When the Bank of Canada slashed its key interest rate by 0.25 percentage points last week, the big question became whether the Big Six banks would follow suit. Traditionally, the country’s largest lenders take their cue from the central bank, adjusting their prime rates by the same amount.
But within hours of the surprising rate cut, Toronto-Dominion Bank said it was considering holding its prime rate steady. For the first few days, rival lenders played along. During this time, three banks privately told The Globe and Mail that they were closely watching each other’s actions. If one cut, it was clear they all would.
To many Canadians, it looked like these lenders were being greedy. By not passing on the rate cut, products such as variable-rate mortgages and lines of credit did not become any cheaper.
However, the banks were in a pickle.
Because interest rates were already so low, their lending margins – or the amount they make per loan – were weak, and some bank executives had already warned about tougher times ahead for the industry. Cutting into these margins would only hurt their bottom lines even more.
They were also stuck in a no-win situation.
If they did not cut their prime rates, they would be blamed for gouging clients; if they did, and Canadians borrowed more money, they could ultimately be blamed for inflaming a massive debt bubble.
What the banks opted for was a half-measure – cutting their prime rates by 0.15 percentage points to 2.85 per cent.
“Perhaps we have arrived at a classic Canadian compromise,” CIBC World Markets bank analyst Rob Sedran wrote in a note to clients. By cutting the overnight rate, the central bank helped send the Canadian dollar lower, which should help the manufacturing industry, exporters and energy producers.
At the same time, a partial prime rate cut protects “the profitability of the financial system while at least slowing the transmission of the lower rates into a housing market that probably does not need any more liquidity at this point of the cycle.”
The banks also had to factor in their public image. Because the five largest lenders each routinely make more than $1-billion a quarter, they must be sensitive about being viewed as rich and powerful monoliths. Lowering their prime rates even a little bit suggests they aren’t free to do whatever they choose. “Fifteen basis points means nothing to anyone,” said Paul Gardner, portfolio manager at Avenue Investment Management. “It’s more the perception, so that everyone knows about the rate cut.”
By cutting rates, the banks also sent a message to skittish investors that they are healthy enough to sacrifice some of their profits. And investors appear to be growing concerned about the prospects of Canadian banks. Royal Bank of Canada’s share price has tumbled nearly 11 per cent since November, marking its most significant correction in two-and-a-half years. Bank of Nova Scotia shares have fallen more than 15 per cent since July.
“The last thing you want to do is create any sense of uncertainty,” said Ian Lee, a former commercial banker and now a professor with Carleton University’s Sprott School of Management. “So you just bite your tongue and don’t say anything and create some symbolic gestures as they did here.”
Having settled on a solution, the big fear for the banks is that there will be another central bank cut. “When policy makers cut rates, it’s like potato chips, you can’t just stop at one,” said Sheryl King, a former Bank of Canada analyst and now senior director with New York-based Roubini Global Economics. “And 25 basis points is not really a meaningful move if you really truly want to provide meaningful stimulus to the economy.”
Any additional cuts would only compress margins further, and hurt the banks’ bottom lines. Mr. Sedran calculated that a 5-per-cent drop in bank net interest margins – or the difference between the rates at which they borrow and lend money – hurts annual Canadian personal and commercial banking profits by 4 per cent.
With files fromWith files from reporter David Berman