“My question concerns interest rates (again) and banks. To what extent are banks linked to the key rate to establish, for example, the mortgage rate they offer? A major Canadian bank is not financially independent enough to be able to stand out from the market and offer a mortgage rate of, say, 4%? » – Jean-François Gauthier
The economic pages of newspapers constantly talk about the evolution of the famous key rates of central banks, in all countries. Few articles, however, look at the real dynamics that link them to the interest that ordinary people pay on their mortgage loans.
So why do banks and credit unions have to follow the “diktat” of the key rate determined by the Bank of Canada?
Basically, because it’s the “bank of banks”.
Central banks rely on the enormous financial power of States, which have delegated to them the power to issue money: no other institution has such strong backs. As a result, no other organization can offer loans at better interest rates than them either.
Key rate, floor rate
The “key rate” that a central bank determines therefore becomes the floor rate in a country or in a monetary zone such as that of the European Union.
It applies to the least risky loans: “overnight financing”, which banks and credit unions agree with each other on a daily basis to settle their customers’ credit card payments, transfers and checks. These loans only last long enough to balance the books at the end of the day.
These are the least risky forms of financing: “A loan from one day to the next is practically cash,” summarizes Jean Boivin, general director of the BlackRock Investment Institute and former deputy governor of the Bank of Canada.
Currently, this key rate is 5% in Canada, after the series of nine increases decreed since 2022 to calm inflation.
For a financial institution, the question is: why would I give this client a mortgage loan at 4% interest, when I could deposit that same amount with the Bank of Canada at 5% interest, at a virtually zero risk?
“The possibility of turning to the central bank is what imposes the key rate,” summarizes Jean Boivin.
The individual may have a good, stable job or be a millionaire – even a billionaire – but lending them money will always remain riskier than depositing it in the Bank of Canada.
On top of the 5% rate offered by other financial institutions, banks therefore add a “premium” for the loans they grant to individuals and businesses, which are necessarily riskier.
Currently, they offer variable rates of 6.25%.
Three-, five- or seven-year fixed-rate mortgages follow other, longer-term rates, such as those on government bonds.
Banks do not lend their own money
No, financial institutions are not sufficiently independent of the market to escape this logic. In fact, they are not at all: “In the end, the banks finance these loans with their own loans,” explains Desjardins Movement chief economist Jimmy Jean. They must therefore necessarily charge more interest than they have to pay themselves.
“Lending below the cost of their own borrowing could give rise to issues and become difficult from a profitability point of view,” says Jimmy Jean. It’s important that financial institutions stay afloat, otherwise it creates immediate problems in the economy. »
To imagine the dramatic consequences that too easy credit could have, you don’t need science fiction.
In the United States, so-called mortgage loans subprime largely contributed to triggering the Great Recession of 2008 throughout the West. Banks granted this financing to high-risk customers, at “promotional” rates which increased over time.
When the value of homes fell, the entire economic machine came to a halt.