate.
Figure 1
The Target Overnight Interest Rate with its Operating Band
Figure 1 illustrates the case where the target overnight rate of interest is 4.25 percent. As a
result, the Bank rate is set at 4.50 percent, since the Bank rate is always set at one quarter of one
percent (or 25 basis points, as financial market specialists say) above the target overnight rate.
Symmetrically, the interest rate on deposits at the Bank of Canada is set at 25 basis points below
the target overnight rate. As a result, the operating band is 50 basis points wide.
The Bank of Canada thus acts as a price-fixer with respect to the short-term interest rate.
It constrains the values that the overnight interest rate can take by setting both a floor and a
ceiling to the values that can be taken by the overnight interest rate. The Bank of Canada
promises to take as a deposit, paid at a 4 percent rate, any amount of positive LVTS balances
held by an individual bank; and it promises to grant advances, at a 4.5 percent cost, to any
individual bank that has negative LVTS balances (provided the bank has adequate collateral).
The overnight rate can, in theory, take any value within the operating band, the range of which is
given by the grey area in Figure 1. But it cannot get outside this band. It is constrained within a
corridor. Why is this so? Why does the Bank of Canada have the power to influence so much the
overnight rate? The essential reason for this is that in Canada, as in virtually all countries, all
payments must eventually settle on the books of the central bank, here the Bank of Canada.
{In RED} Recall from Chapter 12 that payments go through two steps: first they are cleared,
then they are settled. The main clearing system is the Large-Value Transfer System (LVTS).
Clearing is the daily process by which banks exchange and deposit payment items for their
clients, and determine the net amounts owed to each. Settlement is the procedure by which banks
use claims on the Bank of Canada to fulfill their net obligations to all other banks at the end of
the day.
The Bank of Canada is the settlement agent of the LVTS. Banks need to settle with the LVTS at
the end of the day, and they must do so on the books of the Bank of Canada. The Bank of Canada
provides settlement accounts to LVTS participants; it provides funds to those that need to cover
their settlement obligations (those that have negative LVTS balances at the end of the day); and it
transfers claims on itself for those banks ending the day with positive LVTS balances. {End of
Red}
Suppose, as was the case in the example of Table 11 in Chapter 12 which we partly
reproduce here as the top of Table 1, that the Bank of Montreal has a net debit LVTS position
(negative LVTS balances) by the end of the day. How much is it willing to pay other banks to
borrow balances from them and bring its LVTS balance position back to zero? Clearly it is not
willing to pay an interest rate higher than 4.50 percent since this is the rate that the Bank of
Canada will charge to banks with negative LVTS balances. If all other banks were offering to
charge more than 4.50 percent to lend LVTS balances, the Bank of Montreal would turn down
these offers and would simply take an advance from the Bank of Canada at the Bank rate of 4.50
percent.
Now, what about the banks that have positive LVTS balances? What is their reasoning?
Suppose, as shown in the top part of Table 1, that the Toronto Dominion Bank has a net credit
LVTS position. What is the minimum interest rate that will induce the TD Bank to lend its
balances to other banks (thus also bringing its LVTS balance position back to zero)? Clearly, it
needs to get paid more than 4.00 percent, since this is the rate that it would get anyway if it were
to leave its LVTS balances as a deposit at the Bank of Canada. If no deal can be struck between
the Bank of Montreal and the Toronto Dominion Bank, then the balance sheet of the Bank of
Canada will be as shown in Table 2. The Toronto Dominion Bank will be granted a claim on the
Bank of Canada – its LVTS balances will be brought down to zero and transformed into an
overnight deposit at the Bank of Canada; as to the Bank of Montreal, it will have to borrow
$400,000 from the Bank of Canada to bring its LVTS balances back to zero.
