1. 1 Avoiding Collateral Damage Collateral and the Bank of Canada’s ELA Framework David Longworth* Bank of Canada Presentation at Norges Bank Conference on Banking Crisis Resolution 16 June 2005 * The assistance of Walter Engert is gratefully acknowledged

2. 2 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

3. 3 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

4. 4 Two types of LLR Standing liquidity facility (SLF) and emergency lending assistance (ELA) SLF is routine, and facilitates settlement This presentation is about ELA

5. 5 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

6. 6 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

7. 7 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

8. 8 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

9. 9 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

10. 10 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

11. 11 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

12. 12 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.