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Canada's banks, squeezed by tight credit conditions, only passed two-thirds of the central bank's rate cut on to consumers, posing a challenge for Ottawa as the economy withers.

Each of the six largest banks decided Tuesday to lower their prime rate by 50 basis points, to 3.5 per cent, after the Bank of Canada cut its key rate by three-quarters of a percentage point.

The move continues a game of cat and mouse that began in October, when the central bank cut its rate by half a percentage point and the banks only reduced prime by a quarter point. The banks didn't budge until Finance Minister Jim Flaherty announced a $25-billion program to buy mortgages from the banks.

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The program was tripled in mid-November, and Ottawa has also come out with an emergency backstop program for bank debt. But those measures weren't enough to convince the banks to pass along all of Tuesday's rate cut.

"Even with the government programs, which are helping, the ongoing market turmoil has continued to drive up our average cost of borrowing over the past few months making it difficult to pass the full rate cut on," said Toronto-Dominion Bank spokeswoman Kelly Hechler.

Royal Bank of Canada chief operating officer Barbara Stymiest said in October that the central bank's interest rate reduction was gouging the profitability of the banks.

Nancy Hughes Anthony, head of the Canadian Bankers Association, noted Tuesday that, "The cost of borrowing for banks has obviously come down somewhat, but it's still higher than it was before this crisis began."

A number of mortgage rates have been going down. Royal Bank, for instance, cut a number of its rates by 0.2 per cent Tuesday. But, generally speaking, borrowing costs are going to have to go up until the banks can ease some pressure on their profit margins, Ms. Hughes Anthony said.

Liberal MP John McCallum, a former chief economist with Royal Bank, acknowledges that the banks are paying more to obtain funds to lend to customers, but wishes they would sacrifice some profits to help Canada's economy.

"The banks are being squeezed, and hence they're less willing than they normally would be to lower rates," he said. "But, at the same time, it's good for the country if they follow the Bank of Canada."

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Now that Parliament has prorogued, fiscal policy is on hold and monetary policy "is all we have," he noted. "The power of monetary policy comes largely … through the chartered banks following the lead of the Bank of Canada on interest rates. So it's unfortunate if they don't."

The government should have done more to ensure money keeps flowing from banks to borrowers, Mr. McCallum added. "I don't think they've been bold. I think they've been doing the minimum."

Canada's large banks fund about 65 per cent of their loans through deposits, according to a report by RBC Capital Markets analyst André-Philippe Hardy.

"Part of the issue is that the banks depend on deposits for much of their funding, and on many of those deposits the interest rate is already low," said National Bank analyst Robert Sedran. "So, if you reduce prime without being able to reduce deposit rates by the same amount, the margin gets squeezed."

Banks used to fund nearly all of their consumer and business lending through deposits, but the explosion in the popularity of mutual funds in the 1990s, coupled with a gradual decline in interest rates, drove a proportion of savings from bank accounts and guaranteed investment certificates to mutual funds, Mr. Hardy noted.

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