Table 1
Balance Positions of Banks in the LVTS
Intra-day LVTS, Before Settlement
Assets
Liabilities and Net Worth
Balances of Toronto Dominion Bank
+$400,000
Assets
Balances of Bank of Montreal
-$400,000
End-of-day LVTS, After Settlement
Liabilities and Net Worth
Balances of Toronto Dominion Bank
+$0
Balances of Bank of Montreal
+$0
Table 2
Balance Sheet of Bank of Canada, with no Deal Struck Between Banks
Bank of Canada
Assets
Liabilities and Net Worth
Advance to the Bank of Montreal,
Deposits of Toronto Dominion Bank,
at 4.50 percent
at 4.00 percent
+$400,000
+$400,000
The overnight interest rate, that will arise out of the negotiations between potential
lenders and borrowers of overnight funds will thus have to be somewhere between 4.00 and 4.50
percent. Indeed, unless there are some unusual circumstances, the realized overnight rate will
turn out to be very close to the middle of the operating band, at the target overnight rate – in the
case of Figure 1 it will stand at 4.25 percent, or very close to it, say at 4.23 or 4.24, or perhaps
4.26 percent. There are essentially two reasons for this. First, the banks know that the Bank of
Canada wishes the overnight rate to be around 4.25, and that it will intervene if the actual rate
keeps drifting away from the target rate. Secondly, competition should bring the overnight
interest rate near the middle of the operating band, because at that point the opportunity gain of
the lenders and that of the borrowers are precisely the same, being equal to 25 basis points for
both groups of participants to the overnight market.
Figure 2 shows the evolution of the daily differences between the actual overnight rate
and the target overnight rate since 2006, expressed in basis points. Obviously, except for a few
hiccups, the actual rate is equal, or nearly equal, to the target rate. On average, throughout 2006
for instance, the actual rate was 2 basis points lower than the target rate (the discrepancy was
negative on average).
Figure 2:
The Actual Overnight Interest Rate Versus the Target Overnight Interest Rate in Canada, 20062007
Source: Statistics Canada, series v39079 and v39050
Note: Difference is in basis points (A 100 basis point difference equals an interest rate difference
of 1 percent: 4.30 percent versus 4.25 percent is 5 basis points)
{In RED} The Canadian monetary policy implementation framework is such that the realized
overnight interest rate is always, or nearly always, at the mid-point of the operational band, at the
target overnight rate, or within just a few basis points of the target set by the Bank of Canada.
The operational target of the Bank of Canada – the overnight interest rate – is well under its
control. {END RED INK}
Although several countries in the rest of the world have implemented operating
procedures that are highly similar to those of the Canadian monetary system, few manage to drive
the realized overnight rate towards its target level with as much consistency and precision as the
Bank of Canada does. Why is this? It may be because there are very few participants to the
LVTS, which simplifies things for the Bank of Canada. But the main reason is that the
operational instruments create incentives for each bank to target a zero LVTS balance position,
while the Canadian clearing and settlement system allows the Bank of Canada to know with
perfect certainty its own LVTS position by the end of the day. This is not the case in most of the
other monetary systems in the rest of the world, which explains why most other central banks are
not as successful as the Bank of Canada in achieving their operational target interest rate on a
day-to-day basis. However, these other central banks, such as the Federal Reserve System in the
United States, usually manage to achieve overnight rates (called the federal funds rate in the
United States) which are equal, on average over a monthly basis, to their target. The overnight
interest rate is thus nowadays the operational target of virtually all central banks.
Yellow Square
Government Deposit Shifting
As long as LVTS transactions only involve banks, and not the public sector, whenever a bank is
in a deficit position, i.e., whenever it has negative LVTS balances, there is another bank, or a
group of other banks, that has an identical surplus position, i.e., positive LVTS balances, as
described by Table 1. In other words, under the above condition, the net overall amount of LVTS
balances held by banks – the sum of positive and negative LVTS balances of each bank – is zero
at all times.
Things are entirely different when payment transactions involve the federal government
or the central bank. This will be the case when the federal government pays its employees, when
it collects taxes, when the Bank of Canada purchases or sells foreign currencies on foreign
exchange markets on behalf of government, when it provides banks with currency, or when it
undertakes transactions in government securities with banks or dealers. In all these instances, one
bank may be in a LVTS deficit position without any other bank being in a surplus position; or
one bank may be in a LVTS surplus position, with none of the other banks being in a deficit
position. In this case, the net overall amount of LVTS balances held by banks – the amount of
settlement balances as they are called at the Bank of Canada – will be different from zero.
Sidebar:
Settlement balances are the net aggregate amount of LVTS balances held by banks, that is the
sum of positive and negative LVTS balances of each bank.
