Publications and Research

Winter 2004-2005

The Bank of Canada as Lender of Last Resort

Fred Daniel, Walter Engert, and Dinah Maclean,¹ Department of Monetary and Financial Analysis

• The Bank of Canada's lender-of-last-resort role includes the routine provision of liquidity to facilitate settlement in the payments system as well as the provision of liquidity in more exceptional situations.
• Following an internal review, the Bank published the policies governing its lender-of-last-resort activities in the Financial System Review (December 2004).
• The publication of its lender-of-last-resort policies promotes greater transparency and accountability for the Bank in this area.
• This article provides an overview of the Bank's lender-of-last-resort role.

The role of lender of last resort (LLR) is common to central banks around the world; nevertheless, central banks operate under different frameworks in conducting their LLR activities. These differences reflect various country-specific factors, such as historical experience, public policy objectives, the structure of the domestic financial system and the payments system, the prudential supervisory framework, and the laws that govern the central bank and various domestic financial institutions.

In Canada, the Bank of Canada is the ultimate provider of Canadian-dollar liquidity to the financial system. The ability to undertake this function derives from the Bank of Canada Act (BOC Act), which gives the Bank the unique capacity to create Canadian-dollar claims on the central bank and the power to make secured loans or advances to chartered banks and other members of the Canadian Payments Association (CPA). The Bank of Canada has distinct roles as lender of last resort.

• In its day-to-day operations, the Bank supplies overnight credit on a routine basis through the Standing Liquidity Facility (SLF) to direct participants in the Large Value Transfer System (LVTS). This virtually automatic provision of liquidity provides assurance to all participants in the system that they will be able to cover temporary shortfalls in settlement balances that can arise in the daily settlement of payments. The Bank's SLF arrangement contributes to the safe and efficient operation of the LVTS, which is Canada's systemically important payments system.
• The Bank can provide Emergency Lending Assistance (ELA) to deposit-taking institutions (DTIs) that are judged to be solvent and which require more substantial and prolonged credit. ELA is intended to overcome a particular type of market failure associated with DTIs that have a significant share of their liabilities as deposits (fixed-value promises to pay, redeemable at very short notice) and hold assets that are generally illiquid (e.g., commercial loans). DTIs can be vulnerable to sudden, large-scale redemptions of deposits that can lead to insolvency because a DTI's illiquid assets can be sold quickly only at substantial discounts. The purpose of the Bank's ELA is to prevent the failure of a DTI that is illiquid but solvent.

While the Bank's SLF and ELA arrangements are traditional LLR functions, the Bank can also provide liquidity in the following circumstance:

• In the rare situation where the Governor of the Bank of Canada is of the opinion that there is a severe and unusual stress on a financial market or financial system, the BoC Act allows the Bank to be a supplier of liquidity by purchasing a wide variety of securities issued by Canadian or foreign entities, including non-financial firms. The Bank would undertake such transactions for the purpose of promoting the stability of the Canadian financial system.²

The Bank of Canada has recently completed a comprehensive review of its LLR activities. Several developments over the past few years motivated this review. These developments include the expansion in 2002 of the types of institutions eligible to become members of the CPA and, thus, able to participate directly in the payments system; new international linkages, in particular, the entry of foreign bank branches into Canada in 1999; greater sensitivity to the potential need by Canadian institutions for foreign currency liquidity (this concern was particularly evident in the lead-up to the year 2000); changes in the supervisory framework for federally regulated financial institutions; and, more generally, the view that it would be timely to examine the Bank's LLR regime in the context of the Bank's role of promoting financial stability.

In this article, the policy framework that guides the Bank of Canada's LLR function is discussed, as are the key issues associated with the Bank's SLF and ELA activities.³ These include the terms and conditions of both arrangements, access and eligibility provisions, and the Bank's management of ELA lending. This is followed by a discussion of foreign currency ELA. We also consider the relationship between SLF and ELA, and discuss systemic risk and Bank of Canada intervention. We conclude by discussing the potential provision of liquidity to major clearing and settlement systems.

