11.2 The Canadian Banking System

Question 1

What is a Central bank?

Answer 1

Central bank

A bank that acts as banker to the commercial banking system and often to the government as well. Usually a government-owned institution that is the sole money-issuing authority.

Question 2

What are Financial intermediaries?

Answer 2

Financial intermediaries are privately owned institutions that serve the general public. They are called intermediaries because they stand between savers, from whom they accept deposits, and borrowers, to whom they make loans.

Question 3

What do we use the term commercial bank to mean in this book?

Answer 3

In this book, we use the term commercial banks to extend to all financial intermediaries that accept deposits and create deposit money, including chartered banks, trust companies, credit unions, and caisses populaires.

Question 4

Brief history of central banks.

Answer 4

Many of the world’s early central banks were initially private, profit-making institutions that provided services to ordinary banks. Their importance, however, caused them to develop close ties with government. Central banks soon became instruments of the government, though not all of them were publicly owned.

Question 5

When did The Bank of Canada commence its operations?

Answer 5

The Bank of Canada commenced operations on March 11, 1935.

Question 6

What kind of corporation is the Bank of Canada?

Answer 6

It is a Crown corporation; all profits it earns are remitted to the Government of Canada.

Question 7

Who is responsible for the affairs of the Bank of Canada?

Answer 7

The responsibility for the Bank’s affairs rests with a board of directors composed of the governor, the senior deputy governor, the deputy minister of finance, and 12 directors.

Question 8

How is the governor appointed?

Answer 8

The governor is appointed by the directors, with the approval of the federal cabinet, for a seven-year term.

Question 9

What is the intended design of the organization of the Bank of Canada?

Answer 9

The organization of the Bank of Canada is designed to keep the operation of monetary policy free from day-to-day political influence.

Question 10

Discribe the relationship between The Bank of Canada and Parliament? What is “joint responsibility”?

Answer 10

The Bank is not responsible to Parliament for its day-to-day behaviour in the way that the department of finance is for the operation of fiscal policy. In this sense, the Bank of Canada has considerable autonomy in the way it carries out monetary policy.

But the Bank is not completely independent. The ultimate responsibility for the Bank’s actions rests with the government, since it is the government that must answer to Parliament. This system is known as “joint responsibility,” and it dates back to 1967.

Question 11

Who two positions consult regularly under the system of joint responsibility?

Answer 11

Under the system of joint responsibility, the governor of the Bank and the deputy minister of finance consult regularly.

Question 12

What is an explicit directive?

Answer 12

In the case of fundamental disagreement over monetary policy, the minister of finance has the option of issuing an explicit directive to the governor and announcing this decision publicly.

Question 13

What would happen between the governor and the minister of finance in the ouccurence of an explicit directive?

Answer 13

In such a case (which has not happened since the inception of joint responsibility), the governor would simply carry out the minister’s directive or ignore the directive and resign. In the absence of such a directive, however, responsibility for monetary policy rests with the governor of the Bank.

Question 14

What is the purpose of the system of joint responsibility?

Answer 14

The system of joint responsibility keeps the conduct of monetary policy free from day-to-day political influence while ensuring that the government retains ultimate responsibility for monetary policy.

Question 15

What are the three main functions of a central bank?

Answer 15

-A banker for commercial banks
-A bank for the government
-The regulator of the nation’s money supply.

Question 16

Table of the Assets and Liabilities of the Bank of Canada

Answer 16

Question 17

What does the balance sheet of the Bank of Canada show us?

Answer 17

The balance sheet of the Bank of Canada shows that it serves as banker to the commercial banks and to the government of Canada, and as issuer of our currency; it also suggests the Bank’s role as regulator of the money supply.

Question 18

What are the principal liabilites of the Bank of Canada?

Answer 18

The principal liabilities of the Bank are the basis of the money supply.

Question 19

What are Bank of Canada notes and what do the deposits of the commercial banks give them?

Answer 19

Bank of Canada notes are currency, and the deposits of the commercial banks give them the reserves they need to create deposit money.

Question 20

What do the Bank of Canadas holdings of Government of Canada securities arise from?

Answer 20

The Bank’s holdings of Government of Canada securities arise from its operations designed to regulate the money supply.