Why do monetary transactions involving the federal government or the central bank
disrupt the symmetric behaviour of positive and negative LVTS balances? To examine the
peculiarity of federal government transactions, let us suppose that we are around the end of April,
when taxpayers are sending in their tax returns with their tax payment. Take the example of a
wealthy taxpayer who has to send in an additional $60,000 in federal tax, assuming that it goes
through the LVTS. Table 3 summarizes what happens in the payment system.
Table 3
The Impact of Federal Government Collecting Tax Revenues on Intraday Changes in
Balance Sheets
Bank of Montreal (BMO)
LVTS
Bank of Canada (BofC)
Assets
Liabilities
Assets
Liabilities
Assets
Liabilities
LVTS
Deposits of
Balances of
Deposits of
balances
taxpayer
BMO
Canadian
-$60,000
-$60,000
$-60,000
government
+$60,000
Balances of LVTS
BofC
balances
$+60,000
+$60,000
We assume here that the wealthy taxpayer is a customer of the Bank of Montreal. The
Bank of Canada is the fiscal agent of the Canadian government; in other words the Bank of
Canada handles the payments of the federal government. When the taxpayer orders the Bank of
Montreal to make the $60,000 payment, the account of the federal government at the Bank of
Canada gets credited with $60,000 while the LVTS balances of the Bank of Montreal get
diminished by $60,000. The net aggregate amount of LVTS balances held by banks thus
diminishes. Payments to the federal government thus constitute a drain on settlement balances. If
nothing else occurs, the Bank of Montreal will be looking in vain for a counterparty in its efforts
to borrow funds in the overnight market since no bank has compensatory positive LVTS
balances. This will tend to push the overnight rate above the target overnight rate, towards the
Bank rate, since some banks, here the Bank of Montreal, will be forced to borrow from the Bank
of Canada at the Bank rate. The target overnight rate would not be achieved.
What can the Bank of Canada do to avoid such a situation? The Bank of Canada must
pursue neutralizing operations that will neutralize the impact of government transactions on
settlement balances. In other words, the Bank of Canada will take measures to bring back to zero
the amount of settlement balances. The actions taken to modify settlement balances are described
as settlement-balance management, or in short cash setting.
SIDEBAR:
Cash setting, or settlement-balance management, is the action that the Bank of Canada takes to
bring back the supply of settlement balances to their desired level, usually zero. Cash setting is
usually carried by shifting government deposits between the central bank and banks.
In the present case, the Bank of Canada shifts Canadian government deposits back to the
banks. Suppose that it does so, with $60,000 worth of government deposits being shifted to the
government account at the Bank of Montreal, as shown in Table 4. In reality the deposits are
auctioned off, with the banks offering the highest rate getting the government deposits. Suppose
that in this case, the Bank of Montreal acquires $60,000 worth of LVTS balances when the
auction is completed. Adding Tables 3 and 4, we obtain Table 5, which shows that the system is
back to a situation with a zero amount of settlement balances. The payment flows have been
entirely neutralized.
Table 4
The Impact of a Shift of Government Deposits into Banks on Intraday Changes in Balance
Sheets
Bank of Montreal (BMO)
Assets
Liabilities
LVTS
Deposits of
balances
government
+$60,000
+$60,000
LVTS
Assets
Liabilities
Balances of
BMO
$+60,000
Balances of
BofC
$-60,000
Bank of Canada (BofC)
Assets
Liabilities
Deposits of
Canadian
government
-$60,000
LVTS
balances
-$60,000
Table 5
The Neutralizing Impact of a shift of Government Deposits into Banks Following a Federal
Government Revenue Inflow
Bank of Montreal (BMO)
Assets
Liabilities
LVTS
Deposits of
balances
taxpayer
$0
- $60,000
LVTS
Assets
Deposits of
government
+$60,000
Liabilities
Balances of
BMO
$0
Balances of
BofC
$0
Bank of Canada (BofC)
Assets
Liabilities
Deposits of
Canadian
government
$0
LVTS
balances
$0
The process is quite similar when banks need additional banknotes issued by the Bank of
Canada – so they can feed their automatic teller machines and respond to the demand of their
customers who wish to hold and make use of more banknotes. Withdrawals of banknotes from
the central bank are made as needed by the banks. In other words, whenever the demand for
banknotes rises, more banknotes are being supplied by the Bank of Canada. Banks receive the
banknotes and are debited with negative LVTS balances. These are then neutralized at the end of
the day by shifting the appropriate amount of government deposits from the central bank to the
banks.