The Bank of Canada provides services to certain payment, clearing, and settlement systems and their participants.⁴ As part of its activities as lender of last resort, the Bank supplies liquidity via its SLF to direct participants in the LVTS, which is a real-time, electronic funds-transfer system that processes large-value and time-sensitive payments with finality throughout the day. The LVTS is a systemically important payments system, i.e., a system that because of the size or nature of the payments it processes can trigger or transmit serious shocks across domestic financial systems or markets.⁵ The LVTS is owned and operated by the CPA.

Under its SLF arrangements, the Bank provides collateralized overnight loans to direct participants in the LVTS that experience temporary shortfalls in their settlement balances. These routine loans provide participants with a reliable source of liquidity should they need to fund their end-of-day payment obligations. In the absence of the Bank's SLF, it is not clear that alternative arrangements could provide a reliable source of liquidity in all circumstances. And, in those circumstances where alternative arrangements might work, they would be more expensive requiring, for example, that participants hold larger precautionary balances at the central bank. Thus, the Bank's SLF contributes to a payments system that is safe and efficient. In turn, the LVTS is used by other parts of the Canadian financial system and the economy more generally to make large-value or time-sensitive payments in a safe and efficient manner.

Canada's other payments system is the Automated Clearing Settlement System (ACSS). The ACSS is also owned and operated by the CPA and is used for payments not handled by the LVTS, such as paper cheques, automated bill payments, and debit-card transactions. With the introduction of next-day settlement in the ACSS in November 2003, the Bank's SLF is no longer required for the normal operation of the ACSS. Under the new system, direct clearers in the ACSS know the amount of their net ACSS settlement positions in the morning after items are entered into the clearing process. Those participants with negative clearing balances make an LVTS payment to their ACSS subaccount at the Bank of Canada; previously, those participants would have taken an ACSS overdraft loan from the Bank.⁶

Terms and conditions of the SLF

The terms and conditions associated with the Bank's SLF are set out in "Bank of Canada Rules Governing Advances to Financial Institutions."⁷ The terms and conditions for borrowing under SLF are set so as to encourage LVTS participants to use the interbank market to fund end-of-day payment obligations. The interest rate charged by the Bank on overnight loans (called the Bank Rate) is set at 25 basis points above the Bank's target for the overnight rate, which is the average interest rate that the Bank wants to see in the marketplace for overnight (one-day) loans between financial institutions.⁸ This encourages direct participants in the LVTS to reduce any net deficit payment positions by undertaking interbank transactions in the "pre-settlement period" at the end of the LVTS day; in effect, there is a cost incentive for participants to obtain the liquidity that they need from the market, rather than from the central bank. In practice, end-of-day advances extended by the Bank to participants in the LVTS tend to be relatively small.⁹

All loans provided under the Bank's SLF are made on a secured basis. The collateral eligible to secure credit from the SLF is the same as that eligible for intraday credit in the LVTS. These securities are valued at market value less an appropriate margin, or "haircut," to protect the Bank from market risk. This is the risk that the collateral may decline in market value and result in insufficient proceeds to cover the amount loaned in the extremely unlikely event of the borrower failing. The framework that the Bank uses to determine the appropriate margins focuses on broad categories or classes of issuers. These categories are securities issued by the Government of Canada, securities guaranteed by the federal government, provincial bonds, provincial-guaranteed bonds, and private sector debt obligations (further segregated by credit rating). Margins are larger for less-creditworthy categories and longer maturities.¹⁰

Access to Bank of Canada settlement accounts and the SLF

The CPA's bylaws require direct participants in the LVTS and the ACSS to be members of the CPA and to maintain settlement accounts at the Bank of Canada. Prior to the coming into force of the Canadian Payments Act in 2001,¹¹ membership in the CPA included all banks operating in Canada, trust and loan companies, credit union centrals and federations of caisses populaires, and other DTIs. At that time, it was the Bank of Canada's practice to provide settlement accounts and, concurrently, access to its SLF arrangements, to any deposit-taking financial institution that met the CPA's criteria for direct participation in the LVTS or the ACSS.¹² Subsequently, the Canadian Payments Act expanded the types of financial institutions eligible to join the CPA to include life insurance companies, securities dealers, and money market mutual funds. With more diverse types of institutions now eligible for CPA membership, the Bank has reexamined the conditions for providing access to settlement accounts and its SLF arrangements to institutions. (To date, no firm from any class of institution that is newly eligible for CPA membership has applied to become a member of the CPA and, consequently, none has applied to become a direct participant in the LVTS or ACSS.)

