The Bank of Canada will report its first financial loss in its 87-year history in the coming weeks, a development that risks further denting the central bank’s reputation and inviting more political scrutiny over its purchases of government bonds during the COVID-19 pandemic.
In recent months, the bank’s aggressive push to increase interest rates has created a mismatch on its balance sheet. It is now paying a higher interest rate on its liabilities – mostly deposits by Bay Street banks held at the central bank – than it is earning on its assets. That’s generating net interest losses, which will begin showing up in the bank’s third-quarter financial statements, expected later this month.
The central bank is expecting total losses of between $5-billion and $6-billion over the next few years, spokesperson Paul Badertscher said in an e-mail. “Roughly estimated, the bank should return to positive net interest income sometime in 2024 or 2025,” he added.
The Bank of Canada is not alone. Central banks around the world have begun reporting large losses in recent months as they wind down pandemic-era bond buying programs, while also rapidly raising interest rates to combat high inflation.
Experts don’t expect these losses to impact the conduct of monetary policy. Central banks aren’t motivated by profit and they can’t run out of money like a normal corporation.
But the red ink presents a political predicament and communications challenge for the central bank and federal government.
The Bank of Canada is not allowed to retain its earnings, and it does not have a rainy day reserve fund. That means the Department of Finance needs to decide whether to cover the bank’s losses directly – which could damage perceptions of central bank independence from politics – or come up with some other method that would allow the bank to make up for the losses once it returns to profitability.
At the very least, the bank will stop sending profits to the federal government for several years, potentially costing public coffers something in the range of $1-billion a year, based on the prepandemic average amount of those remittences.
The main beneficiaries of rising interest payments on Bank of Canada liabilities are Bay Street banks, who are now earning much higher rates on their risk-free deposits at the central bank.
The losses are an unintended consequence of the central bank’s quantitative easing (QE) program, a monetary policy tool aimed at holding down interest rates, which caused its balance sheet to balloon during the pandemic.
The bank’s use of QE, which ended in the fall of 2021, has been heavily criticized by some Conservative politicians, who blame it for today’s high inflation. Conservative Party Leader Pierre Poilievre has begun warning of a central bank “bailout.” The losses could fuel further political debate about whether QE is an appropriate central bank tool.
“There’s no theoretical reason for the bank’s monetary policy to change because of these losses,” Jeremy Kronick, director of monetary and financial services research at the C.D. Howe Institute, said in an interview. “But there’s all these kinds of reputational and independence issues that come to the forefront when that happens.”
Other central banks have already begun reporting losses – both net interest losses and direct losses from selling bonds whose value has dropped as interest rates have risen.
In September, the Reserve Bank of Australia recorded an 36.7-billion Australian dollar accounting loss for the year, leaving it with a negative-equity position of 12.4-billion Australian dollars. In October, the British government earmarked more than £11-billion to transfer to the Bank of England, to cover its losses.
This is uncharted territory for the Bank of Canada. Since its founding in 1935, the bank has always generated a profit, which it has remitted each year to the federal government.
In normal times, central bank liabilities consist largely of physical Canadian dollar bank notes, which the Bank of Canada does not pay interest on. On the other side of the ledger, it holds interest-paying assets like government bonds. This set-up was a reliable money-maker. After covering its own expenses, the bank typically sent around $1-billion in annual profit to the federal treasury in the years leading up to the pandemic.
So what changed? Two things: first the size of the bank’s balance sheet, then its benchmark interest rate.
In the spring of 2020, the Bank of Canada began buying massive quantities of government bonds from investors, first to help shore up financial markets, then as part of a QE program aimed at lowering interest rates to stimulate the economy during the pandemic.
It paid for these assets, previously owned by commercial banks and other investors, by creating “settlement balances” – a type of electronic money similar to reserves in other central banking systems. These settlement balances are essentially deposits that belong to commercial banks, and the Bank of Canada pays interest on them equal to its benchmark overnight rate.
These transactions radically transformed the bank’s balance sheet. At first the arrangement was profitable. The bank was bringing in revenue from its expanded bond holdings while only paying 0.25 per cent to commercial banks on their deposits. It made around $4.7-billion in profit over the past two fiscal years, which it sent to the federal government.
However, the calculus changed dramatically as the bank increased its overnight rate to fight inflation. It is now paying an overnight rate of 3.75 per cent on roughly $200-billion worth of settlement balances. Meanwhile, the weighted-average yield of government bonds the bank bought during the pandemic is only 0.65 per cent, according to Mr. Badertscher. That’s a money-losing formula.
Trevor Tombe, an economics professor at the University of Calgary, said these losses should be seen as the fallout from legitimate monetary policy choices. “They are not due to mismanagement or errors in the same way that you would think about losses of a normal corporation,” he said.
Nonetheless, the losses could hurt public confidence in the bank, and they will have an impact on public finances, Prof. Tombe said. “Bank losses don’t require a bailout, but it does mean the federal government will not be receiving remittances for some time.”
Returning to profitability means rebalancing the central bank’s mix of assets and liabilities. That could take some time. If the bank sold its assets outright, it would trigger massive losses totalling some $31-billion, according to its second-quarter financial statements. Bank of Canada Governor Tiff Macklem has said the bank intends to hold bonds to maturity and let the balance sheet shrink over time.
In March, 2020, the government indemnified the bank against any losses it might incur on bond sales. But this indemnity does not cover net interest losses.
Other countries have handled the issue in a variety of ways. In New Zealand, the government is covering the losses directly. In the United States, the Federal Reserve is accounting for its losses by creating a deferred asset that will be paid off over time as the Fed starts making money again.
Neither the Bank of Canada nor the Department of Finance would confirm what options are being considered.
Adrienne Vaupshas, press secretary for Finance Minister Chrystia Freeland, said in a statement that the government would “continue working with the Bank of Canada on the matter of quantitative easing, recognizing the importance of both respecting the independence of the bank and the government’s accountability to Canadians for public finances.”
“Similar conversations are occurring worldwide between governments and central banks, and we will continue to monitor them closely,” she said.