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January 12, 2023 – Cumulative losses at the Bank of Canada could reach between $3.6 billion and $8.8 billion over the next two to three years, according to a new report from the C.D. Howe Institute.

In “Reversal of Fortunes: Rising Interest Rates and Losses at the Bank of Canada,” authors Trevor Tombe and Yu (Sonja) Chen examine the state of central bank’s finances, how it got into a loss position and how big those losses could be. 

The Bank is currently responding to high inflation by increasing its policy interest rate. Having expanded its balance sheet by buying government bonds and increasing its liabilities to the financial institutions it bought them from, the Bank now faces growing interest expenses and multi-billion-dollar losses.

Here’s why. With bonds purchased from financial institutions, the payments were overwhelmingly added to the institutions’ deposits, or settlement balances, at the Bank of Canada – dramatically increasing the Bank’s interest-bearing deposits.

“While future inflation and monetary policy remains uncertain, the existence of financial institutions’ large deposits at the Bank of Canada means rising interest rates causes large losses for the Bank — a first in Canadian history,” says Tombe.

Starting with Q3 2022 financial statements, the authors project forward the Bank’s assets, liabilities, and policy rates. “Our projection suggests Bank losses may continue until late 2024 or 2025, with peak losses in Q1 2023,” says Chen. “Our preferred estimate of $5.7 billion in losses reflects the scenario where non-interest deposits absorb one-third of the bond maturities. The faster settlement balances decline, the smaller the Bank’s financial losses will be.”

Notably, the actual path the Bank of Canada will face will change with market conditions as well as monetary policy decisions, such as the size and composition of asset purchases or changes in target for the overnight rate. For instance, if the peak target rate is 5 percent rather than the authors’ assumed 4.5, then losses rise from $5.7 billion to $7 billion. As well, regarding the decision to cease interest payments on Government of Canada deposits in May 2022 was very significant, as Tombe and Chen estimate losses would otherwise have been approximately $13 billion.

Despite these short-term losses, the Bank’s long-run financial position remains sound, and Tombe and Chen’s projections show a return to positive net income within two to three years in all scenarios, although policy choices or economic developments may affect this timeline.

“Over the longer-term beyond these projections, since the yield on government bonds will normally exceed the deposit rate, and a substantial portion of Bank asset holdings are funded with currency in circulation, which pays no interest, financial losses by the Bank are unlikely,” explains Tombe.

While these losses do not affect the Bank of Canada’s ability to conduct monetary policy, they do create new reputational and communications challenges – especially at a time of heightened political attention towards monetary policy. Additionally, as the Bank is wholly owned by the federal government and surpluses add to government revenues, financial losses mean its remittances to the government are likely to cease for some time and losses will be directly reflected on the government’s financial statements as lower federal revenues.

Although Canada’s approach to handling cash losses at the Bank is still in development, the authors discuss several options. These range from accumulating losses in a negative retained earnings account, as the Bank is currently doing, to allowing for negative values within the Bank’s reserve fund. The best option may be to follow the approach of the U.S. Federal Reserve, which is accumulating losses in a deferred account that prevents the central bank’s capital from turning negative.

“Whatever the eventual details, a better understanding of central bank finances in Canada among policymakers, researchers and the public is necessary,” conclude Tombe and Chen.

Read the Full Report

For more information contact: Trevor Tombe, Professor of Economics, University of Calgary, and Research Fellow, The School of Public Policy, University of Calgary; Yu (Sonja) Chen, Assistant Professor of Economics, University of Calgary; and Lauren Malyk, Communications Officer, C.D. Howe Institute, 416-865-1904 Ext. 0247, lmalyk@cdhowe.org

The C.D. Howe Institute is an independent not-for-profit research institute whose mission is to raise living standards by fostering economically sound public policies. Widely considered to be Canada's most influential think tank, the Institute is a trusted source of essential policy intelligence, distinguished by research that is nonpartisan, evidence-based and subject to definitive expert review.