The various classes of financial institutions eligible for CPA membership, and therefore able to hold settlement accounts at the Bank, are subject to different bankruptcy laws and regulatory regimes. Accordingly, for some classes of institutions, the Bank probably would not be able to recover funds from any unsecured portion of a loan in the event of default. To reduce this risk, the Bank may therefore use haircuts on collateral that vary for different classes of borrowing institution, or may set different restrictions on the quantities of corporate securities that can be pledged by different classes of institutions.

The Bank decides on a case-by-case basis whether to provide a particular institution access to a settlement account and access to its SLF arrangements. In general, access would be given to an institution that is a member in the CPA on condition that the institution:

• participates directly in the LVTS or the ACSS;
• in the case of ACSS direct clearers, settles all net ACSS positions with LVTS payments credited to its ACSS settlement account at the Bank of Canada;
• provides the Bank with valid and enforceable first-priority security in collateral of a type that is acceptable to the Bank;
• provides acceptable legal documentation to support the Bank's security interest in pledged collateral; and
• accepts the collateral terms and conditions that may be set by the Bank, which take into account varying exposures to credit risk across different types of institutions.

Upon receiving an application for a settlement facility, the Bank would notify the institution's regulator that the institution intends to open a settlement account. For a federally regulated financial institution, it is expected that such notification would be provided as a matter of course through the Financial Institutions Supervisory Committee (FISC). (See Box 1 for a discussion of the FISC.)

The Bank of Canada's Emergency Lending Assistance

The purpose and objectives of ELA

The classical lender-of-last resort doctrine was developed during the nineteenth century. The original concept of LLR concerns the actions taken, often by the central bank, in a period of financial stress in order to preserve the liquidity of the financial system. The most common application of LLR theory involves sudden, unexpected withdrawals by a large number of depositors (i.e., a run) at an individual bank or, more generally, at a deposit-taking institution (DTI). Currently, measures taken by the central bank to address such circumstances are associated with its ELA role.

The rationale for the central bank to supply ELA in such situations is based on the idea that a DTI, because of the nature of its activities, is vulnerable to a sudden loss of depositor confidence. A DTI uses liquid, fixedvalue deposits (liabilities) to fund illiquid, longer-term loans (assets). The liquidity and maturity mismatch between the assets and liabilities on its balance sheet is a significant source of the valuable role played by DTIs. In undertaking this activity, a DTI relies on depositors in aggregate to not withdraw more than a fraction of their funds at any given time. However, an institution that loses market confidence can be faced with a run and might be unable to raise replacement funds at or near their usual rates of interest, even though the institution is solvent. This can lead to the insolvency of the institution because a DTI's illiquid assets can be sold quickly only if they are subject to substantial discounts. It is this market failure—a sudden, large-scale withdrawal of liquidity from a solvent DTI—that is addressed by the provision of ELA by the central bank.

The interbank market, in such situations, may not always function efficiently because interbank participants might have access to incomplete information, with the possibility that doubts could arise about the solvency of an institution that is in fact sound. Additionally, in times of stress, the interbank market may become more cautious. Lenders might be reluctant to take on risks that they would normally accept, as incomplete information leaves them uncertain about the nature of the risks involved in interbank lending. Another situation that can lead to the inefficient functioning of the interbank market occurs when lending institutions become concerned that their own sources of liquidity may be less reliable than usual. In these circumstances, banks may reduce the volume of funds that they lend in the interbank market, setting up a situation of self-fulfilling expectations.

Some classes of financial institutions that are not DTIs issue deposit-like instruments and other claims. As a practical matter, the challenge is judging the point at which these instruments are a sufficiently important source of funding, and assets are sufficiently illiquid, such that these classes of institutions would be considered vulnerable to the kind of market failure described above. More generally, for a number of reasons, it is also increasingly unlikely that DTIs will experience this kind of market failure. (The Bank has used ELA only rarely—it has not provided ELA to any institution since the mid-1980s; see Box 2.) For example, assets of DTIs are becoming more liquid with increased opportunities for securitizing or selling loans on secondary markets. Changes in the regulatory environment at the federal level have also decreased the probability of a run occurring. These changes include the establishment of a clear mandate for the Office of the Superintendent of Financial Institutions (OSFI) that focuses on protecting the interests of depositors and other creditors, and giving OSFI and the CDIC the authority and obligation to act promptly with regard to troubled institutions.

