Banks trim prime but lag BoC cut

Globe and Mail Update

October 8, 2008 at 2:40 PM EDT

OTTAWA — Major Canadian banks said they would lower their prime rates by just a quarter of a percentage point, refusing to pass along all of the Bank of Canada's half-point decline.

The rebellious move is a departure from the past, when the big banks have fully matched central bank rate cuts, despite complaints they couldn't really afford it.

The first move was made by Toronto-Dominion Bank, cutting the prime rate to 4.5 per cent, effective Thursday – a tepid measure that amounts to thumbing its nose at the central banks. It was soon followed by Canadian Imperial Bank of Commerce and later by Royal Bank of Canada.

“Like all financial institutions, we have been watching the key lending rates very closely. Continuing market turmoil has steadily driven up the cost of borrowing for financial institutions,” said Tim Hockey, president and chief executive officer of TD Canada Trust

TD's move was just one signal that the aggressive rate cuts by central banks were not immediately resolving the dysfunction gumming up lending markets.

The Bank of Canada had to intervene in overnight money markets again on Wednesday morning, this time with a $430-million injection, in order to drag drifting overnight rates back to its target.

“It's not a huge surprise, but it's a real problem,” said Dale Orr, chief economist at Global Insight Canada. “It makes monetary policy less effective than it otherwise would be.”

The Bank of Canada joined other key countries around the world in a surprise co-ordinated rate cut early Wednesday. The United States, the United Kingdom, Europe, Switzerland, Sweden, China and Hong Kong also slashed their interest rates in a bid to bolster the flagging global economy, and instill some confidence into credit markets that have become paralyzed by fear.

The Canadian central bank's key rate is now 2.5 per cent, down from 3 per cent.

Only Japan, among the major central banks, opted out, since its rates are already at a rock bottom 0.5 per cent.“The pace of economic activity has slowed markedly in recent months,” the Federal Reserve said. “Moreover, the intensification of financial market turmoil is likely to exert additional restraint on spending, partly by further reducing the ability of households and businesses to obtain credit.”

The move gave some comfort to economists, but they warned the action is not enough to end the deepening financial crisis.“Today's co-ordinated half-point cuts from all the major central banks ... will provide at least a temporary boost to confidence, but we fear there is still a lot more work to do,” said economists at London-based Capital Economics. “For a start, the fact that the central banks have had to take such extreme measures underlines how bad market conditions have become.”

The Bank of Canada said it joined in the co-ordinated action because “credit conditions in Canada have tightened significantly, despite the relative health of our financial institutions.”

Canada needs an emergency rate cut because U.S. growth is weaker, trade is dropping off, and the domestic economy is no longer flying high on the profits from high commodity prices.

But mortgage rates in Canada have actually risen over the past week, and the central bank moves on Wednesday don't seem to be able to change that momentum.

Banks can't afford to cut their prime rates because they're paying exorbitant costs to fund their own borrowing through global credit markets, said Mr. Hockey.

“We recognize the efforts the Bank of Canada is making and, despite the fact that our cost of funds remains high, we have decided to reduce our rate by 25 basis points. We see this as a balanced move in managing our funds and passing along the intended benefits to our customers.”

National Bank's chief economist had the same sentiment.

“It is far from evident that such Bank of Canada overnight decline will be followed by an automatic prime rate reduction by majors banks in coming hours or days since the liquidity squeeze has intensified over the last few weeks in the Canadian banking system (just like in other countries),” said Clément Gignac, chief economist at National Bank.

Banks in Australia have also refused to match their central bank's recent cuts, noted Eric Lascelles, chief economics and rates strategist at TD Bank.

“We'll see what others do and how the manoeuvring occurs, but it does seem to me that there is a very substantial risk that we don't see the prime rate move down by the full 50 basis points and I would suspect that that would have the tacit blessing of the Bank of Canada,” he said, noting that the central bank has said in commentary that it expects commercial banks will pass along some of the higher costs they are facing as a result of the credit crunch, he said.

“Really the motivation is that bank borrowing costs are absolutely through the roof by any definition, so this is not in any way shape or form a gouging operation, it's one where you're really just trying to minimize your losses,” he said.

But, “it does mean that the Bank of Canada has a little less traction,” he said. “But at times like this keep in mind that central easing is intended in large part to help the financial sector.”

Economists said they expect further rate cuts are in store from the Bank of Canada.

Inflationary pressure is not an issue any more, the central bank said, since demand from Canadian consumers and businesses is no longer strong. Its next date to set rates is Oct. 21.

Still, if commercial banks refuse to follow the central bank's lead in taking interest rates lower, the Bank of Canada will no doubt be asking itself what the point of further cuts is, said Mr. Orr.

“It really is a tough one.”

It's the first time since the terrorist attacks of September, 2001, that the Bank of Canada has cut rates outside of its regular schedule. The decision to move in concert with other powers was made Tuesday after policy makers agreed that working together would have far more impact on confidence and markets than taking individual measures.

Financial institutions in key countries around the world have essentially stopped lending money to each other for fear they won't be paid back. That, along with their need to deal with losses stemming from bad loans, has sparked a major increase in the cost of borrowing. It has also made the availability of money extremely scarce for consumers and businesses.

This credit crunch comes at the same time as the world economy is slowing, led by the United States, where the housing collapse has spread to the rest of the economy.

However, one concerted move by the central banks will not be enough to turn the tide, said Douglas Porter, deputy chief economist at BMO Nesbitt Burns.

“There need to be further moves down the road, and I don't necessarily mean just in rate cuts,” Mr. Porter said.

The rate cut is just the latest in a long string of moves made by central banks in recent weeks. They have repeatedly flooded money markets with fresh cash in the form of short-term loans, and made borrowing easier by broadening what they will take as collateral from financial institutions.

In the United States, the government put together the rescue plan to sop up toxic assets undermining the stability of key banks. And in Europe, governments are bailing out banks, guaranteeing bank deposits, and talking about stimulus packages.

“Everybody's throwing everything in the tool box at this problem.” said Royal Bank of Canada chief economist Craig Wright. “I don't know that, given how negative sentiment is, any one event would turn it, but the hope is that the culmination of all these events starts at least to get recognized.”

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