Tom Hanson/AP
Bank of Canada Governor Mark Carney leaves his office in Ottawa, Canada.

Bank of Canada Braces for Recession With Interest Rate Cut

December 10, 2008 12:24 PM
by Liz Colville
Canada’s banks have largely avoided the troubles of their American counterparts, but the decision to cut rates, motivated by steep job losses, now paints a bleaker picture.

New Canadian Interest Rate Is Lowest in Half a Century

Bloomberg reported December 9 that the Bank of Canada, the country’s central bank, cut interest rates three-quarters of a point to 1.5 percent, a “half-century low.” The news suggests that, despite Canadian banks’ seeming immunity to the troubles plaguing numerous banks in leading economies like the United States and England, Canada is not immune to a recession. Indeed, unemployment is up and exports are down, according to Bloomberg.

But the country’s commercial banks were reluctant to match the central rate cut, which was motivated by news that Canada, the world’s eighth-largest economy, suffered the most job losses since 1982.

But “there are serious doubts about how much stimulus a lower interest rate will deliver in an environment where financial institutions are afraid to lend while businesses and households are reluctant to borrow,” economist Erin Weir, of Toronto’s United Steelworkers, told Bloomberg.

The Financial Post reported December 9 that there is now “pressure” on the Canadian government to deliver a “hefty” stimulus package in January. Following the Bank of Canada cut, “analysts say the onus now rests on federal Finance Minister Jim Flaherty to pull the Canadian economy out of a potentially protracted downturn.”

A separate Financial Post article explains the commercial banks’ decision to only cut their rates by 50 basis points instead of the central bank’s 75: “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.”

Background: Canadian Banks Largely ‘Solid and Solvent’

As many Group of Seven (G7) countries, including the United Kingdom, the United States and Germany, have found themselves bailing out their failing banks with government money in recent weeks, Canada and its banks were seen as “solid and solvent,” Time magazine reported November 10.

But how? For one, explains Time’s Erik Heinrich, the Canadian government agreed to insure the money it borrows from other banks, because other countries’ banks that have done this now “get a government seal of approval” and hence a “competitive advantage” over those that don’t have government backing.

Also, in the 1980s the Canadian government “decided to allow commercial banks to acquire investment dealers on Toronto’s Bay Street, the country’s financial hub,” Heinrich explains, meaning that investment dealers were subjected to the same tough regulations as commercial banks. By contrast, in the United States, investment dealers are currently “subject to only light supervision” by the Securities and Exchange Commission (SEC).

But despite Canadian banks’ stability, the Toronto Stock Exchange (TSX) has suffered as have other major exchanges. A new report from CIBC World Markets—a branch of CIBC, one of Canada’s largest banks—suggests that the “‘building blocks’ for a sustained [economic] rally are not yet in place,” Canada’s Financial Post reports.

Notably, CIBC was the only Canadian bank to lose money due to the sub-prime mortgage crisis, according to finance blog Cosmoloan. Its losses amounted to approximately $2 billion.

Opinion & Analysis: Canada’s solid economy

CIBC economist Jeff Rubin noted recently, “With credit and liquidity fears abating somewhat” due to government injections around the world, “concern” in Canada “is rapidly shifting to one of the other key factors clouding prospects for a heavily resource weighted TSX: the troubled global economy.”

A survey by the World Economic Forum, an influential organization based in Geneva, Switzerland, recently ranked Canada as the “world’s soundest banking system,” a fact noted in the Time article. The survey was published in early October. Reuters reported Oct. 9 that the United States “rated only 40” just following the collapse of several major U.S. banks, behind Germany at 39 and ahead of the United Kingdom at 44. Behind Canada was Sweden, followed by Luxembourg.

The Bank of Canada’s governor, Mark Carney, suggested in a recent interview with the Financial Post that Canada’s regulatory system “could form the backbone of any new rules governing global finance that countries eventually agree on,” a suggestion echoed by Time’s Erik Heinrich.

Reference: Canadian bank regulations

Finance blog Cosmoloan runs through key laws and regulations affecting Canadian banks and credit unions, explaining that the Canadian Bank Act of 1991 has been instrumental in bank regulation. An essential clause in the Act states that, “Domestic banks are the only institutions allowed to hold and enforce security interests (mortgages) under Canadian law. The fact that only domestic banks can issue mortgages means that outside firms cannot purchase up large quantities of debt for profit.”

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