The terms and conditions attached to ELA serve a dual function: they provide the Bank with protection against credit and legal risks in situations where such risks may be greater than normal; and they promote the view that the Bank is the lender of last resort, rather than the lender of preferred resort, thus dealing in part with concerns about moral hazard. (See Box 3 for a discussion of moral hazard.) In other words, institutions should not draw on ELA for routine liquidity management. While specific terms and conditions attached to ELA would be contained in the individual loan agreement established between the Bank and the borrowing institution, the following describes the general considerations that would apply.

Term to maturity: Under the BoC Act, the Bank is permitted to provide loans with a term to maturity not exceeding six months. The loans can be renewed for further periods, up to six months each. In practice, it would be expected that an ELA loan agreement between the Bank and the borrowing institution would provide for a one-day revolving facility in which the Bank would have the discretion to decline to make any further one-day loans.

Rate of interest: Under the BOC Act, the minimum interest rate that the Bank can charge on ELA is the Bank Rate. While the Bank has discretion to charge a higher interest rate if it sees fit, in its limited experience with ELA situations, the Bank has charged the Bank Rate.

Collateral: Under its statutes, the Bank is required to lend on a secured basis. The Bank is willing to take a broader range of collateral for ELA than it accepts for credit under the SLF. In practice, it would be expected that the borrowing institution would use its holdings of marketable securities to obtain liquidity from the private sector before approaching the Bank for ELA. If appropriate, the Bank could provide ELA loans on the pledge or hypothecation of assets that are not subject to as precise a valuation as are readily marketable securities. For example, the Bank may provide loans against the security of the Canadian-dollar non-mortgage loan portfolio of the institution, which can make up a significant portion of the institution's assets.¹³ Because the composition of a loan portfolio changes over time and the valuation of individual loans is subject to fluctuation, the Bank would likely take as security a floating charge against the institution's loan portfolio. The provision of ELA loans initially would likely constitute only a small fraction of the assessed value of the institution's loan portfolio but could rise over time, subject to an upper limit that the Bank would set, which would depend on the nature of the portfolio.

Eligibility criteria for ELA

The Bank's ELA and SLF have different objectives, and it therefore follows that different types of financial institutions would be eligible for each of these arrangements. In addition, the risks faced by the Bank are greater under ELA than under SLF. In the case of SLF, access is a routine part of an institution's operations in the payments system; there is no presumption of a protracted liquidity problem or solvency risk; and the loans are secured by high-quality, liquid assets. In contrast, ELA situations are complex; they are typically characterized by protracted liquidity problems; there are solvency concerns evidenced by the inability of the financial institution to raise the needed funds from the private sector; and the collateral used to secure ELA is typically illiquid and difficult to value.

As a result of the significant risk inherent in ELA situations, the following considerations are important for the Bank:

• ELA is used to address a particular market failure, described above, that can occur because of the liquidity and maturity differences between the assets and liabilities held by certain types of financial institutions in their normal course of business. The Bank provides ELA only to classes of institutions that are vulnerable to this market failure.
• The availability of ELA should not encourage excessive risk-taking by financial institutions. To minimize moral-hazard concerns and to avoid impairing the interests of unsecured creditors of the institution, it is the Bank's policy to provide ELA only to those institutions that are judged to be solvent. ELA does not—and could not—correct the capital problems of an insolvent institution: while ELA enables an institution to pay its liabilities as they come due, it does not create new capital for an insolvent institution, and thus it does not remedy the negative net worth of an institution. Any decision to make a capital injection in an insolvent firm would be a matter for private investors or, in extremely rare circumstances, public authorities. Therefore, as part of the Bank's due diligence, it is important for the Bank to have timely and accurate judgments on solvency for any institution requesting or using ELA. The Bank relies primarily on the institution's prudential supervisor to provide judgments on solvency.
• Since the Bank relies primarily on prudential supervisors for judgments on solvency and, if necessary, for remedial measures and collaboration on work-out strategies, a sound supervisory framework is critical for ELA decisions and ELA management. Such a framework would include a clear supervisory mandate, adequate supervisory authority, and a program of early intervention in troubled institutions. In the absence of such a framework, and without information-sharing protocols and a close working relationship between the Bank and the supervisory agency, it would be difficult for the Bank to obtain timely and accurate judgments on solvency. Finally, a strong supervisory framework mitigates incentives for supervisors to delay dealing with a problem institution; such forbearance could shift risks to the Bank.
• The BOC Act requires the Bank to lend on a secured basis, and the Bank endeavours to minimize its exposure to loss in the event of default by the borrowing financial institution. Thus, it is important for the Bank to have a valid first-priority security interest in any collateral pledged to support ELA.

