If the Bank of Canada cuts its key interest rate on Wednesday, the big banks are unlikely to match the reduction with equally lower prime lending rates, raising questions about how consumers will react.
Robert Sedran, an analyst at CIBC World Markets, estimates that the big banks will likely trim their prime rates by just 0.10 percentage points (or 10 basis points) if the central bank cuts its key rate by 0.25 percentage points (or 25 basis points), meaning that variable rate mortgages would barely budge.
However, he expects a more muted consumer reaction than the outrage seen at the start of this year over the slow response from banks.
"If the Bank of Canada moves again, we expect less drama this time, but a directionally similar reaction," Mr. Sedran said in a note.
When the Bank of Canada cut its key interest rate in January by a quarter of a percentage point, in an effort to support the Canadian economy after a sharp drop in the price of crude oil, the banks followed – slowly – with more modest cuts to their prime rates of about 0.15 percentage points.
Many consumers were shocked that the banks were not passing along their lower borrowing costs by equally lowering lending rates, as they usually do. The banks' reason: Protecting the profits generated by borrowing at one rate and lending at another, or net interest margins.
Many economists expect that the Bank of Canada will cut its key rate again on Wednesday, given that the economy contracted in the first quarter and has shown few signs of picking up since then, dashing the central bank's relatively upbeat economic forecasts.
Mr. Sedran believes that another rate cut, which would reduce the Bank of Canada's overnight rate to 0.5 per cent, would have little impact other than driving the Canadian dollar down. However, it will force the big banks into making another uncomfortable decision on their prime rates.
"We suppose that it is also possible that prime may be left unchanged," he said in his note. "That action, however, would bring back the negative media and political implications that ultimately saw the banks move prime in January after the initial delay."
A modest cut to the banks' prime rates looks like an acceptable compromise, he added, given that the central bank probably doesn't want to stimulate the housing market with substantially lower mortgage rates.
If the banks do cut their prime rates by 0.1 points, it will mean that prime rates will have fallen a total of 0.25 points this year, or half the 0.5-per-cent reduction in the Bank of Canada's overnight rate over the same period – for what Mr. Sedran calls a "tidy solution" that would likely spur less concern among consumers.
For the banks themselves, though, an interest rate cut is not good news. Even with their muted response to January's rate cut, the banks' net interest margins have been flat this year, creating a headwind to their profit growth. This is because the spread between the banks' borrowing costs and their lending rates has compressed.
"It is, to be sure, overly simplistic to suggest that the banks borrow short and lend long," Mr. Sedran said. "However, a yield curve that looks more like a straight line at a low level is hardly conducive to profitable banking."
He believes that lower prime lending rates are unlikely to spur additional consumer borrowing, either.
"Given the lingering concerns over the housing market and overall consumer indebtedness, we would not expect lower rates to drive a big increase in loan demand," he said. "With these concerns we are not sure the banks would mind slower growth in Canadian retail lending at this point in the economic cycle."