Banks, banks, banks

by Stubborn Mule on 5 November 2010 · 58 comments

There has been a frenzy of bank bashing in Australia over the last few weeks. The attacks intensified on Tuesday when the Commonwealth Bank decided to raise their standard mortgage rate by 0.45%. As the national broadcaster did not want us to miss, this was almost double the Reserve Bank’s interest rate increase of 0.25%. Politicians have been particularly keen to get into the action, with some peculiar results. One minute shadow treasurer Joe Hockey was pilloried for advocating tighter regulation of banks when supposedly representing the party of free markets, while days later the Commonwealth Bank’s move made him look penetratingly prescient.

Home ownership is a topic close to the hearts of many Australians and it should come as no surprise that, as mortgage rates rise and some borrowers start to experience real financial distress, the actions of banks should come under the spotlight. Unfortunately, very few commentators seem to have a good understanding of how banks operate which means that while there are some good questions being asked (such as why are banks so quick to put the squeeze on the customers who can least afford it while they are turning record profits and paying themselves such generous bonuses), there are also plenty of red herrings cropping up (like the idea that banks are getting a free kick from their offshore borrowing since interest rates are lower overseas).

For a few weeks now I have been contemplating a blog post that attempts to make the mechanics of banking a little clearer. There is too much to fit comfortably in one post, so here are some of the subjects I’ll aim to cover over the next week or so (in no particular order):

  • Are bank funding costs really still going up?
  • If bank lending creates deposits, why do they need to borrow in offshore markets at all?
  • How does offshore funding work and how much does it cost for the banks?
  • Is there a problem with competition in banking in Australia and (if so) what can be done about it?

While I will not get to any of these questions in this post (other than touching on the first), I will give some historical perspective on mortgage rates and other lending rates.

The chart below shows the history of some key interest rates over the last 20 years. The lowest of these is the Reserve Bank cash rate, and coming in at the top is the average rate banks charged small businesses for unsecured loans. Interest rates for small business loans secured by property are somewhat lower. The mortgage rates are based on a simple average of the rates offered by the four major banks on loans for owner-occupiers.

Interest Rates

Australian Interest Rates 1990-2010

Since everyone’s eyes have been on changes in mortgage rates compared to the Reserve Bank’s overnight cash rate, here is a chart showing the difference between these two rates. It is not clear yet which (if any) of the other banks will follow the Commonwealth Bank’s lead in raising mortgage rates by 0.2% over the Reserve Bank move, but for the purposes of this chart I have assumed half the banks lift their rates 0.25% and half 0.45%, thereby pushing the average spread up 0.1% to 3%.

Mortgage SpreadAustralian Mortgage Spread to the Cash Rate 1990-2010

This chart provides an interesting historical perspective. As interest rates began to fall in the early 1990s, banks were slow to push through the reductions to borrowers, thereby building up healthy margins. This helped them recover from a rather painful period for Australian banks. Westpac in particular had come close to collapsing in 1992. Then in the mid-90s, aided by securitisation non-bank lenders like Aussie Home Loans and RAMS introduced new competition to the market, pushing the margins down. Margins were then stable for a number of years. During this period, then treasurer Peter Costello established the political sabre-rattling to keep banks in line, which cemented the idea that mortgage rates should move in lock-step with Reserve Bank cash rate moves. Prior to this, the relationship had not been so stable.

Now, in the wake of the global financial crisis, driven by a combination of increased bank funding costs and the fading of non-bank competitors, the spread to the cash rate has been on the rise once more, although it is yet to reach the levels of the early 1990s. However, as the chart below indicates, small businesses have seen their margins rise even more rapidly. A few commentators have noticed this fact, but most of the indignation of pundits and politicians has been focused on mortgages.

Australian Interest Rate Spread to the Cash Rate 1990-2010

Despite the fact that the link to the cash rate is so well established, the cash rate is not the primary driver of banks’ funding costs. Changes in the rates on bank bills with maturities in the range of 30 to 90 days give a better indication of day to day changes in bank funding costs. On top of that, funding they source from domestic and international bond markets adds a margin on top of these bill rates. Although there is a high correlation between changes in the Reserve Bank cash rate and bank bill rates, the relationship is not perfect. This means that the spread between lending rates and the 90 day bank bill rate (labelled BB90 in the chart below) provides a better indication of changes in bank margins, although it does not capture increases in bond market margins in the wake of  the global financial crisis.