Question 21

How does the Bank of Canada provide the commerical banks with the means of settling debts to other banks?

Answer 21

The central bank accepts deposits from commercial banks and will, on order, transfer them to the account of another bank. In this way, the central bank provides the commercial banks with the means of settling debts to other banks.

Question 22

Are cash reserves of commercial banks deposited with the central banks liabilities or assets to the central bank?

Answer 22

Notice that the cash reserves of the commercial banks deposited with the central bank are liabilities of the central bank, because it promises to pay them on demand.

Question 23

What is one of the earliest services provided by central banks?

Answer 23

Historically, one of the earliest services provided by central banks was that of “lender of last resort” to the banking system. Central banks would lend money to private banks that had sound investments (such as business loans, home mortgages, and government securities) but were in urgent need of cash.

Question 24

What would happen if banks could not obtain ready cash?

Answer 24

If such banks could not obtain ready cash, they might be forced into insolvency, because they could not meet the demands of their depositors, in spite of their being basically sound.

Question 25

What was The Bank of Canadas response to the 2008 financial crisis?

Answer 25

At that time, commercial banks around the world dramatically reduced their interbank lending after the failure of some large U.S. and U.K. financial institutions.

The reduction in lending reflected heightened uncertainty regarding the credit-worthiness of all commercial banks. In response, the Bank of Canada took unprecedented actions designed to keep credit flowing as normally as possible in Canada, including the significant provision of short-term loans to Canadian financial institutions.

Question 26

Where does the Government keep their money?

Answer 26

Governments, too, need to hold their funds in an account into which they can make deposits and on which they can write cheques or make electronic transfers. The Government of Canada keeps some of its chequing deposits at the Bank of Canada. In December 2019, the federal government had $21.8 billion in deposits at the Bank of Canada (an unusally large amount).

Question 27

What is the money supply? What is a very general measure of the money supply?

Answer 27

One of the most important functions of a central bank is to regulate the money supply. Though we have not yet defined the money supply precisely—and there are several different definitions of the money supply that we will encounter—we will see that most measures of the money supply include currency in circulation plus deposits held at commercial banks.

Question 28

What are the vast majorities of the Bank of Canada’s liabilities?

Answer 28

The vast majority of the Bank of Canada’s liabilities (that is, its promises to pay) are the currency in circulation or the reserves of the commercial banks.

These reserves, in turn, underlie the deposits of households and firms—in exactly the same way that in much earlier times the goldsmith’s holdings of gold underlay its issue of notes.

Question 29

How can the Bank of canada change the amount of its liabilities? What is it’s most important asset?

Answer 29

You may be wondering how the Bank of Canada can change the amount of its liabilities—especially the currency in circulation or the reserves of the commercial banks.

The answer relates to the most important assets of the Bank—its holding of Government of Canada securities.

Question 30

What does the government do when it requires more money then it collects in tax revenues?

Answer 30

When the federal government requires more money than it collects in tax revenues, it needs to borrow, and it does this by issuing new government securities—either short-term Treasury bills or longer-term bonds.

The government then sells these newly issued securities directly to financial institutions or institutional investors (who purchase them to have low-risk assets in their portfolios).

Question 31

During normal times how much government securitires does the BoC typically purchase over the course of one year?

Answer 31

During normal times, the Bank of Canada enters the financial markets and purchases a small amount of government securities, typically purchasing about $5 billion over the course of one year.

Question 32

How does the Bank purchase securities?

Answer 32

It does so by crediting the account (at the Bank of Canada) of the financial institution from which it purchased the asset. The result of this transaction is that the Bank’s assets and liabilities both increase by exactly the same amount.

Question 33

“For what reason would the Bank decide to purchase these assets?”

Answer 33

The answer is fairly detailed and lies at the heart of the Bank of Canada’s conduct of monetary policy.

But for now, simply note that the Bank’s purchases (or sales) of government securities are directly related with the expansion (or contraction) of the amount of money in the banking system.

Question 34

What was the Government of Canada’s and the BoC’s responce to the Pandemic?