The above considerations have the following implications for the eligibility of various classes of institutions for ELA:

• Federally incorporated banks (including foreign bank subsidiaries) and federally incorporated trust and loan corporations would be eligible for ELA.¹⁴ These firms are susceptible to the relevant market failure referred to above. The Bank can be confident of receiving timely and accurate information regarding the solvency of these institutions from the federal supervisor. And the federal supervisory regime provides a reliable means to establish remedial measures and to implement work-out strategies. The CDIC can also act as a provider of liquidity to its member institutions (both federal and provincial) through purchases of assets, and loans or advances (with or without security).¹⁵
• Insurance companies, mutual funds, and investment dealers would not be eligible for ELA, since they do not issue deposits and hold a significant share of their assets in illiquid, hard-to-value claims. However, see the section on "Systemic Risk and Bank of Canada Intervention."
• Credit union locals and caisses populaires would not generally be eligible for ELA. In most cases, these institutions have access to provincial centrals, the Corporation de Fonds de Sécurité de la Confédération Desjardins (CFSCD), or the Credit Union Central of Canada (CUCC) for liquidity assistance. As well, very few credit union locals or caisses populaires are members of the CPA.
• In the case of an extraordinary, widespread event that would have significant, adverse consequences for a provincial credit union/caisse populaire system, the Bank would consider providing ELA through the CUCC, a provincial central, the Caisse centrale Desjardins, or the Fédération des caisses Desjardins, as appropriate, provided that legal arrangements satisfactory to the Bank were established by these entities.¹⁶
• With regard to foreign bank branches, in a prospective ELA situation, it could be difficult to receive timely and accurate information on solvency from foreign supervisors, and to successfully manage the conflicts in incentives faced by the relevant supervisors when interacting with the Bank in such cases. There can also be legal complications and risks with regard to establishing a security interest for the Bank in some of the assets of these institutions in an ELA situation. Accordingly, foreign bank branches would not normally be eligible for ELA. Nevertheless, in very exceptional circumstances where the home central bank was unable to lend for a day or two for operational reasons (e.g., if it was a statutory holiday in the country of the home central bank), the Bank of Canada could provide interim lending for a very brief period, typically against collateral that would be eligible for credit through the SLF.

The above discussion sets out various conditions for the provision of Bank of Canada ELA. Other central banks, for a variety of reasons, operate under different frameworks in conducting their lender-of-last-resort function. For a brief discussion of some of these differences, see Box 4.

The management of ELA with respect to financial institutions subject to federal regulation would be in close collaboration with OSFI and other members of the FISC. In the event that ELA is provided to an institution, the Bank would immediately confirm such lending with the FISC. The FISC would serve as the primary forum for the exchange of information and coordination of strategies of member agencies regarding an institution receiving ELA. When providing ELA, the Bank would request the FISC, or a subcommittee of the FISC, to meet at least weekly to consider the situation. An institution using ELA would be required to provide a business plan to OSFI that outlined remedial measures to rectify its liquidity problems, and to provide increased reporting (data and other information) on its evolving situation. In addition, the FISC would coordinate contingency planning, including possible private sector solutions, as well as alternative work-out arrangements. While the repayment of SLF loans is routine, terminating ELA is likely to be more complicated. If all goes well, the management of ELA would focus on normalizing the institution's position in the market, or facilitating a merger of the institution, such that ELA could be expeditiously withdrawn.

