FAC 12 - Ch. 2 - Central Banks Lower Rates

Summary
The article reports that our central bank, The Bank of Canada (TBC), lowered the interest rate by 1/2% but the major banks in Canada lowered the prime rate (the rate given to its best customers) by half that amount - 1/4%. The TBC is following the moves of other central banks. It is interesting to note the US central bank (The Federal Reserve) lowered its interest rate by 1/2% as well and several large US banks lowered the prime rate by 1/2% matching the Federal reserve rate. When questioned why Canadian Banks did not pass on the full rate cut to consumers, the CEO of TD Trust stated that their borrowing costs are also up due the turmoil in the financial sector.



Connections
The connection to the chapter is how loans are recorded in the balance sheet equation. If a company is approved for a loan, then the principal of the loan would appear as a credit to loan payable (liability) and a debit to cash (asset). As the interest is paid, the portion of interest that matches the accounting period would be a debit entry for interest expense (SE) and a credit entry for cash (asset). It seems that loans from banks are only one source of start up capital as banks generally don't provide a loan to meet all the capital needs of a business that is just starting. However, as the business grows and has solid financials, banks are more willing to provide a loan. This was the experience of Chris Emery and Larry Finnson, the entrepreneurs who started Clodhoppers. Even though loans would be cheaper for Chris and Larry, they probably would only be able to get the prime rate once their business is established.

Reflection
The purpose of lowering the central bank rate is to provide an incentive to banks to lower their rates. With cheaper credit, business has an incentive to borrow. This injection of capital should stimulate business. I wonder if our banks are being too conservative. Our Finance Minister, Jim Flaherty doesn't want to "advise" the banks to lower their rates because he believes that we have a competitive banking system and the banks will respond to TBC rates "as they see fit". I read a prediction that Canada will be in a recession by the end of the first quarter of 2009. Is 1/4% enough to hold off a recession?