We may now examine, more quickly, what happens when the federal government makes
a payment, for instance when it pays for the report of a private-sector economist on the future
competitiveness of the Canadian economy. This time the bank winds up with positive LVTS
balances as a result of the government payment, as shown in Table 6. If the public sector and the
bank of Canada engaged in no further transactions, the Bank of Montreal would be forced to
deposit its LVTS balances at the Bank of Canada, and the actual overnight rate would tend to fall
towards the rate on deposits at the central bank. To stop this, the Bank of Canada must bring the
amount of settlement balances back to zero. Once again, it will do so by shifting the deposits of
the federal government, but this time from its accounts at banks towards its account at the central
bank, as shown in Table 7.2 As a result, as can be seen in Table 8 (which adds Tables 6 and 7),
the federal government payment transaction is neutralized, with the net amount of settlement
balances in the system being brought back to zero. In all likelihood, the actual overnight rate will
be close to the target.
Footnote 2: In reality, the Bank of Canada will auction an amount of government deposits that is
smaller than the amount maturing on that day (and hence returning to the government account at
the Bank of Canada, formally called the Receiver General balances).
Table 6
The Impact of Federal Government Expenditures on Intraday Changes in Balance Sheets
Bank of Montreal (BMO)
Assets
Liabilities
LVTS
Deposits of
LVTS
Assets
Liabilities
Balances of
Bank of Canada (BofC)
Assets
Liabilities
Deposits of
balances
+$60,000
economist
+$60,000
BMO
$+60,000
Balances of
BofC
$-60,000
Canadian
government
-$60,000
LVTS
balances
-$60,000
Table 7
The Impact of Shifting Government Deposits from Banks to the Central Bank on Intraday
Changes in Balance Sheets
Bank of Montreal (BMO)
Assets
Liabilities
LVTS
Deposits of
balances
government
-$60,000
-$60,000
LVTS
Assets
Liabilities
Balances of
BMO
-$60,000
Balances of
BofC
+$60,000
Bank of Canada (BofC)
Assets
Liabilities
Deposits of
Canadian
government
+$60,000
LVTS
balances
+$60,000
Table 8
The Neutralizing impact of a Shift of Government Deposits into the Account at the Central
Bank Following a Federal Government Expenditure Outflow
Bank of Montreal (BMO)
Assets
Liabilities
LVTS
Deposits of
balances
economist
$0
+ $60,000
Deposits of
government
-$60,000
LVTS
Assets
Liabilities
Balances of
BMO
$0
Balances of
BofC
$0
Bank of Canada (BofC)
Assets
Liabilities
Deposits of
Canadian
government
$0
LVTS
balances
$0
{In RED} When the federal government receives a payment (taxes), the banking system as a
whole is put in a negative settlement balance position; when the federal government makes a
payment (expenditures), the banking system as a whole is put in a positive settlement balance
position.
To neutralize the effects of financial payments received by the federal government, the
Bank of Canada shifts government deposits from the central bank to banks; to neutralize the
effects of financial payments made by the federal government, the Bank of Canada shifts
government deposits from banks to the central bank. {END of RED}
The Bank of Canada transfers government deposits twice a day. It does so first in the
early morning, when most of the bank payments through the LVTS are made. It does it again late
in the afternoon, after all bank payments involving the federal government have been made.
When this second adjustment is being carried, the Bank of Canada knows with certainty how
much settlement balances there are in the system. The Bank of Canada is thus able to calculate
the exact amount of government deposits that need to be shifted to achieve a zero amount of net
settlement balances, as occurred in our examples of Tables 5 and 8. Unless there are some
unusual circumstances, the amount of government deposits being auctioned will be such that the
amount of settlement balances is indeed zero by the end of the day. In other words, the Bank of
Canada normally targets a zero amount of settlement balances.