• The Bank's Financial System Committee (FSC)¹⁷ would meet immediately and then at least weekly to review any ongoing ELA, formally reconsider the borrowing institution's solvency and the appropriateness of continuing to provide ELA, as well as the limits on lending to the institution.
• If it was felt necessary, the Bank could hire a third-party agent to perform an examination of the financial condition of the institution.
• The ELA loan agreements between the Bank and the borrowing institution would create a one-day, revolving facility in which the Bank would have discretion to decline to make any further one-day loans. This would allow the Bank to readily cease ELA if it judged that the borrowing institution was insolvent, or that the available collateral to support ELA was at a higher risk of being inadequate.
• The Bank would cease ELA when this was judged by the Bank to be appropriate, most notably, when the institution was judged by the Bank to be insolvent, on the basis of information received from OSFI and possibly from third-party agents, or when available collateral was inadequate to support further ELA.
• If the Bank became aware of a borrowing institution's insolvency or pending insolvency, it would refrain from taking any new collateral as security for outstanding advances made when the institution was still solvent. At the same time, the FISC would be working to implement an orderly work-out.

For some Canadian financial institutions, foreign currency liquidity is important. This is illustrated by the fact that assets and liabilities denominated in foreign currency represent about 40 per cent, respectively, of Canadian banks' aggregate assets and liabilities on their balance sheet, with a very large proportion of this denominated in U.S. dollars. This reflects the importance of Canada's trade activities, and the presence of Canadian banks in the global economy. Canadian banks have often sought growth opportunities outside the country, particularly in the United States, and some Canadian banks have adopted business strategies that focus on North America.

For the Bank, providing liquidity support in a foreign currency is considerably more difficult than providing Canadian-dollar ELA: while the Bank can create liquidity in Canadian dollars, it cannot do so in foreign currencies. This reinforces the importance for Canadian financial institutions to have in place a sound framework for the management of foreign currency liquidity risks, and to establish reliable arrangements for private sector liquidity support in foreign currencies relevant to their business. Such liquidity arrangements should provide adequate diversification in the potential sources of foreign currency liquidity funding as well as contingency planning. In addition, where possible, Canadian financial institutions should arrange access through foreign central banks to liquidity facilities in those currencies important to their business.

Provided that the institution qualified for ELA, the Bank could lend Canadian dollars on a collateralized basis to the illiquid institution which, in turn, could purchase the needed foreign currency in the market with those Canadian dollars.

The Bank's SLF is used to address a temporary maldistribution of liquidity among direct participants in the payments system. In contrast, the Bank's ELA deals with fundamental and potentially persistent liquidity problems where the institution is denied liquidity by market participants, typically because of credit concerns. In practice, it might not always be immediately known to the central bank whether an institution requesting SLF loans needs the liquidity for its payment activities or whether the institution is experiencing liquidity problems of a more persistent nature. Indeed, for reputational reasons, it might be expected that a troubled institution would initially use SLF on a frequent or repeated basis, rather than request ELA from the central bank. Thus, it is important for the Bank, as well as the supervisory authority, to know whether an institution is using SLF as a substitute for ELA, and whether the institution is being denied access to market liquidity for reasons related to solvency concerns, for example.

The Bank would rely on various signs to indicate whether an institution is using SLF as a substitute for ELA:

• The Bank's market intelligence might detect that the institution is being forced to pay higher interest rate spreads to raise funds in the money market.
• There might be a steady increase in the amount of the institution's SLF borrowing, indicating that the institution could be experiencing a net outflow of deposits and the withdrawal of funds by creditors. The amount borrowed under the SLF by the institution could also increase significantly relative to the size of its balance sheet.
• There could be a noticeable reduction in the bilateral credit lines granted to the institution in the LVTS. This could indicate that market participants are reducing their potential exposure to the institution because of credit concerns.
• The institution could have difficulty providing sufficient collateral that is eligible for the Bank's SLF. If the institution ran out of eligible collateral for SLF, it would be forced to request ELA, which can be secured by a broader range of assets.

OSFI is also an important source of information in determining whether an institution is using SLF as a substitute for ELA. In the course of monitoring and examining the institution, OSFI could discover that the financial health of the institution has deteriorated and that the risk of protracted liquidity problems has increased. OSFI is responsible for sharing this type of information with the FISC.