Answer 34

Beginning early in 2020, with the need to shut down large parts of the economy to prevent the spread of the highly contagious virus, the Government of Canada issued a massive amount of new securities to finance an enormous increase in government spending—much of which was used to provide financial relief to unemployed workers and businesses whose revenues had collapsed.

The Bank of Canada played an important role by purchasing a large amount of these newly issued securities, thereby expanding the amount of money in the banking system.

Question 35

What was the increase in the BoC’s total assets and liabilties as a result of the pandemic?

Answer 35

The Bank’s total assets (and liabilities) increased from $122 billion in January of 2020 to $560 billion by the end of that year—an increase of about 360 percent (whereas a normal year sees an increase of more like 5 percent).

Question 36

How much did the deposits of the BoC and the GoC increase during 2020 in reponse to the pandemic?

Answer 36

During that same year, the amount of currency in circulation was approximately stable at about $100 billion, but the deposits of commercial banks increased by about $350 billion and the Government of Canada’s deposits increased by about $75 billion.

Question 37

When do most economits expect the BoC’s balance sheet to return to a more normal situation?

Answer 37

With the arrival of vaccines in early 2021 and the swift recovery of the economy that followed, most economists expected the Bank of Canada’s balance sheet to return to a more normal situation by late 2022 or 2023.

Question 38

What isa Commercial Bank?

Answer 38

Commercial banks

A privately owned, profit-seeking institution that provides a variety of financial services, such as accepting deposits from customers and providing loans, mortgages, and other financial products.

Question 39

What are the common attributes of Commercial banks?

Answer 39

-They hold deposits for their customers

-They permit certain deposits to be transferred electronically or by cheque from an individual account to other accounts in the same or other banks

-They purchase and hold government securities (short-term Treasury bills and longer-term bonds)

-They make loans to households and firms

-They often divide these loans into small pieces and re-package them into securities, each of which contains a diversified collection of many pieces from the original loans—a process called securitization.

Question 40

What is securitization?

Answer 40

They often divide these loans into small pieces and re-package them into securities, each of which contains a diversified collection of many pieces from the original loans—a process called securitization.

Question 41

What are some other financial institutions?

Answer 41

Many other privately owned, profit-seeking institutions, such as

-trust companies and credit unions, accept deposits and grant loans for specific purposes.

-Retail stores and credit-card companies also extend credit so that purchases can be made on a buy-now, pay-later basis.

Question 42

What is the most important role played by commercial banks?

Answer 42

From the perspective of the overall economy, the most important role played by commercial banks is that of financial intermediary.

Question 43

How do commercial banks act as essential intermediaries in the credit market?

Answer 43

By accepting their deposits, banks borrow from households and firms that have money they do not currently need.

And they provide credit by lending to those households and firms that need credit to achieve their objectives.

They therefore act as essential intermediaries in the credit market.

Question 44

What do households often require credit for?

Answer 44

Households often require credit to make large purchases, such as home appliances and cars, and they almost always use credit in the form of a mortgage when they buy a house. Without easy access to credit, most of these household purchases would either be delayed by many years or impossible altogether.

Question 45

Why do firms often require credit?

Answer 45

-Firms often need to pay their workers and pay for their inputs before receiving payment for their output.

-In addition, firms often finance their capital investments—purchases of equipment or the construction of facilities—with the use of borrowed money.

Without easy access to credit, many firms would be unable to conduct their normal business operations and, as a result, the level of economic activity would decline.

Question 46

What did the recession in 2008 cause in reguards to credit?

Answer 46

The economic recession that began in the United States in 2008 and quickly spread around the world originated in the failure of some large U.S. and U.K. banks, which in turn led to a reduction in the flow of credit and a rise in interest rates in most advanced countries.

Question 47

What was a central part of the policy reponsce to the 2008 recession?

Answer 47

A central part of the policy response, in Canada and elsewhere, involved taking actions to ensure that banks and other financial institutions were in a position to extend credit in a normal manner.

Question 48

What is a “pool loan”?

Answer 48

Banks often share loans. Even the biggest bank cannot meet all the credit needs of a giant corporation, and often a group of banks will offer a “pool loan,” agreeing on common terms and dividing the loan up into manageable segments.

