How does the Bank of Canada’s balance sheet affect the banking system? | Techy Kings

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The COVID‑19 pandemic is causing severe stress in the fixed income market. In response, in April 2020, the Bank of Canada launched a Government of Canada (GoC) bond purchase program. Initially, the program focused on restoring market function in the GoC bond market. In July 2020, the focus shifted to providing additional monetary stimulus through quantitative easing (QE).

Under QE, the Bank buys government bonds in exchange for settlement balances and, as a result, its balance sheet expands., Settlement balances (or reserves) are deposits held by major Canadian banks at the Bank (Chu et al. 2022).

The Bank’s quantitative tightening (QT) program, which begins in April 2022, is the opposite process. Through QT, the Bank allows its GoC bond holdings to mature and stop reinvesting principal and coupon repayments. As a result, the Bank’s balance sheet will shrink over time.

In this note, we explain how both QE and QT affect the Bank’s balance sheet and the Canadian banking system as a whole. We show that the direct impact on the size, composition and liquidity of the banking system’s balance sheet during QE and QT depends on who sells (during QE) or buys (during QT) GoC bonds in the financial system—banks or non-bank participants (such as home, business or investment fund). During QT, the impact will be greater if non-bank participants replace Banks as marginal buyers of GoC bonds. This is the most likely scenario given that historically, non-bank participants have held a significant share of the GoC bond market. Also, during QE, the Bank mainly replaced these entities in terms of GoC holdings.

This analysis focuses exclusively on the mechanical effects of QE and QT. Other factors that can affect the size and composition of commercial banks’ balance sheets, including natural growth in bank deposits, loan growth and changes in the level of government bond issuance, remain constant.

The Bank’s footprint in the government bond market will shrink as quantitative tightening takes place

The Bank holds a total of about $430 billion of GoC bonds before it ends QE and enters the reinvestment phase in November 2021. During this period, the Bank roughly maintained its GoC bond holdings (Chart 1). QT, launched in April 2022, begins to reduce GoC bond holdings on the Bank’s balance sheet by not replacing maturing GoC bonds. As a result, the size of the Bank’s balance sheet will decrease over time in a predictable manner.

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