Spreads to bill rates

Australian Interest Rate Spread to 90-day Bank Bills 1990-2010

One thing that this chart highlights is that the strong link to the cash rate in fact introduces quite a bit of volatility in bank margins. Over time this volatility averages out and banks can also use derivatives (primarily “overnight indexing swaps”) to smooth this volatility.

Without taking into account the margins banks face in the bond market, these charts are not enough by themselves to determine whether banks are reasonably passing on rising margins or are simply lining their pockets. That is a question I will return to in a later post.

Data Source: Reserve Bank of Australia.

Thanks to @Magpie for the link to this piece by Christopher Joye which has a detailed discussion of the issue of interest rates for businesses, a topic which generated a lot of discussion in the comments here on this post.

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{ 56 comments… read them below or add one }

51 Magpie November 24, 2010 at 4:31 pm

Stubborn,

Here Peter Costello proposes an explanation to the change in spreads we see in your chart “Australian Mortgage Spread to the Cash Rate 1990-2010″ (above):

“The difference, or spread, between the cash rate and the variable mortgage rate has varied over time. In 1996 it was 300 basis points (3 per cent). By encouraging competition, particularly from mortgage originators, and a bit of jawboning it came down to 180 and stayed there for about eight years from 1999. WHEN LABOR WAS ELECTED IN 2007 THE BANKS TOOK THE OPPORTUNITY TO WIDEN SPREADS. By July 2008 – before the Lehman crash and global financial crisis – it had risen to 235 points. Through 2008 mortgage originators were struggling to write new business and after the Lehman crash government guarantees gave banks a privileged position over competitors. They widened spreads again. Now they are more than 300 points and right back where they were in 1996.”

Peter Costello. “The best price signaller in the land”. November 24, 2010. (My emphasis)
http://www.smh.com.au/opinion/politics/the-best-price-signaller-in-the-land-20101123-185il.html

52 Stubborn Mule November 24, 2010 at 8:26 pm

Magpie: as you know, I do not think that the banks are really in dire straights as a result of their increased funding costs, but by the same token, Costello’s line seems to be that nothing has changed since 1996 other than a change to a Labor government. This is pretty silly and ignores the very real impact of the GFC and, while to many outside the financial markets, the GFC seemed to start when Lehman Brothers collapsed, did Costello stop to consider why Lehman collapsed? If he did, he may recall that Bear Stearns had to be bailed out in March 2008 which in turn got into trouble because the roots of the financial crisis actually began in early 2007 and by mid to late 2007, funding costs had already risen sharply. There’s no doubt that banks have done what they could to take advantage of the collapse of their non-bank rivals and the resulting evaporation of competition, but this had everything to do with the GFC and nothing to do with a Labor government. The same thing would have happened if the Coalition was in power, but things may have been worse since they appear pathologically afraid of government debt and would almost certainly have enacted a much smaller stimulus package. So then unemployment would be higher and mortgage rates would have gone up.

53 Magpie November 24, 2010 at 9:40 pm

Stubborn,

I couldn’t agree more. I just wanted to know your opinion, as you’ve done some thinking about this subject.

As I see it, Mr. Costello might have started to believe his party official line.

54 Stubborn Mule November 24, 2010 at 10:06 pm

The instinct to put the boot into the other side never seems to wane!

55 Magpie December 17, 2010 at 10:42 am

Hey Stubborn,

Did you gain another follower?

http://christopherjoye.blogspot.com/2010/11/great-small-business-loan-puzzle.html

In fact, although I often disagree with the poster, I found that particular blog quite interesting and well reasoned. Certainly worth a look.

56 Stubborn Mule December 17, 2010 at 4:36 pm

Magpie: it is a good piece…I think that his second point

Competition that may have kept small business rates in line with other residential rates evaporated during the GFC and allowed the incumbents to extract much higher margins

is very plausible. I’ll add a link in the main post.

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