Last month, I wrote a series of articles (here, here and here) arguing that the Australian banks’ funding costs had risen since mid-2011 and that the banks were justified in raising lending rates independent of any moves by the Reserve Bank of Australia (RBA).
Yesterday, the RBA released its Bulletin for the March quarter of 2012, which contains a paper, Banks’ funding costs & lending rates, that confirms my analysis by calculating that bank funding costs have risen by 20 to 25 basis points since the middle of 2011 (full paper below). Below are the key extracts from the paper, along with some commentary [my emphasis].
The RBA paper begins with the abstract summarising the key findings:
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Over the past year, lending rates and funding costs have both fallen in absolute terms but have risen relative to the cash rate. The rise in funding costs, relative to the cash rate, reflects strong competition for deposits, particularly term deposits, and higher spreads on wholesale debt reflecting an increase in investors’ concerns about the global banking industry. While spreads have narrowed recently, they are still noticeably higher than they have been over the past couple of years. Over the past six months, lending rates have generally fallen by more than funding costs.
Then it moves to a discussion on the composition of bank funding:
The level of the cash rate set by the Reserve Bank is a primary determinant of the level of intermediaries’ funding costs and hence the level of lending rates. It is the short-term interest rate benchmark that anchors the broader interest rate structure for the domestic financial system. However, there are other significant influences on intermediaries’ funding costs, such as risk premia and competitive pressures, which are not affected by the cash rate.
At various points in time, changes in these factors can result in changes in funding costs and lending rates that are not the result of movements in the cash rate. The Reserve Bank Board takes these developments into account in its setting of the cash rate to ensure that the structure of interest rates in the economy is consistent with the desired stance of monetary policy…
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The above point is often overlooked by commentators, who argue that if bank funding costs are reduced, it will automatically result in lower mortgage interest rates. However, the RBA takes into consideration the banks’ end-user lending rates when deciding on the appropriate level of official interest rates.
So if the Government was to significantly lower bank funding costs, say via adopting a CMHC-style government guarantee of mortgages, the RBA would be likely to compensate by increasing the official cash rate so that end-user mortgage rates end up unchanged.
Back to the RBA.
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The increase in the relative cost of term deposits and wholesale debt has led to an increase in the weighted-average cost of funds for banks, relative to the cash rate, since mid 2011. This increase is in addition to the increase that occurred between mid 2007 and 2010. The article also documents the decline in bank lending rates since mid 2011, and discusses the effect on banks’ margins of the movement in funding costs and lending rates…
Within banks’ deposit funding, there has been a marked shift towards term deposits, which pay higher interest rates than other forms of deposits. Indeed, term deposits have accounted for most of the growth in bank deposits since the onset of the financial crisis and now account for about 45 per cent of banks’ deposits, up from 30 per cent in the middle of 2007 (Graph 2).
For banks, term deposits have the advantage of generally being a relatively stable funding source: while the average maturity of term deposits is fairly short, at somewhere between four and seven months, these deposits are typically rolled over a number of times. The rates on new term deposits can also be adjusted quickly to influence the growth in this source of funding.
While most of the competition among banks has been for term deposits, banks have also offered more attractive transaction and savings accounts, particularly through paying higher interest rates on these accounts…
In wholesale markets, the major banks have raised a sizeable amount of funding through covered bonds in recent months. In total, the major banks have issued more than $22 billion of covered bonds following the passage of enabling legislation in October 2011…
[Covered bonds have also] allowed the major banks to achieve funding at longer tenors than is usually available with unsecured bonds. Covered bonds have generally been issued for terms of 5 to 10 years, whereas unsecured bank bonds are generally issued with maturities of 3 to 5 years…
The RBA paper then moves on to the cost of funding, which has risen for almost all funding sources since mid-2011:
The absolute level of banks’ funding costs fell over the second half of 2011, but by less than the reduction in the cash rate. There were particularly pronounced increases in the cost of term deposits and long-term wholesale debt relative to the cash rate as financial market conditions deteriorated in late 2011…
Competition for deposits, which had moderated somewhat in early 2011, intensified in late 2011. Consequently, while the cash rate has fallen by 50 basis points since mid 2011, the major banks’ average cost of deposits is estimated to have declined by about 25 basis points…
The average advertised rate on at-call savings deposits – including bonus saver, cash management and online savings accounts – rose by around 20 basis points relative to the cash rate over 2011 (although again the interest rate declined in absolute terms). Taking into account an increase in the proportion of savings deposits earning bonus rates, the average effective rate on these deposits is estimated to have increased by between 35 and 50 basis points relative to the cash rate…
The absolute cost of issuing new unsecured wholesale debt fell during 2011… Relative to risk-free benchmarks, however, the cost of issuing wholesale debt has increased materially since mid 2011 (Graph 5). This increase was particularly pronounced at longer maturities.