{IN RED} Under normal circumstances, the net amount of settlement balances in the system is
zero at the end of the day. The amounts of positive LVTS balances held by some banks are
exactly equal to the amounts of negative LVTS balances held by the other banks. {END of RED}
Thus, despite the existence of government payment transactions, the situation by the end
of the day is exactly the one that was described in Chapter 12, in Table 11. Thus any bank with a
net debit LVTS position that needs to borrow funds to settle its position is aware that there is at
least one other bank with an offsetting net credit LVTS position, which is a potential lender of
LVTS balances. These banks will meet on the overnight market and the rate of interest on which
they will agree to borrow or lend will be the overnight interest rate. All bank payments involving
a client come to a close at 6:00 pm, with banks being given an additional half hour to interact one
last time on the overnight market, lending their remaining positive balances or borrowing from
other banks when they are in a debit LVTS position. Hence each individual bank is able to bring
its LVTS balances to zero, thus avoiding having to take overnight advances from the central bank
at the Bank rate or avoiding depositing its positive LVTS balances for the night at the Bank of
Canada, as was described in the example of Table 13 of Chapter 12.
It follows that, whatever the size of GDP or the size of daily transactions, under normal
circumstances, bank deposits at the Bank of Canada are zero or very close to zero, while
advances by the Bank of Canada are also zero or next to zero. This can be verified with a look at
Figures 3 and 4, which show the evolution of overnight bank deposits at the central bank and
overnight advances taken by banks at the Bank of Canada. The magnitude of these deposits and
advances, a few dozen million dollars on average with a few spikes in the hundreds of millions,
is dwarfed by the size of daily transactions through the LVTS – more than $165 billions, and the
size of monetary aggregates such as M2 – over $750 billions! These few dozen millions are
peanuts when measured by the scale of the Canadian monetary system, and hence can be
considered as being virtually equal to zero. Actually, to “grease” the wheels of the payment
system, the Bank of Canada purposefully targets an amount of $25 million in positive settlement
balances as of 2007. A banking officer that lets this amount as an overnight deposit at the Bank
of Canada, instead of lending it in the interbank market, foregoes about $175 in interest!
Figure 3:
Bank Deposits at the Bank of Canada
Source: Statistics Canada, series v36629, weekly series
Figure 4:
Bank of Canada Advances to Banks
Source: Statistics Canada, series v36634, weekly series
What would be abnormal or unusual circumstances? A well-known instance occurred
when the World Trade Centre in the financial centre of New York was subjected to two airplane
attacks on September 11, 2001. The Bank of Canada, along with other central banks, made it
clear that it would alleviate any fear of financial disruption by providing the monetary system
with the additional liquidity that was being demanded by the banks and other financial
institutions. For more than a week, the Bank of Canada set settlement balances at levels of
several hundreds of million dollars. This was done with appropriate government deposit shifting
actions. These settlement balances were then gradually brought back to zero. Technical factors
have also forced occasionally the Bank of Canada to set settlement balances at negative levels in
2006 and 2007.
In other words, the Canadian monetary system is such that the overall demand for
settlement balances is usually zero, so that the Bank of Canada sets the supply of settlement
balances to zero in normal circumstances. In the case of 9/11, there was a temporary large
demand for settlement balances, which induced the Bank of Canada to set the supply of
settlement balances much above zero, equal to this overall demand, so as to keep the overnight
interest rate on target. In addition, we have already pointed out that currency is provided to the
banks on demand. Thus, if we designate the sum of currency and bank deposits at the central
bank by the term base money, we can say that there is a horizontal supply of base money, at the
target overnight interest rate. Whenever the demand for base money increases, so does the supply
of base money. This is illustrated in Figure 5, under the standard assumption that the demand for
base money is downward sloping (the interest rate being a measure of the opportunity cost of
holding coins or banknotes – the higher the interest rate, the less base money one wishes to hold).
If there is a shift in the demand for base money, from D0D0 to D1D1, the supply of base money
will accommodate at the target overnight interest rate.
Sidebar:
Base money is made up of two components of the liability side of the balance sheet of the central
bank: currency and deposits at the central bank (which used to be called bank reserves).
Figure 5
The Demand for and the Supply of Base Money
Box
The Evolution of the Canadian Monetary System
The Canadian monetary system that we describe in this chapter is relatively new. It was fully
implemented only in February 1999, when the Large Value Transfer System became operational.
As pointed out in Chapter 12, page 238, prior to 1994, Canadian banks were under a legal
requirement to hold deposits at the Bank of Canada that were not remunerated, called reserves.
These reserves had to be a certain percentage of the deposits held by the public in banks.
Reserves had a dual role: in theory they provided banks with the means to face a bank run; in
practice they were said to help the control of monetary aggregates.
