INTEREST RATES: Lowest in 50 years

Bay Street's profit margins are starting to come under pressure as official interest rates creep closer to zero, prompting retail banks to change the rules of the game so customers pay more.

While the Bank of Canada on Tuesday cut interest rates to the lowest level since the 1950s, the country's five big banks indicated they would no longer march in lock step with the central bank.

Instead, Bay Street is keeping the cost of borrowing for consumers more elevated in a bid to protect corporate earnings, passing on only part of the rate cut to customers.

While the decision of Bay Street to pocket part of the Bank of Canada rate cut is seen as good for shareholders but bad for customers, there is less certainty about how it will impact wider demand, partly because there are few historical precedents.

"We just don't have much experience with this," said an official at the U.S. Federal Reserve who has studied how financial institutions behave when central banks cut rates close to zero.

The central banker said data was limited but suggests retail banks remain willing to lend even when official rates fall near zero, as they tend to find ways to protect profit margins on loans.

In normal times, financial institutions do better when the central bank lowers the cost of funds, happily passing on cheaper loan rates to consumers to encourage them to borrow more. But when the official rate starts getting closer to zero, the dynamics start to change as the prime rate that banks charge customers is pushed nearer to their own cost of funds.

This was key to Tuesday's decisions by Royal Bank of Canada, Toronto-Dominion Bank, Bank of Nova Scotia, Bank of Montreal and Canadian Imperial Bank of Commerce to cut their prime rate by 50 basis points instead of the full Bank of Canada cut of 75 basis points, according to people in the industry.

Joan Dal Bianco, vice-president of real estate-secured lending with TD Bank, said it would have left the bank without a profit if the full rate cut had been passed on to customers with variable products tied to prime.

"We are still trying to earn something on this stuff. This has been quite the roller-coaster ride and it has not been too hot on the mortgage front.

"We just can't take on the whole 75-point cut," said Dal Bianco.

John Aiken, an analyst at Dundee Securities, said banks were "starting to see margin compression" as the central bank cut rates to 1.5 per cent from 2.25 per cent, while banks reduced their prime lending rate to 3.5 per cent from four per cent.

"The new loans that are being put in the books are arguably at a less profitable rate," he said.

Vince Gaetano, a vice-president with Monster Mortgage, said he expects pressure will start to mount on the banks in the coming weeks to reduce prime further.

"That's what happened the last time they tried to resist rate cuts," he said.

This willingness to pass on rate cuts is critical to determining the ability of the Bank of Canada to stimulate the economy in the midst of a downturn.

(prepared by Eoin Callan and Gary Marr/Vancouver Sun)