When the Bank of Canada cut interest rates in 2015, the big banks brazenly refused to fully pass along the full extent of lower borrowing costs to their clients.
Expect the banks to be good little soldiers when the Bank of Canada raises its benchmark overnight rate, possibly as soon as next Wednesday. Every drop of the central bank's rate hike will be passed down to borrowers, and maybe more.
There used to be some predictability and transparency to the rates banks charged borrowers. When the Bank of Canada changed its overnight rate, banks made identical adjustments to their own rates. But the banks today are grabbier than they ever have been, and that means we have to watch carefully what they do with borrowing costs for mortgages, lines of credit and loans in a rising rate world.
There is no requirement for banks to match the Bank of Canada's moves in changing interest rates. So there was nothing technically wrong with their decision in 2015 to lower their prime rates by a total 0.3 of a percentage point after the Bank of Canada cut by a combined 0.5 of a point. There were two cuts of 0.25 of a point that year – in January and July.
There's a strong sense that the Bank of Canada will twice raise its overnight rate this year by 0.25 of a point. Expect the banks to announce identical increases in their prime rate, now at 2.7 per cent. The prime is a benchmark for variable rate mortgages and lines of credit, which is to say it's vitally important to borrowers.
Banks have already showed a willingness to play games with the prime rather than simply mirror all moves up or down in the Bank of Canada's benchmark rate. Back in July, 2015, Toronto-Dominion Bank responded to a 0.25-of-a-point cut in the overnight rate by reducing its prime by 0.1 of a point. Other banks then cut their prime by 0.15, which prompted TD to cut another 0.05.
It's unlikely a bank would raise its prime rate by more than the amount of any increase in the overnight rate. The banks are grabby these days, but they'll want to minimize negative publicity just now because of recent events that raise questions about the extent to which they're exploiting clients in pursuit of profits.
Royal Bank of Canada just became the fifth big bank to pay fines to regulators for overcharging clients on investment fees. And the federal Financial Consumer Agency of Canada is currently investigating the banks' in-branch sales practices. The investigation follows media reports of branch staff acting unethically to sell products to clients.
Watch for the banks to use stealth tactics if they decide to push the limits on rate increases. One possibility would be to bump up their current mark-ups over prime for lines of credit. Another possibility would be to follow Toronto-Dominion Bank's example and create a proprietary in-house prime rate for pricing variable-rate mortgages. TD's mortgage prime is 2.85 per cent, compared with 2.7 per cent for its conventional prime rate.
Keep your eye on savings rates as well. The big banks are paying as little as 0.4 to 0.5 per cent on their best savings account offerings, and in some cases there's zero interest paid on small balances. Are they going to improve these accounts as interest rates rise?
Banks will want to manage their borrowing and savings rates in a way that sustains the impressive profit growth they've shown in recent quarters. A risk looking forward is that rising rates slow the already declining level of growth in new borrowing by consumers. Loan losses could also increase, although a rise in borrowing costs of 0.25 or 0.5 of a percentage point should be manageable in most households.
The Big Six banks posted average share price gains of just over 18 per cent in the 12 months to midweek, while the S&P/TSX composite index made just 6.1 per cent. The average bank dividend yield was 4 per cent at midweek, enough to keep investors way ahead of inflation at current levels.
Banks make us richer through our direct share holdings and investments in exchange-traded funds and mutual funds. To see how they'll keep it up, watch how they handle the coming round of interest rate increases.
Rob Carrick