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Bank of Canada: Keeping markets liquid

When the COVID-19 pandemic hit Canada, the Bank acted quickly. We needed to make sure the financial system worked well enough that credit could continue to flow. That meant addressing shortages of liquidity in financial markets—the backbone for lending and borrowing in the economy.

What market liquidity is

Liquidity refers to how quickly or easily you can buy or sell assets.

A good way of assessing liquidity is to look at whether—and how much—an asset’s price needs to be lowered to make a reasonably quick sale.

A house, for example, is a relatively illiquid asset. It takes weeks or months to sell one, and the parties often have to pay high transaction costs such as brokerage fees. Depending on conditions in the housing market, the seller might have to accept a much lower price to complete the sale faster.

Financial assets, such as Government of Canada bonds, are normally much more liquid than houses.

Government of Canada bonds, in fact, are considered to be such a safe investment that the interest rate attached to them helps determine a range of other lending rates.

When safety isn’t enough

Still, sometimes it’s much harder than usual to buy or sell assets even when they are considered safe.

This tends to happen when people who trade assets in financial markets become less certain about the state of the economy.

Heightened uncertainty can cause liquidity in markets to dry up because the people who trade start behaving differently than they would in normal times. Buying and selling either slows quite a bit or it tilts firmly in one direction.

In extreme cases, as with the COVID-19 pandemic, many people in markets may prefer to hold cash instead of even the safest assets. As everyone turns to the safety of cash, the market can’t function as well as it usually would.

Toni Gravelle, Deputy Governor

Why market liquidity is important

Governments and companies borrow all the time to fund things such as social programs or new factories. They do this by issuing debt securities—bonds, treasury bills or commercial paper, for example. These are then traded in markets.

Banks and other financial institutions also borrow money using these markets. They then lend this money to businesses and households.

So, it’s very important for the economy that markets for debt securities function well.

When trading in these markets is strained or stops completely, the whole chain of lending and borrowing that underpins economic activity can break down. Governments and companies, including banks, might find it harder to borrow. And banks and other lenders might pull back on extending credit to households.

Liquidity and COVID-19

Liquidity is particularly important during the COVID-19 pandemic because every corner of the economy is relying on credit to get through these extraordinary times:

  • Governments need a market for their bonds so they can finance the spending that they’re taking on during the crisis, ideally at reasonable borrowing rates.
  • Banks, asset managers and other credit providers rely on liquidity in financial markets so that they can lend and provide wealth-management services to Canadians.
  • Companies need a market for their bonds so they can continue to pay for expenses and operating costs despite huge hits to their revenue. They rely on credit to keep paying employees or to invest in manufacturing capacity so they’re prepared when orders start up again.
  • Households need credit for basic needs, such as buying groceries or paying bills, at a time when many have lost their jobs or have had their hours cut.

If Canadian businesses and households found it more difficult to borrow, the economic impact of COVID-19 would likely be worse—potentially leaving waves of bankruptcies and mortgage defaults.

How the Bank is providing liquidity

Central banks can create liquidity by providing cash in the form of short-term lending to intermediaries, or agents, in the financial system. Central banks can also buy bonds and other debt. This provides companies and governments with cash they can use to pay for such things as salaries or emergency benefits.

Within the first few weeks of COVID-19, we had used all the tools that we had in our tool kit to support market functioning back in the 2007–09 global financial crisis. So, we quickly created a number of new programs.

These actions reinforce the cuts that we made in the Bank’s policy interest rate, which is now at 0.25 percent. That’s the lowest we plan to go for now because moving to zero or below could hinder the markets and intermediaries that we’re trying to support.

Low borrowing costs are most effective when the financial system is working well. A well-functioning financial system allows these lower costs to be passed through to all corners of the economy.

Taken together, the Bank’s programs are making sure that there is enough liquidity in the financial system for it to keep working well. That means credit can continue to flow.

As a result, banks can still lend to businesses and households. And governments can still access borrowing markets, allowing them to defer tax payments and to fund critical programs like temporary income support for millions of Canadians.

Toni Gravelle, Deputy Governor

By making sure credit flows, the Bank is providing a bridge through the crisis. This also helps lay the groundwork for a solid recovery when things start getting back to normal.

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