Question 49

How is the bank credit card an example of interbank cooperation?

Answer 49

Another form of interbank cooperation is the bank credit card. Visa and MasterCard are the two most widely used credit cards, and each is operated by a group of banks.

Question 50

What is the most important form of interbank cooperation?

Answer 50

Probably the most important form of interbank cooperation is cheque clearing and collection, including the clearing of electronic transfers through debit cards and online banking activities.

Question 51

What is the only reason that bank deposits are an effective medium of exchange?

Answer 51

Bank deposits are an effective medium of exchange only because banks accept each other’s cheques and allow funds to be transferred electronically when purchases are made with debit cards and other forms of electronic transfer.

Question 52

What is clearing house?

Answer 52

Clearing house

An institution in which interbank indebtedness, arising from the transfer of cheques between banks, is computed and offset and net amounts owing are calculated.

Question 53

How does clearing house work?

Answer 53

At the end of the day, all the transfers (cheque and electronic) from the Bank of Montreal’s customers for deposit to CIBC are totalled and set against the total of all the transfers from CIBC’s customers for deposit to the Bank of Montreal. It is necessary only to settle the difference between the two sums. Electronic transfers take place immediately, whereas cheques are passed through the clearing house back to the bank on which they were drawn.

Question 54

When is an overall transfer betwen banks necessary?

Answer 54

An overall transfer between banks is necessary only when there is a net transfer from the customers of one bank to those of another. This is accomplished by a daily transfer of deposits held by the commercial banks with the Bank of Canada.

Question 55

What profitable services do commercial banks provide to customers?

Answer 55

-The convenience of deposits that can be transferred by personal cheque, debit card, or online transaction.

-A safe and convenient place to earn a modest but guaranteed return on savings

-Financial advice and wealth-management services.

Question 56

What are the bulk of any pank’s liabilities?

Answer 56

The bulk of any bank’s liabilities are deposits owed to its depositors.

Question 57

What are the principal assets of a bank?

Answer 57

The principal assets of a bank are the securities it owns (including government bonds), which pay interest or dividends, and the interest-earning loans it makes to individuals and to businesses, both in Canada and abroad.

Question 58

Consolidated balance sheet of Canadian Chartered Banks.

Answer 58

Question 59

What fraction of deposit liabilites are reserves?

Answer 59

Reserves are only a tiny fraction of deposit liabilities.

Question 60

What would happen if all the chartered banks’ customers who held demadn and notice deposits tried to withfraw them in cash?

Answer 60

If all the chartered banks’ customers who held demand and notice deposits tried to withdraw them in cash, the banks could not meet this demand without liquidating almost $2 trillion of other assets. This would be impossible without assistance from the Bank of Canada.

Question 61

How do commercial banks attract deposits?

Answer 61

Commercial banks attract deposits by paying interest to depositors and by providing them with services, such as clearing cheques, automated teller machines, debit cards, and online banking.

Question 62

How do banks earn profits?

Answer 62

Banks earn profits by lending and investing money deposited with them for more than they pay their depositors in terms of interest and other services provided.

They also earn profits through the wealth-management and investment services they provide to their customers.

Question 63

How much reserves are needed to ensure that depositors can withdraw their deposits?

Answer 63

The reserves needed to ensure that depositors can withdraw their deposits whenever they like will normally be a tiny fraction of total deposits.

Question 64

What is a bank run?

Answer 64

Bank run

A situation in which many depositors rush to withdraw their money, possibly leading to a bank’s financial collapse.

Question 65

What would banks have to do in the instance of a bank run?

Answer 65

Faced with such a panic, banks would have to close until either they had borrowed enough funds from a willing lender or raised enough cash by “calling in” their loans.

The likelihood of a bank in this situation finding a willing lender is low given its tenuous financial position.

And calling in the bank’s loans is difficult because it involves requiring its borrowers to immediately pay back their loans—money which is tied up in such things as real estate or business enterprises.

In short, a panic that leads to a bank run puts the commercial bank in a very difficult position.

Question 66

How can the Central bank solve the problems that result from a bank run?

Answer 66

The central bank can solve this problem by standing ready to provide all the reserves needed by the commercial banks. It can do this in two ways.