Discussions on the possibility of implementing Canadian monetary policy with highly
reduced reserves and even no reserves at all started in September 1987. A first step towards this
process was implemented in 1991, when restrictions on the frequency and size of Bank of
Canada advances to banks (with the appropriate collateral) were lifted. Compulsory reserve
requirements were also progressively phased out over a three year period, until they were
completely eliminated in mid-1994. The focus of monetary policy moved away from the
Treasury bill rate – the interest rate on short-term (mainly 90-day) government securities –
towards the overnight rate. The 50 basis points operating band for the overnight rate of Figure 1
was put in place in 1994, and in 1996 the Bank rate was disconnected from the Treasury bill rate,
and set instead at the upper end of the operating band, to provide more clarity as to the intentions
of the Bank.
A second round of discussions took place in 1995, when the present system, dealing with
electronic large-value payments, was designed. As noted above, the LVTS was implemented in
1999. An official target overnight rate was put in place, as the rate to be found at the midpoint of
the operating band, thus completing the corridor system that had been started in 1994. And
finally, in late 2000, the Bank of Canada moved to a system whereby possible changes in the
target overnight rate are announced at eight annual preset dates, the so-called fixed
announcement dates.
Nearly identical corridor systems with no reserve requirements exist in New Zealand,
Australia, England and Sweden, but not yet in the United States or in the European Monetary
System with its European Central Bank.
{End of Box}
Box
What Happens to our Cheques?
Both the description of the clearing and settlement system and the discussion about monetary
policy implementation were conducted as if all payments went through the LVTS. But what
about the cheques for $100 or $200 that we make to other individuals or to various merchants,
the payments that we make with our debit cards, and the direct deposits that we receive when we
are on the payroll of some firm or of the university? What happens to these small value
payments? These payments go through another clearing and settlement system, called the
Automated Clearing Settlement System (ACSS), the participants of which are nearly the same as
those of the LVTS. But although most transactions occur through the ACSS, the value of these
transactions now only represents about 10 percent of total clearing aggregates.
The ACSS functions under rules that are similar to, but yet different from, those of the
LVTS. Banks in a negative ACSS position at the end of the day are charged the target overnight
rate, and those in a positive ACSS position receive the target overnight rate. Settlement occurs on
the day following clearing, with banks in a debit ACSS position making a LVTS payment that
incorporates the interest cost being charged. However, ACSS transactions involving the federal
government must be presented before 3 p.m. each afternoon, so that their settlement occurs on
the same day, also by a LVTS payment. Thus all net public sector payment flows end up as
residual balances in the LVTS. As a result, the Bank of Canada has full information on its own
overall net balance position when it proceeds to its final cash setting operation, in the late
afternoon, and can thus bring to zero the amount of settlement balances. For this reason, the
LVTS remains the sole focus of monetary policy operations.
The Canadian Payments Association plans to introduce electronic images of cheques in
2008, with paper cheques being scanned and cleared on an electronic support, in an effort to
improve efficiency of the payment system.
Yellow Square
Open Market Operations and Buyback Operations
The Bank of Canada can make use of another operational instrument when unusual
circumstances arise. This instrument is called open-market operations. In contrast to the
American monetary system, in the Canadian monetary system open market operations never
played a key role, being mainly a supporting instrument, most of the adjustment being carried by
government deposit shifting.
SIDEBAR:
Open market operations refer to the sale or purchase of government securities by the Bank of
Canada through transactions in the open market.
Open-market operations traditionally involve the sale or the purchase of government
securities by the central bank. The counterparty to this transaction could be a bank or a nonfinancial firm, but most often it involves a government securities distributor, called a primary
dealer. When the central bank purchases securities on the open market it adds settlement balances
to the monetary system. When the central bank sells securities it drains settlement balances out of
the system. The bookkeeping of such open market operations is shown in Tables 9 and 10, where
for simplicity it is assumed that a bank is the counterparty. Table 9 illustrates the central bank
purchase of securities. The Bank of Montreal receives a payment inflow when it sells the
securities to the central bank, thus obtaining LVTS balances. The Bank of Canada thus adds
$100,000 worth of settlement balances to the system. Reciprocally, Table 10 shows what happens
when the central bank sells some of its securities to the Bank of Montreal. This bank makes a
payment outflow to purchase the securities, thus losing $100,000 in LVTS balances. The net
amount of LVTS balances held by banks is thus reduced by this same amount, meaning that the
Bank of Canada has reduced settlement balances to the tune of $100,000.
