If the Bank of Canada cuts its key interest rate on Wednesday in response to dismal economic conditions, don't expect the big banks to follow with similar reductions to their prime lending rates.
Robert Sedran, an analyst at CIBC World Markets, figures that banks will cut their prime rates by just 5 or 10 basis points if the Bank of Canada cuts its overnight rate by 25 basis points. (There are 100 basis points in a percentage point.)
"As the overnight rate gets closer to zero, margin pressure becomes more acute and especially in a year in which loan losses would appear set to begin rising, we think bankers will be – and should be – very focused on protecting their revenues," Mr. Sedran said in a note.
They have been for some time. In 2015, when the Bank of Canada cut its key rate twice – by a total of 50 basis points – the banks reduced their prime rates by a total of just 30 basis points.
The banks took a public grilling for what some people believed was a profit grab, illustrated by the fact that the spread between prime and the overnight rate is at its widest level in 50 years.
But in maintaining stickier prime rates, the banks weren't exactly being callous: They were merely reacting to what Ratespy calls an "inhospitable lending environment." Part of this environment is characterized by low interest rates and low bond yields, which are squeezing the banks' margins on loans.
Net interest income accounts for about 70 per cent of the banks' revenue from retail banking. Yet net interest margins – or the difference between the banks' lending income and funding – recently fell below 1.8 per cent. That's the lowest level so far this century, outside of the financial crisis, according to RBC Dominion Securities.
Although the Bank of Canada cut rates last year to help stimulate a domestic economy that is reeling from depressed commodity prices, Mr. Sedran argued that policymakers likely wouldn't have a problem with banks failing to match the central bank's stimulus point-for-point.
"With policymakers concerned enough about the housing market and consumer debt to announce another round of tighter rules for that market late last year, the great Canadian compromise this time might actually be to let lower rates negatively affect the currency but not further stimulate domestic consumer demand," he said in his note.
"Either way, we expect the banks to do what they can to protect their margins from what is already a tough interest rate environment."