The increase in spreads on banks’ wholesale funding reflects global investors demanding more compensation for taking on bank credit risk, although the rise for Australian banks has been less marked than it has been for other banks globally… There has also been an increase in the costs associated with hedging the foreign exchange risk on new foreign-currency denominated bonds.
While the relative cost of new long-term wholesale funds is currently higher than that of maturing funds, this has had only a moderate effect on the major banks’ average bond funding costs relative to the cash rate to date (Graph 6). This reflects the fact that it takes at least 3 to 4 years for the major banks’ existing bond funding to be rolled over. Since spreads began to rise sharply in August 2011, the major banks’ issuance of new bonds amounts to about 12 per cent of their outstanding bonds. As a result, the cost of the major banks’ outstanding long-term wholesale debt is likely to have risen by about 25 basis points relative to the cash rate over the past year…
If the cash rate, bond spreads and hedging costs remain at their current levels, the average cost of banks’ long-term wholesale debt will increase by a further 5 to 10 basis points, relative to the cash rate, by the end of 2012 as maturing bonds and hedges are rolled over…
Short-term wholesale debt is mainly priced off 1- and 3-month bank bill rates. While these rates generally fell over the latter half of 2011 due to the sharp fall in the expected cash rate over this period, there was an increase in the cost of short-term debt relative to the expected cash rate…
Taking the costs of individual funding sources noted above, and weighting them by their share of total bank funding, provides an estimate of the overall change in the cost of funding banks’ aggregate loan books. Compared with mid 2007, the average cost of the major banks’ funding is estimated to be about 120–130 basis points higher relative to the cash rate (Graph 8). Most of the increase occurred during 2008 and early 2009 when the financial crisis was at its most intense. Since the middle of 2011, however, there has been a further increase in banks’ funding costs relative to the cash rate of the order of 20–25 basis points.
The RBA paper then turns to the asset side of the balance sheet and finds that banks have increased average lending rates by around 5 basis points relative to the cash rate:
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Since the onset of the financial crisis, banks have increased the spread between lending rates and the cash rate for all loan types…
Over 2011, the average interest rate on new variable-rate housing loans decreased by about 10 basis points relative to the cash rate as banks increased the size of the discounts on new mortgages amidst stronger competition for mortgage lending (Graph 9). In the latter stages of 2011 and early 2012 there was, however, a small reduction in these discounts. Furthermore, in early 2012, most banks increased their standard variable rates by an average of about 10 basis points.
Consequently, between early 2011 and early 2012, the spread between new variable-rate loans and the cash rate has increased by about 5 basis points. The spread between the average interest rate on outstanding variable-rate housing loans and the cash rate has risen by a similar amount…
Finally, the RBA paper notes that the major banks’ net interest margins have contracted by around 5 to 10 basis points, with larger contractions in margins experienced by the regional banks (emphasis added):
Over the past year, lending rates and funding costs have both fallen in absolute terms but have risen relative to the cash rate. Lending rates have generally fallen by more than funding costs which, all else being equal, would imply that the major banks’ net interest margins have contracted a little. However, while lending rates and funding costs are important determinants, banks’ net interest margins are also influenced by a number of other factors including:
changes in the composition of banks’ assets;
changes in banks’ use of equity funding (given that equity does not incur interest payments but banks seek a return on this source of funding when setting their lending rates);
changes in the interest income lost because of impaired loans; and
the use of derivatives to hedge the interest rate risk on their assets and liabilities.
December quarter trading updates provided by three of the banks report a narrowing in margins of around 5 to 10 basis points, consistent with the above analysis.
The regional banks’ net interest margins continue to be lower than those of the major banks, primarily reflecting more expensive deposit and long-term wholesale debt funding costs, and a larger share of lower-margin housing lending.
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So overall, the RBA paper is consistent with my own analysis published last month.
Leith van Onselen is Chief Economist at the MB Fund and MB Super. He is also a co-founder of MacroBusiness.
Leith has previously worked at the Australian Treasury, Victorian Treasury and Goldman Sachs.
