The Foreign Currency Business of the Canadian Banks: An Econometric Study

The foreign currency assets and liabilities of the Canadian chartered banks grew rapidly over the 1960s and now account for a substantial share of their total assets and liabilities. In this study I analyze the forces underlying this growth as well as some of the implications for Canadian monetary policy and for the Canadian balance of payments of transactions in these assets and liabilities. I also examine the role of the chartered banks as participants in the Euro-dollar market and as a possible conduit for funds between the United States and the Euro-dollar market. A complex process determines the quantities of chartered bank foreign currency assets and liabilities outstanding. The process reflects interaction among depositors, borrowers, and the banks themselves. I examine in detail the behaviour of each of these groups. Interest rates offered by the banks on foreign currency deposits are set on the basis of the rates obtainable by investors on competing financial instruments and the rates the banks can earn on assets in which they invest. Given the interest rates on foreign currency deposits and those on competing financial instruments, depositors decide what quantity of such deposits they wish to hold. The banks appear to determine the size of their net foreign asset positions on the basis of interest rates in the United States and Canada, the stance of Canadian monetary policy, and the amount of swapped deposits outstanding. Chartered bank foreign currency loans are primarily a function of the borrowers' demand for funds. This demand is influenced by relative interest rates and by the degree of difficulty encountered in obtaining loans elsewhere. Chartered bank foreign currency liquid assets are allocated among deposits, call loans, and securities. Throughout this study careful attention is paid to the effect of certain official guidelines on the various behavioural relationships. In the concluding chapter I attempt to evaluate the significance of chartered bank transactions in foreign currency assets and liabilities. Changes in Canadian interest rates relative to rates abroad give rise to substantial capital outflows and inflows via these transactions. The scope for varying their net foreign asset positions gives the banks an additional degree of flexibility in responding to the central bank's cash reserve management. Before the guidelines were imposed, Canadian banks channeled substantial amounts of funds between the United States and the Euro-dollar market in response to relative interest rate changes. In short, transactions in chartered bank foreign currency assets and liabilities play a significant role both in the working of the Canadian financial system and as part of the international linkages between Canada, the United States, and the rest of the world.