Big banks consider defying rate cut

Some of Canada's big banks are contemplating holding their prime rates steady in the face of a rate cut by the Bank of Canada, a move that could destabilize the country's monetary policy.

The central bank is expected to cut its key interest rate by a quarter of a percentage point on Jan. 22. But since the global credit crunch has driven up the cost of borrowing for commercial banks, some are questioning whether they should match the central bank's move, banking sources say.

“It's a possibility,” a senior bank executive said Tuesday.

Banks are feeling the pinch of surging interbank lending rates since the market turmoil of last summer, and some face exposure to the U.S. subprime meltdown. Another rate cut would add to their woes.

“I think the real issue is, as administered [central bank] rates continue to come down, what does happen to prime going forward, and I think that's something that we'll watch very carefully,” Gordon Nixon, chief executive of the Royal Bank of Canada, mused Tuesday during a banking conference.

The Bank of Canada would not comment directly on what would happen if the banks rebelled, but comments from top officials over the past few months indicate they are watching the banks' reaction to monetary policy very closely, and are poised to react to a variety of scenarios.

Without a matching cut from the banks, a change in the central bank's key interest rate would have little effect on economic activity, and borrowers wouldn't get lower rates on mortgages and loans.

“If the banks were to choose not to reduce the prime rate after a Bank of Canada rate cut, the Bank of Canada would lose important traction in the impact of its monetary policy actions,” Toronto-Dominion Bank said in a recent note to clients.

While sources say some of the banks are considering the highly unusual move, it likely couldn't be sustained because of a backlash from consumers and businesses. Competition would likely lure at least one into matching the central bank's rate cuts, forcing the others into line.

Still, the fact banks are discussing such a scenario illustrates the conflict between what the central bank believes is good for the Canadian economy and what the chartered banks believe is good for their bottom lines. This will prove a challenge Mark Carney, the next governor, will have to deal with when he takes over Feb. 1.

“This phenomenon is happening everywhere in the world, and it's no more pronounced than in the U.K., or even in the U.S., where you had this huge drop in the [central bank] rate yet you didn't have the corresponding decline in deposit rates, and lending rates, and things like that,” the senior bank executive said.

When the Bank of Canada cut its key interest rate on Dec. 4 – the first cut in 31/2 years – there was enough discomfort among the commercial banks that they delayed announcing prime-rate cuts, sources say.

“It was probably not as automatic as one would think, but clearly it's a competitive market and everyone went quickly,” said the senior banking executive.

In the end, the banks moved, but didn't maintain their usual pecking order, sources said.

“If we can read between the lines, we wonder whether some of the banks were a touch reluctant to respond with lower lending rates,” said one internal bank memo exchanged among economists and strategists. “In turn, there is a small risk that future Bank of Canada rate cuts – January, say – might not be matched by a further decline in the prime rate.”

While the banks do not have to act in tandem, ever since the central bank moved in 1996 to its current regime of rate changes, the chartered banks have always followed, except during the Asian financial crisis of 1997. However, the commercial banks understood that the central bank did not expect them to match the cut.

When the central bank changes its rate, the commercial banks usually change their prime rates in a couple of hours. The chartered banks' prime rate is almost always 175 basis points above the central bank's key lending rate (100 basis points is equal to a full percentage point).

The TD memo – titled Could the Bank of Canada Lose Traction? – suggests the prime rate determines the cost of 65 per cent of business and household borrowing in the economy, either directly or by determining the level of other rates.

But, the memo says, if the chartered banks refused to play along, each central-bank cut would carry only about a third of its normal heft, stymieing the central bank's attempts to stimulate the economy.

Much of the banks' willingness to match the central bank will depend on what happens to the costs of borrowing money on international markets before the Jan. 22 rate announcement, a source from a different bank said. These costs have come down since December, and if that trend persists, the rationale for rebelling fades.

The Bank of Canada could try to offset a united front by cutting its rate again. It could wait for one bank to break ranks. Or it could arm-twist the banks into action.

The power of a central bank to fine-tune the economy has already been thrown into question the past couple of years because of the growing amount of credit that was being traded off banks' balance sheets