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.
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%.
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.
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.