Table 9
Effects of a Central Bank Open Market Purchase of Securities on the Intraday Balance
Sheet of Banks and that of the Bank of Canada
Bank of Montreal
Assets
Liabilities
Canadian Government
Securities
-$100,000
Bank of Canada
Assets
Canadian
Government
Securities
Liabilities
+$100,000
LVTS balances
-$100,000
LVTS balances
+$100,000
Table 10
Effects of a Central Bank Open Market Sale of Securities on the Intraday Balance Sheet of
Banks and that of the Bank of Canada
Bank of Montreal
Assets
Canadian Government
Securities
+$100,000
LVTS balances
-$100,000
Liabilities
Bank of Canada
Assets
Canadian Government
Securities
-$100,000
LVTS balances
+$100,000
Liabilities
What is the impact of such operations on the overnight interest rate? When the central
bank purchases securities on the open market, it increases the net amount of settlement balances
in the system. This will tend to push down the overnight interest rate since some banks will wind
up with positive LVTS balances that they will be unable to lend on the overnight market, being
forced to deposit them at the end of the day on their account at the Bank of Canada. In symmetry,
central bank sales on the open market decrease the net amount of settlement balances and hence
pushes up the overnight interest rate, as some banks will be forced to take advances from the
Bank of Canada at the Bank rate.
Since 1995, the Bank of Canada no longer pursues outright open market operations.
Instead it only pursues buyback operations, which were introduced in 1985. The Bank of
Canada sells or purchases government securities, but with the promise to reverse the transaction
on the next day, at a predetermined price. In Canada, when the central bank purchases securities
for one day, this is called a Special Purchase and Resale Agreement (SPRA), or specials. This
instrument gives much more flexibility to the Bank of Canada because the settlement balances
which are added to the system are removed automatically the next day, when the resale provision
kicks in. Similarly, when the Bank of Canada sells securities for one day – an operation
designated as a Sale and Repurchase Agreement (SRA), or reverses – settlement balances are
removed from the system for one day, being added back automatically on the next day when the
repurchase provision takes effect. The buyback operations, because they are repurchase
operations, are called repos. This gives rise to the repo market, which is the third component
(besides the interbank and the wholesale deposit markets) of the overnight market, since the
purchase operations are usually reversed on the very next day.
SIDEBAR:
Buyback operations are sales of securities that are accompanied by promises to repurchase the
securities at a predetermined price, on a specific day, usually the next day. They occur on a
segment of the overnight market, called the repo market.
Nowadays the Bank of Canada uses buyback operations when it is unhappy with the
evolution of the overnight interest rate, as determined in the repo market, relative to the target
overnight rate. Banks transact with each other and with other financial entities on the overnight
market all day long, on the basis of their current LVTS balance positions, and not only when they
know for certain what their final LVTS balance position will be. When the overnight rate (more
precisely the repo rate) is trading above the target rate, the Bank of Canada might intervene on
the repo market, typically a bit before noon, conducting SPRAs at the target overnight rate, thus
inducing banks and other repo market participants to bring the overnight rate back to its target.
By contrast, when the overnight rate is trading below the target rate, the Bank of Canada can
intervene with SRAs at the target overnight rate, thus inducing banks to negotiate the overnight
rate around the target overnight rate. The effects of these operations are usually quite immediate.
{In red} Central bank open-market purchases of securities and SPRA interventions on the repo
market increase the amount of settlement balances and tend to decrease the overnight interest
rate. Central bank open-market sales of securities and SRA interventions on the repo market
decrease the amount of settlement balances and tend to increase the overnight interest rate. {END
of RED}
In late afternoon, when the bank decides on the amount of government deposits to be
shifted, the buyback operations will be taken into account and neutralized. For instance, if
liquidity has been inserted into the system through SPRA operations, more liquidity will be
removed than otherwise would have been the case, as more government deposits will be shifted
back to the central bank, unless the Bank of Canada is still unsatisfied about the actual overnight
rate relative to its target.
