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Canada’s banking regulator and central bank announced a suite of measures to encourage banks to keep lending and to increase liquidity in key parts of the financial system that are at risk of seizing up amid extreme market volatility.

The extraordinary measures came in tandem with an unscheduled Bank of Canada rate cut of half a percentage point – the second in just 10 days – and promises from the federal government for aggressive fiscal stimulus, as officials race to stabilize Canada’s economy in the midst of a global pandemic.

The Office of the Superintendent of Financial Institutions said it was easing capital reserve requirements for large banks by cutting their domestic stability buffer by 1.25 per cent. This could free up an additional $300-billion worth of lending capacity, OSFI superintendent Jeremy Rudin said at a joint press conference in Ottawa. He said OSFI will not raise the stability buffer for 18 months, and may cut it further.

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“OSFI expects that banks will use the additional lending capacity to support Canadian businesses and households, and should not use this measure to increase distributions to shareholders or employees or to undertake share buybacks,” the regulator said in a statement after the announcement.

At the same time, Bank of Canada Governor Stephen Poloz announced additional measures to improve liquidity for a key part of the financial market by agreeing to buy banker’s acceptances from financial institutions. Banker’s acceptances are a kind of bank draft commonly used by small and mid-sized businesses, which also trade on secondary markets.

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“This was a necessary step to support short-term funding markets," Toronto Dominion Bank analyst Andrew Kelvin said in a note following the announcement. "The [banker’s acceptance] market was freezing up and dealers were having a hard time moving inventory.”

The moves were announced one day after the Bank of Canada agreed to pump additional liquidity into the financial system by expanding its bond buyback program and introducing new “repo operations,” in which it buys securities from Canada’s large banks on a short-term basis to increase cash in the financial system.

“Many of these measures are positioned so the banking system continues to work,” Mr. Poloz said. “If the banking system continues to work well and people are able to tap their credit lines uninterrupted to get them through this, then I think we will have achieved a major buffering action.”

The Bank of Canada could introduce additional policy tools if credit channels “get clogged,” he added.

“If the funding markets for banks get a little choppy -- they’ve been a little choppy, but they could get tighter -- then we’re in a position to help them with that," Mr. Poloz said. As an example, he said, the central bank could start accepting parts of their mortgage book as collateral. "This was a capability we didn’t have back in 2008.”

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The additional breathing space the regulator offered to banks by lowering the domestic stability buffer will be welcomed by the banking industry, but it may not be particularly effective as policy tool, according to Barclays analyst John Aiken.

“While the easing of the [domestic stability buffer] could potentially encourage additional lending, we believe that it will be used more as a relief valve for the banks given uncertainty about the level of internally generated capital going forward and the potential erosion to capital from losses or spikes in risk-weighted assets,” he said in a note to clients on Friday.

In addition, the buffer cut won’t offset additional pain for banks of Friday’s additional rate cut, he said. When central banks cut rates, banks have to lower the rates they charge on loans, crimping profit margins.

“As the clouds gather, we find it increasingly difficult to see how the banks, insurers, asset managers and diversified financials will be able to generate earnings growth,” Mr. Aiken said.

In a note released before the announcements, BofA Merrill Lynch analyst Ebrahim Poonawala suggested that Canada’s five largest banks could see their earnings per share drop by as much as 40 per cent in the coming quarters if Canada falls into recession, due to a combination of lower rates and higher loan losses.

On a positive note for the banking industry, Mr. Poloz said that he was unlikely to resort to negative interest rates.

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"I don’t think I’m alone among central bankers; we don’t like the idea that much. It’s in the tool kit … [but] it’s not a happy place for the banking system,” he said. "The idea of negative interest rates is something we can put up on the shelf, and know that it’s there, but it’s very unlikely to be needed.”'

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