Well it seems like some fallout from the US credit crisis has finally spilled over the border for Canadian borrowers (of course for investors it spilled over a long time ago). On Monday TD announced that home equity lines of credit and variable rate mortgages would increase from prime to prime +1%. I am a TD Canada Trust customer and I have a home equity line of credit with them. When I read that press release I was concerned that the rate on our home equity line of credit would jump from the 4.75% prime rate to 5.75% so I checked our account on-line. The interest rate was still set at 4.75%. Interesting.

Yesterday in a coordinated effort with central banks around the world the Bank of Canada lowered overnight rates in a coordinated effort with central banks around the world by 50 basis points or 0.5%. Usually this results in a lowering of the prime rate by the big 5 Canadian banks of the same amount. In the last 8-12 months or so the big banks have been reluctant to pass on the rate reduction to consumers through the lowering of their prime rate. In fact, during the last Bank of Canada rate reduction there seemed to be a little bit of a game of chicken going on where the banks waited until the end of the day to announce interest rate reductions after the Bank of Canada changed their target overnight rate the the regular time of 9:00 am.

So the banks also seemed reluctant yesterday to lower their interest rates. The interest rate announcement came fairly early in the morning (I can't remember the exact time but I am pretty sure it was before 9:00 am) and the first bank to announce a reduction in their prime rate was TD but it didn't make the announcement until around 1:00 pm and it only reduced the prime rate by 0.25%, not the full 0.5% the Bank of Canada reduced their target rate by. When I look at my home equity line of credit interest rate today it is still set at 4.75% but if you add together all of these changes to the prime rate and variable interest rate policy it should be at 4.75% + 1% - 0.25% = 5.5%. Interesting.

What is the Bank of Canada target rate anyway? Well, according to the Bank of Canada, it is the middle of a range that the bank wants to see the average of the rates for overnight lending between banks to happen at. So what motivation do the banks have to lend to each other at the target rate? Well, the Bank of Canada sets up a range that is 0.5% wide with the target rate in the middle of the range. The Bank of Canada will lend money to banks at the top end of the range (or the target rate + 0.25%) and it will pay interest on deposits at the bottom end of the range (or target rate - 0.25%). So if a bank wants to try to charge or pay an interest rate outside of the range the other banks can just go to the Bank of Canada to get a better interest rate. There is no motivation for a bank to try to charge outside the target range, they won't be able to get anyone else to accept those rates.