Where do the Bank of Canada’s profits come from?
The Bank of Canada, like all other central banks, is generally a very profitable business. Its profits come from the issuance of money, called seigniorage rights, a right that belongs exclusively to central banks. The Bank of Canada also receives interest income on the federal government debt securities it purchases. These revenues, minus the interest paid on the reserves of the commercial banks it hosts, are sufficient to pay its operating expenses and they generate surpluses year after year which are paid to the federal government. These profits reach approximately $1 billion annually.
How can a central bank lose money?
The short answer is the quantitative easing that the Bank of Canada has done to reduce the impact of the pandemic on the Canadian economy, explains David Dupuis, economist and professor at the University of Sherbrooke.
Like the other central banks, the Bank of Canada massively bought federal government debt securities to put oil in the engine of the economy. Its balance sheet thus increased from 120 billion to 575 billion in the space of 12 months. The bank has stopped these purchases, but still has 415 billion dollars worth of securities which pay a very low interest rate, while it must remunerate the reserves deposited by commercial banks at the key rate, a rate which has increased rapidly. and which today reaches 3.75%.
The central bank’s interest income is therefore lower than its interest expenditure, hence the appearance of a deficit, the first in its history.
It’s unheard of, but the Bank of Canada is not the only one to post losses this year. The US Federal Reserve and the Central Bank of Australia, among others, are in the same situation.
Does that mean the Bank of Canada has done too much to stimulate the economy?
It is not in the balance sheet of the central bank that we can see whether there has been too much or not enough quantitative easing, but rather in inflation, specifies David Dupuis. The increase in the inflation rate is the combined result of monetary policy and federal government relief measures, but also of external factors such as supply chain issues and the war in Ukraine. Canada is one of the countries that has actually had the most to reduce the impact of the pandemic on the economy, and some of the inflation is certainly attributable to fiscal and monetary policies. These policies have also enabled a rapid recovery of the economy, underlines the professor.
When will profits return?
The Bank of Canada ended quantitative easing and began trimming its Government of Canada bond portfolio in October 2021. Since then, its balance sheet has shrunk by 28%, from $575 billion to $415 billion. The bank’s financial situation should improve as this balance sheet becomes thinner, which could take a few years.
“The Bank will experience losses for a period and then return to positive net gains,” Governor Tiff Macklem told the House of Commons Finance Committee on Wednesday.
The losses could reach 5 billion, according to the figures which circulate, but which the central bank does not confirm. The magnitude of those losses will depend on the path of interest rates and how the economy develops, the governor said.
“If inflation continues to subside and rates stop rising, it could take two years to return to profits,” said Steve Ambler, David Dodge Chair in Monetary Policy at the CD Howe Institute and professor at the University of Quebec in Montreal.
How will these deficits be filled?
The deficit does not change the functioning of the central bank. As it has never happened before, a solution will have to be found to absorb the losses, the time that its balance sheet normalizes. One of the solutions considered would be for the shareholder of the central bank, the federal government, to simply write a check to the central bank. According to Steve Ambler, this solution could give the impression that the federal government is coming to the rescue of the central bank and that it can thus influence monetary policy. “It wouldn’t be, but you have to think about appearances,” he observes.
In order not to damage the credibility of the central bank, a better solution would be to allow the Bank of Canada to create a deferral account for its losses, which would allow it to reimburse its deficit when profits are back, above all payment to the government.
An amendment to the Bank of Canada Act would be necessary to create such an account, believes Steve Amber who, with two colleagues, details this avenue in a publication of the CD Howe Institute.