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PA R T V
Central Banking and the Conduct of Monetary Policy
In addition to its use as a standing liquidity facility to reinforce the operating band
for the overnight interest rate, Bank of Canada lending is also important in pre-
venting financial panics. In fact, one of the Bank s most important roles is to be
the lender of last resort in the Canadian economy.
8
It provides emergency lending
assistance (against eligible collateral) for a maximum period of six months (which
can be extended for periods up to six months as many times as the Bank judges)
to solvent (but illiquid) deposit-taking institutions to prevent bank failures from
spinning further out of control, thereby preventing bank and financial panics. The
rate that the Bank normally charges on these loans is the bank rate, although the
Bank has discretion to charge a higher rate. In providing emergency lending assis-
tance, the Bank always makes a judgement with respect to the trade-off between
morally hazardous behaviour and the costs in terms of financial stability. Last-
resort lending is a particularly effective way to provide reserves to the banking sys-
tem during a banking crisis because reserves are immediately channelled to the
banks that need them most.
Avoiding financial panics by performing the role of lender of last resort is an
extremely important requirement of successful monetary policymaking. As we
demonstrated with our money supply analysis in Chapter 16, the bank panics in
the United States in the 1930 1933 period were the cause of the sharpest decline
in the money supply in U.S. history, which many economists see as the driving
force behind the collapse of the world economy during the Great Depression.
Financial panics can also severely damage the economy because they interfere
with the ability of financial intermediaries and markets to move funds to people
with productive investment opportunities (see Chapter 8).
At first glance, it might appear as though the presence of the CDIC, which
insures depositors from losses due to a bank s failure up to a limit of $100 000 per
account, would make the lender-of-last-resort function of the Bank of Canada
superfluous. (The CDIC is described in detail in Chapter 10.) There are two reasons
why this is not the case. First, it is important to recognize that the CDIC s insurance
fund amounts to a small fraction of the amount of deposits outstanding. If a large
number of bank failures occurred, the CDIC would not be able to cover all the
depositors losses. Indeed, the failures of deposit-based financial institutions in the
1980s and early 1990s in Canada, described in Chapter 10, led to large losses and
a shrinkage in the CDIC s insurance fund, which reduced the CDIC s ability to cover
depositors losses. This fact has not weakened the confidence of small depositors
in the banking system because the Bank of Canada has been ready to stand behind
the banks to provide whatever reserves are needed to prevent bank panics. Second,
the large-denomination deposits in the banking system are not guaranteed by the
CDIC because they exceed the $100 000 limit. A loss of confidence in the banking
system could still lead to runs on banks from the large-denomination depositors,
and bank panics could still occur despite the existence of the CDIC.
The importance of the Bank of Canada s role as lender of last resort is, if any-
thing, more important today because of the bank failures experienced in Canada
in the 1980s and early 1990s. Figure 17-11, which shows Bank of Canada advances
to members of the Canadian Payments Association, reveals that the Bank of
Canada advanced considerable funds in the recent past to financial institutions fac-
ing liquidity crises. Unfortunately, the Bank of Canada s lending policy has not
8
Regarding the policy framework that governs the Bank of Canada s lender-of-last-resort activities, see
Daniel Fred and Walter Engert, The Bank of Canada as Lender of Last Resort,
Bank of Canada Review
(Winter 2004 2005).
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