In the event that the Bank identifies a situation where a financial institution is making use of SLF for ELA-type borrowing, the following would apply:

• If the institution were considered to be eligible for ELA, the Bank would initiate internal processes for managing ELA activity, would require the institution to sign additional ELA legal documentation, and would request that appropriate actions be conducted at the FISC.
• For other LVTS participants that are not considered to be eligible for ELA, upon identifying ELA-type borrowing, the Bank would indicate to the financial institution that additional borrowing based on a broader range of collateral would not be granted, and the Bank would contact the institution's regulator. The Bank would deny access to additional liquidity once the institution had exhausted its SLF-eligible collateral.

In 1997, an amendment was made to the BOC Act (paragraph 18 (g.1)) such that "if the Governor is of the opinion that there is a severe or unusual stress on a financial market or financial system," the Bank can purchase a wide variety of securities issued by Canadian or foreign entities, including non-financial firms. The BOC Act specifies that such transactions are "for the purpose of promoting the stability of the Canadian financial system." In effect, the Bank can use this authority to provide liquidity to a broad range of financial and non-financial institutions when the Governor of the Bank judges that such transactions are justified to safeguard the safety and soundness of Canada's financial system. This does not include more general liquidity provided through the Bank's monetary policy actions or at times of stress in the financial system (see Box 5).

To promote transparency and accountability, if the Bank undertakes such transactions, Section 19 of the BOC Act requires the Bank to publish a notice in the Canada Gazette stating that "the Governor has formed an opinion that there is a severe and unusual stress on a financial market or financial system. The notice is to be published as soon as the Governor is of the opinion that its publication will not materially contribute to the stress to which the notice relates." In addition, the Bank would be expected to fully disclose and justify these transactions in its public statements, including its Annual Report.

If problems in a financial institution not eligible for ELA under the above policy (but a CPA member) could, in the Bank's judgment, lead to severe and unusual stress on a financial market or financial system, then the Bank may choose to make a liquidity loan instead of making purchases or undertaking repos under paragraph 18 (g.1).

The powers given to the Bank under paragraph 18 (g.1) of the BOC Act are intended to be used only in very exceptional circumstances. The Bank has never entered into any transactions under this provision of the BOC Act.

In the event that an LVTS participant defaults, the-Bank of Canada could be obliged (under LVTS bylaws) to knowingly lend to an insolvent institution, on the basis of collateral pledged earlier.¹⁸ More specifically, the Bank would be obliged to lend to the defaulting institution on the day of failure against previously pledged collateral to settle that member's obligations to other participants in the LVTS, and so protect against systemic risk.

In the extremely unlikely event of the failure of more than one LVTS participant on the same day during LVTS operating hours, where the sum of the exposures of the failed participants exceeds the value of all the collateral pledged in the system, the Bank of Canada guarantees settlement of the LVTS.¹⁹ In this event, the Bank could be obliged to lend to a failed institution, on a partially unsecured basis, to ensure settlement of the LVTS and so protect against systemic risk.

As noted, the likelihood of this scenario is extremely remote, and the fact that participants pledge collateral sufficient to cover the single largest possible default provides a large element of co-insurance (a deductible) that provides strong incentives for LVTS participants to manage their risks prudently in the system.

Finally, under the provisions of the Payment Clearing and Settlement Act, the Bank of Canada has the power to make liquidity loans to the clearinghouse or central counterparty of a clearing and settlement system designated for oversight by the Bank.

Bank of Canada. 2004. "Bank of Canada Lender-of-Last-Resort Policies." Financial System Review (December).

Dingle, J. 1998. "The LVTS—Canada's Large-Value Transfer System." Bank of Canada Review (Autumn): 39–55.

Goodlet, C. 1997. "Clearing and Settlement Systems and the Bank of Canada." Bank of Canada Review (Autumn): 49–64.

———. 2001. "Core Principles for Systemically Important Payments Systems and Their Application in Canada." Bank of Canada Review (Spring): 19–31.

Howard, D. 1998. "A Primer on the Implementation of Monetary Policy in the LVTS Environment." Bank of Canada Review (Autumn): 57–66 (revised December 2002).

Northcott, C.A. 2002. "Systemic Risk, Designation, and the ACSS." Financial System Review (December).

Tuer, E. 2003. "Technical Note: Elimination of Retroactive Settlement in the ACSS." Bank of Canada Review (Autumn): 39–42.