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Avoiding Collateral Damage

Collateral and the Bank of Canada’s ELA Framework

David Longworth*Bank of CanadaPresentation at Norges Bank Conference on Banking Crisis Resolution16 June 2005

* The assistance of Walter Engert is gratefully acknowledged

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Overview

Introduction: "Avoiding Collateral Damage" Two types of lender-of-last resort loans Avoiding inappropriate emergency lending

assistance Appropriate justification; solvency; appropriate framework

Avoiding damage to unsecured creditors, BoC Collateral; haircuts; loan portfolio

Conclusions

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Introduction

Bank of Canada recently reviewed its LLR policy

One aim was to be more transparent Another aim was to spell out what LLR can

do And what it can’t do

One wants LLR lending to be appropriate And to “Avoid Collateral Damage“ of an

inappropriate policy

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Two types of LLR

Standing liquidity facility (SLF) and emergency lending assistance (ELA)

SLF is routine, and facilitates settlement This presentation is about ELA

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Avoiding inappropriate ELA (1) Need appropriate justification for eligibility BoC justification: market failure related to a

“deposit-taking” institution (DTI) Relies on liquid, fixed-value deposits to fund illiquid assets

(If large DTI involved, could also be systemic) Difficult to assess such a market failure Such market failure seems increasingly unlikely Indeed, BofC ELA has been rare

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Avoiding inappropriate ELA (2) BoC policy: ELA is for solvent DTIs

Minimizes moral hazard Avoids impairing interests of unsecured creditors Recognizes that ELA cannot correct capital

deficiencies of insolvent DTIs Public-sector capital investment in a failed DTI is a fiscal

matter, requiring government decision and accountability

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Avoiding inappropriate ELA (3) Have an appropriate framework for dealing with

other safety-net agencies Rely primarily on supervisor for solvency judgement,

collaborate on remedial measures and work-out Sound safety net framework is critical

Clear supervisory mandate Adequate supervisory powers Structured, early intervention Bank can provide input into process and decisions

Financial Institutions Supervisory Committee Good working relationships among safety net agencies Bank can compel inspections, including by third parties

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Avoiding damage to creditors, BoC (1) Collateral supports policy of lending to

solvent institutions Requires Bank to assess borrower’s assets,

encourages due diligence Avoids impairing interests of unsecured creditors

Collateral protects the Bank Security required by law ELA situations are complex and high-risk

Protracted liquidity problems, doubts about solvency

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Avoiding damage to creditors, BoC (2) Must be appropriate haircuts for collateral

Based on market data for marketable securities In ELA situation, such securities would be gone

Bank would take a broader range of collateral for ELA than for SLF Provide ELA loans against security of discounted

Canadian-dollar loan portfolio

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Avoiding damage to creditors, BoC (3) Take as security a floating charge against the

borrower’s loan portfolio ELA loans would be a fraction of assessed value

of loan portfolio Fraction could rise over time Subject to an upper limit set by the Bank, would

depend on the nature of the portfolio

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Conclusions

Lend only to solvent institutions Otherwise, capital injection from government

Take collateral With appropriate haircuts Of all kinds, in ELA situation

Ensure that inspections undertaken To support solvency judgment

Establish framework to co-operate with other safety-net agencies

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For more…

The Bank has recently completed a comprehensive review of its LLR policies Bank of Canada, “Bank of Canada Lender-of-Last-Resort

Policies.” Bank of Canada Financial System Review. December 2004.

F. Daniel, W. Engert and D. Maclean, “The Bank of Canada as Lender of Last Resort.” Bank of Canada Review. Winter 2004-2005.

On safety net arrangements more generally, W. Engert, “On the Evolution of the Financial Safety Net.” Bank of Canada Financial System Review, June 2005.