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The corner of Bay Street and Adelaide streets in the heart of Toronto’s financial district.

Gloria Nieto/The Globe and Mail

The last thing Canada's biggest lenders wanted was a sudden rate shock. What they got was a double whammy: a surprise move, coupled with a shift in the wrong direction.

Caught off guard, banks are now scrambling to protect their lending margins. On Wednesday Toronto-Dominion Bank said it is considering keeping its prime interest rate at 3 per cent, meaning it would not lower its customers' cost of borrowing in line with the Bank of Canada. TD said the central bank's actions are just one of the factors it considers when setting rates.

After bond yields started soaring in 2013, Royal Bank of Canada chief financial officer Janice Fukakusa stressed that a hasty rate decision was one of the few things with the power to really sting the banks. (Back then, everyone worried the Bank of Canada would hike too quickly.)

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Because the Big Six lenders are massive organizations with scores of loans, they can't shift gears in an instant. Just like an oil tanker trying to turn around on the open water, the banks need time to recalibrate. What they pray for, then, is solid forward guidance from the central bank on interest rates, as well as gradual shifts when rate changes are made.

The latest move not only flies in the face of these hopes, but the Bank of Canada also slashed rates instead of raising them.

After the Great Recession ended, shareholders focused with laser-like intensity on net interest margins, or the difference between the rates at which banks borrow and lend money. These margins plummeted after the central bank started slashing rates, and that meant the banks made less per loan.

For the past year, most people believed interest rates were the cusp on rising. Because that was considered inevitable, investors stopped fretting about bank loan margins – especially given that NIMs, as they are known, had finally stabilized. The new rate cut throws the spotlight back on these margins.

There is a saving grace for the banks. Early in 2014, when there were high hopes of a rate hike, shareholders started asking how quickly these lenders would benefit from such a move. The response wasn't what the investors wanted to hear: Bank executives stressed that any hike would take four to six quarters to benefit their bottom lines.

The core problem when rates rise quickly is that banks can't reprice their assets at the same speed. While the banks do have some short-term assets the mature every few months, their big loan books are spread out over multiple years. Because a good chunk of the money is tied up for periods longer than one year, the bank is locked into pre-established rates of return, and those rates can't be repriced until the preset term ends. The rate on a five-year loan issued this January, for instance, won't change until 2020.

Although that hurts the banks in a rising rate environment, it actually benefits them in the early days of a rate cut, for the reverse reason. A five-year loan, for instance, will stay at an elevated rate until it matures or until the borrower refinances.

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Of course, there is also a chance that lower rates will spur more household borrowing. But the jury's out on whether that will happen, since Canadians are already heavily indebted. Overborrowing is what got us into this nasty debt bubble, and that the last thing we need is for another one to pop. Bank executives themselves have started acknowledging this, albeit not as directly, in recent quarters.

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