Question 67

What are the two ways that The Central bank can be prepared to assist in the isntance of a bank run?

Answer 67

First, it can lend reserves directly to commercial banks on the security of assets that are sound but not easy to liquidate quickly, such as interest-earning residential or commercial mortgages.

Second, it can enter the open market and buy all the government securities that commercial banks need to sell in order to increase their available cash reserves.

Once the public finds that deposits can be turned into cash at their request, any panic would usually subside and any further drain of cash out of commercial banks would cease.

Question 68

How has the possibility of a bank run in Canada been all but eliminated?

Answer 68

The possibility of a bank run in Canada has been all but eliminated by the provision of deposit insurance by the Canada Deposit Insurance Corporation (CDIC), a federal Crown corporation.

Question 69

What does the CDIC (Canadian deposit insurence corporation) guarantee?

Answer 69

The CDIC guarantees that, in the unlikely event of a bank failure, depositors will get their money back, up to a limit of $100 000 per eligible deposit. Most depositors will not rush to withdraw all of their money as long as they are certain they can get it when they need it.

Question 70

Why do Canadian banks hold reserves against their deposit liabilities?

Answer 70

Canada’s banks hold reserves against their deposit liabilities for the simple reasons that they want to avoid situations in which they cannot satisfy their depositors’ demands for cash, and it is costly for them to borrow from other banks or from the Bank of Canada when they run short of reserves.

Question 71

What can bank resrves be so low?

Answer 71

-Banks know that it is very unlikely that even 2 percent of their total deposits will be withdrawn at any given time.

-Banks know that the Bank of Canada will help them out in time of temporary need.

Question 72

What is a fractional-reserve system?

Answer 72

Fractional-reserve system

A banking system in which commercial banks keep only a fraction of their deposits in cash or on deposit with the central bank.

Question 73

What is a reserve ratio?

Answer 73

Reserve ratio

The fraction of its deposits that a commercial bank actually holds as reserves in the form of cash or deposits with the central bank.

Question 74

What is a target reserve ratio?

Answer 74

Target reserve ratio

The fraction of its deposits that a commercial bank ideally wants to hold as reserves.

Question 75

Are target reserve rations constant over time?

Answer 75

This target reserve ratio will generally not be constant over time. During holiday seasons, for example, banks may choose to hold more reserves because they know, based on past experience, that there will be heavy demands for cash.

Question 76

What are excess reserves?

Answer 76

Excess reserves

Reserves held by a commercial bank in excess of its target reserves.

Question 77

What process must we understand in order tounderstand the “creation” of deposit money?

Answer 77

As we will see next, a bank can expand or contract its portfolio of loans to adjust its actual reserves toward its target level. Understanding this process is the key to understanding the “creation” of deposit money.

Question 78

What two concepts are at the core of any commercial banking system?

Answer 78

At the core of any commercial banking system lies both confidence and risk. Depositors need to have confidence that their money will be safely held and available when they want it; banks need to recognize the risks involved in lending to households, businesses, and even governments.

Question 79

What government regulations are applied to commerical banks in order to mitigate the risk taking aspect of their organizations?

Answer 79

• All Canadian banks are members of the Canadian Deposit Insurance Corporation (CDIC). CDIC is a Crown corporation that uses fees paid by the member banks to provide insurance to depositors against the risk of bank failure.
• Banks are limited in the amount of their assets (loans) that can be financed by customer deposits. Some fraction of their assets must be financed by the financial capital provided by the banks’ owners; this is known as the bank’s required capital ratio. Such restrictions permit the banks’ assets to fall in value by a modest amount, as occasionally happens, without leading to the bank’s insolvency and failure.
• Banks that extend home mortgages to customers are required to purchase mortgage insurance if the value of the loan exceeds 80 percent of the value of the home (i.e., if the borrower’s down payment is less than 20 percent). With such insurance, the bank is protected from loss in the event that the borrower defaults on the loan.

Question 80

Where can the bank purchase mortgage insurance from?

Answer 80

The bank can purchase mortgage insurance from the Canada Mortgage and Housing Corporation (CMHC), a Crown corporation, or from private-sector insurers.