Yellow Square
Standing Facilities and the Role of Lender of Last Resort
Standing facilities are now a key element of all monetary systems that rely on a corridor
framework, as is the case in Canada. Standing facilities are defined as monetary operations
involving the central bank that banks can use at their discretion at any moment. Standing
facilities are divided into borrowing facilities and deposit facilities. We have already encountered
several instances of standing facilities within the Canadian monetary system in this chapter. First,
during the day, a net debit LVTS position constitutes a form of borrowing facilities, although it
only involves the Bank of Canada indirectly, as the holder of the pledged collateral.
SIDEBAR:
Standing facilities are routine monetary operations involving the central bank that banks can use
at their discretion at any moment. Standing facilities include borrowing facilities and deposit
facilities.
Secondly, as we have also seen, at the end of the day, when the overnight market closes at
6:30 pm and settlement occurs, any remaining negative LVTS balances gets transformed into an
overnight loan – an advance – by the Bank of Canada. This is done without restrictions, at the
Bank rate, as long as the borrowing bank has adequate collateral. By contrast, in some countries,
taking advances from the central bank is highly discouraged, as it was in Canada until 1991.
Thirdly, also at the end of the day, banks that still have positive LVTS balances can deposit them
on their account at the Bank of Canada, earning the interest rate on deposits at the central bank.
This thus constitutes a classic example of deposit facility. Banks that, for any reason and at their
discretion, do not wish to lend to other banks or to a specific bank on the overnight market, can
still earn interest on the LVTS balances that they have left over.
Standing facilities are the oldest of the central bank instruments. Open market operations
were introduced much later, with most central banks in the world relying on standing facilities
rather than on open market operations. At the beginning of central banking, banks brought
commercial bills, that is, promises by a company to pay a given amount, say $10,000 in three
months, to the central bank. The banks would then get an amount smaller than the nominal value
of the bill from the central bank, say $9,900, immediately, with the central bank getting the full
$10,000 three months later. The bill was thus being discounted, with the discount rate here being
1 percent ($100/$10,000) for three months, or 4 percent per annum. As a result, advances by
central banks came to be known as discount facilities, or the discount window. This is why the
interest rate on central bank advances to banks – the Bank rate – is still known in many countries
as the discount rate.
In addition to its standing facilities, the Bank of Canada offers an additional access to
borrowing, which is tied to its role of lender of last resort. One of the roles of the Bank of Canada
is to prevent financial panics and to avoid the spread of bank defaults, where the failure of one
bank would generate the failure of another bank, with a domino effect. As we saw in Chapter 12,
various rules and controls have been put in place in the LVTS, so that a defaulting or a failing
bank should not jeopardize the health of the rest of the banking industry. In that event, the Bank
of Canada would seize the collateral pledged by the failing bank, and would provide the funds
needed for settlement. In the unlikely event that two large banks would fail simultaneously, the
Bank of Canada might be obliged to supply more funds to the LVTS system than the value of the
collateral, thus acting as the lender of last resort.
The Bank of Canada may also act as a lender of last resort in another situation. An
otherwise solvent bank may be subjected to a bank run, where depositors all wish to turn their
deposits into cash or wish to transfer their deposits to another institution. In such a case it may
difficult for the bank to respond to such a change of mind without selling some of its assets,
many of which may be non-marketable and difficult to sell without enduring large losses. To
prevent a liquidity problem from turning into a solvency problem, the Bank of Canada may
decide to grant loans to this bank at the Bank rate, for a maximum term to maturity of six
months, and this would be called an Emergency Lending Assistance (ELA) loan.
Box
The Timetable of Monetary Policy Implementation
All Eastern times
7:00am
Banks set their bilateral credit limits and pledge their collateral.
8:00am
LVTS opens for transactions.
9:00am
On fixed dates, the Bank of Canada announces new target overnight rate.
9:15am
Morning auction of government deposits (early cash setting).
11:45am
Open-market buyback operations by the Bank of Canada, if required.
3:00pm
Last ACSS transaction involving the public sector.
4:00pm
Last LVTS transaction involving the public sector.
4:15pm
Afternoon auction of government deposits (final cash setting).
6:00pm
Last LVTS transaction involving clearing of payment.
6:30pm
End of pre-settlement period; closing of the overnight market.
8:00pm
Calculations of LVTS balances are final and banks are advised of their settlement
position (deposits at, and advances from, the Bank of Canada).
{END OF BOX}