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In Canada, banks set their prime rate which affects the lending rates for many of their products including variable-rate loans. Many sources say that the Bank of Canada's (BoC) interest rate determines/influences the bank prime rate, and currently all major banks have theirs at 4.70%. (Notably, TD has a separate mortgage prime rate which is different at 4.85%).

What incentives are stopping banks from raising their prime rate independent of the BoC rate, thereby increasing the lending rate for all of their existing variable-rate debtors?

It is clear that this makes their loans less competitive for future customers, but the immediate increased income must be tempting (it was for TD).

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    Free market? If the rate is lower somewhere else, why would lenders take their money?
    – littleadv
    Commented Aug 21, 2022 at 18:52
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    @littleadv you probably mean borrowers. Current borrowers have contracts with that bank and have no choice but to pay the variable interest that's linked to the bank's prime rate (or exit the contract and thereby incur penalties which, funnily, are also tied to the prime rate)
    – DrSAR
    Commented Aug 21, 2022 at 19:00
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    @DrSAR lenders actually. Prime rate is the inter-bank rate at which banks borrow one from the other in order to lend to other people. That's why the consumer loans are tied to prime rate + margin.
    – littleadv
    Commented Aug 21, 2022 at 19:02
  • @littleadv I think that's the crux of the OP's question. In Canada the inter-bank rate (currently averaging 3.65%) is influenced by the BoC overnight rate but fluctuates constantly. The banks' prime rate (currently at 4.7%) is set by individual banks and is rather sedate. It does not affect how much it costs TD to get money from RBC for short-term loans. So the OP is asking why there is a market for the banks to get their money but it appears that they have discretion to set the cost for their existing customers. And I'd like to know as well.
    – DrSAR
    Commented Aug 21, 2022 at 19:19
  • Increasing the prime rate also has the effect of making the bank pay more interest on variable rate GICs.
    – iter
    Commented Aug 23, 2022 at 13:54

2 Answers 2

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What incentives are stopping banks from raising their prime rate independent of the BoC rate, thereby increasing the lending rate for all of their existing variable-rate debtors?

Nothing but reputation damage and competition from other banks. And probably eventual public outrage and political action if they were to all do this in a significant way with no reason.

It has happened in the past, as recently as 2015 when the BoC rate was reduced by 0.5% but the bank prime rates only lost 0.3%. This is effectively hiding an increase of 0.2% as when the BoC rate later went back up, they followed the increases fully. This increase in spread from 2% to 2.2% persists to this day.

I'll quote this article about the event briefly:

“RBC dropped just 15 basis points to preserve margins and because it could,” said Mr. McLister.

So there you have it: they do whatever they can get away with.

It is clear that this makes their loans less competitive for future customers, but the immediate increased income must be tempting (it was for TD).

Not true as they can adjust the discount they offer to new customers to keep offering the same rates as before an increase in prime rate. Those discounts already vary from bank to bank, over time, according to mortgage size, etc.

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The market convention for "prime" rates is generally the central bank's rate plus a spread, as "prime" rates are really just a marketing tool and merely a starting point for setting interest rates on consumer lending products. In the U.S. the convention is the Federal Reserve's Discount Window rate plus 300 basis points (i.e., 3%), and in Canada, the convention appears to be the top of the BoC's Bank Rate plus 195 basis points (i.e., 1.95%). Again, the "prime" rate is really just a marketing rate and a starting point for setting consumer lending rates (for instance, the rate you actually pay is based heavily on your individual credit score/profile, among other things), so don't read too much into it.

As for TD, it could be that they are trying to take advantage of brand equity and they realized that the price-elasticity of demand (i.e., how sensitive people are to changing prices) for their loan products was such that they could charge a premium relative to the other major Canadian banks because of their perceived premium market position (again, another marketing trick). Moving it much higher would, as you point out, result in reduced lending volumes/new customers, but basically, they figured out how much they could raise the temperature in the proverbial pot of water before the frog would jump out (it could also be a cost of funding issue, too, but that's a much longer explanation). In any case as you noted, that's just a "prime" mortgage rate, and their regular "prime" rate is in lockstep with the other big banks (https://wowa.ca/banks/prime-rates-canada).

I'd also point out that the Bank of Canada is aware that some banks may not all move in lockstep on their prime rates, as there is some interesting language in the statistical methodology in how the BoC determines what to publish as the "prime" rate (https://www.bankofcanada.ca/rates/banking-and-financial-statistics/posted-interest-rates-offered-by-chartered-banks/).

tl;dr: don't read too much into "prime" rates; they're mainly just for marketing.

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