The reason is that banks’ cost of borrowing has increased considerably thanks to the subprime crisis. Banks are looking for any way possible to preserve profit margins. Keeping prime rate at 6.00% would add a juicy 1/4% to their rate spreads (assuming the BoC lowered rates 1/4%).
While not unprecedented, this would certainly be an unusual scenario. For almost 10 years, banks have lowered their prime rates every time the BoC has lowered its overnight rate. The prime-BoC spread has been a steady 1.75% the whole time.
The underlying problem is that prime rate determines 65% of all business and consumer interest rates, either directly or indirectly. Unless the banks lower their prime rates, the Bank of Canada’s own rate cut would have much less power to stimulate our economy.
Many are upset by this prospect, and some have even accused the banks of colluding to set rates.
In reality, though, the chance of banks defying the Bank of Canada are rather small. Banks don’t want to threaten their relationship with the BoC…or lose business if competitors break ranks and match the BoC’s rate cut.
Indeed, the chances of banks flouting the BoC are greatest if their cost of borrowing increases further before the BoC’s next meeting. Most likely, however, banks will make do with lowering prime but keeping their discounts off prime stingy.
The Bank of Canada meets next on January 22, and is expected to cut rates 1/4%.