Flywheel - Building - Interest rates drop

This information was forwarded by Laurie Baird of Okanagan Mortgages.com

Below is a Financial Post article regarding the decision of the Bank’s to not pass on the full 75 bps rate cut. Specifically:

“In normal times, financial institutions do better when the central bank lowers the cost of funds, happily passing on cheaper loan rates to consumers to encourage them to borrow more. But when the official rate starts getting closer to zero, the dynamics start to change, as the prime rate that banks charge customers is pushed nearer to their own cost of funds.”

Simply put, we’re in unchartered territory. The BOC rate is at a 50 year low. There’s little data available to see what Bank’s have done in the past under these circumstances. So while many economists suggest a further 50 bps rate cut is going to happen January 20th, there are absolutely no guarantees the Banks will follow. We’re getting to the point where further BOC rate cuts may not have much of an impact in terms of economic stimulus.

Bay Street changes rules of rates game

Eoin Callan and Gary Marr, Financial Post Published: Tuesday, December 09, 2008

Canadian bank executives say the cost of funding in international markets remains extraordinarily high.
Bay Street's profit margins are starting to come under pressure as official interest rates creep closer to zero, prompting retail banks to change the rules of the game so customers pay more.

While the Bank of Canada on Tuesday cut interest rates to the lowest level since the 1950s, the country's five big banks indicated they would no longer march in lock step with the central bank. Instead, Bay Street is keeping the cost of borrowing for consumers more elevated in a bid to protect corporate earnings, passing on only part of the rate cut to customers.

While the decision of Bay Street to pocket part of the Bank of Canada rate cut is seen as good for shareholders and bad for customers, there is less certainty about how it will impact wider demand, partly because there are few historical precedents.

"We just don't have much experience with this," said an official at the Federal Reserve who has studied how financial institutions behave when central banks cut rates close to zero.

The central banker said data were limited but suggests retail banks remain willing to lend even when official rates fall near zero, as they tend to find ways to protect profit margins on loans.

In normal times, financial institutions do better when the central bank lowers the cost of funds, happily passing on cheaper loan rates to consumers to encourage them to borrow more. But when the official rate starts getting closer to zero, the dynamics start to change, as the prime rate that banks charge customers is pushed nearer to their own cost of funds.

This was key to Tuesday's decision by RBC, TD, Scotiabank, BMO and CIBC to cut their prime rate by 50 basis points instead of the full Bank of Canada cut of 75 basis points, according to people in the industry.

Joan Dal Bianco, vice-president of real estate-secured lending with TD Bank, said it would have left the bank without a profit if the full rate cut had been passed on to customers with variable products tied to prime.

"We are still trying to earn something on this stuff. This has been quite the roller-coaster ride and it has not been too hot on the mortgage front. We just can't take on the whole 75-point cut," Ms. Dal Bianco said.

Nancy Hughes-Anthony, head of the Canadian Bankers Association, acknowledged the decision to break step with the Bank of Canada created a public-relations challenge for Bay Street.

But she said: "The banks are still borrowing in a very volatile marketplace. The Bank of Canada rate is only one component of their cost of funding, and while the cost of borrowing in international markets has come down a bit, it is still higher than before the crisis."

John Aiken, an analyst at Dundee Securities, said banks were "starting to see margin compression" as the central bank cut rates to 1.5% from 2.25%, while banks reduced their prime lending rate to 3.5% from 4%.

"The new loans that are being put in the books are arguably at a less profitable rate," he said.

Vince Gaetano, a vice-president with Monster Mortgage, said he expects pressure will start to mount on the banks in the coming weeks to reduce prime further.

"That's what happened the last time they tried to resist rate cuts," he said.

This willingness to pass on rate cuts is critical to determining the ability of the Bank of Canada to stimulate the economy in the midst of a downturn.

The central bank's own research shows "it is the real rate of interest that is most relevant" to the purchasing decisions of households, and that it can "influence demand only to the extent that adjustments to the [official] interest rate feed through to the real interest rate.