Bank funding costs

This post returns to the theme of interest rates on Australian mortgages. The first post showed the extent of the increases in mortgage rates over and above the Reserve Bank cash rate. The rationale banks have been giving for these increases is that their own funding costs have been continuing to blow out in the wake of the global financial crisis. In the spirit of occasional Stubborn Mule contributor @pfh007, it is time for some beer coaster calculations to see how plausible this argument is!

A number of commentators have accused the banks of out and out dishonesty on the subject of their funding costs. A few weeks ago in the Sydney Morning Herald, Ian Verrender focused on banks’ offshore borrowing and argued

if that really is the case, and only half their funding is sourced locally, then logically they should be raising interest rates by only half the rise in the official cash rate

Last week, also in the Herald, Richard Denniss built on this argument and argued that not only are offshore borrowings unaffected by Reserve Bank interest rate movements but so are all of their customer deposits. This led to the following conclusion.

Only about one-third of the banks’ funds come from the Australian money market, which means that when the official rate rises by 1 per cent, the banks’ costs only rise by about a third of 1 per cent.

But these simplistic arguments are incorrect. In saying this I am not defending the actions of the banks. There is no divine right for businesses to be able to preserve their margins at all times. Margin compression is a fact of life for many businesses. But more importantly, the ability Australian banks have to recoup costs from existing borrowers not just new borrowers is inherently anti-competitive.

Nevertheless, given the heat in the issue, it is worth getting a better understanding of exactly what is happening to bank funding costs.

A look at the balance sheet of any of the major Australian banks will show that their liabilities (which effectively represent the “funding” for their assets) are drawn from a range of sources. While the makeup will vary from bank to bank and change over time, roughly 50% of their funding is sourced from customer deposit balances and 50% from the wholesale markets (both domestic and offshore). Within those two categories, further distinctions can be made.

Wholesale Funding

Wholesale funding is a mix of short term “money market” borrowings and longer-term debt. Again, very roughly, about 50% of this wholesale funding is short-term (prior to the financial crisis, quite a bit more would have been short-term) and 50% long-term. Somewhat arbitrarily, “short term” tends to be defined as borrowings with a term of less than one year. Much of this borrowing takes the form of “certificates of deposit” (CDs) which are mostly bought by other banks or financial institutions like fund managers (much of the “cash” component of superannuation funds is invested in these sorts of instruments).

The interest rate paid on these deposits depends on the term and will be closely related to what the Reserve Bank does with its cash rate. For example, since the Reserve Bank just raised rates to 4.75% and it is almost a month until the next rate decision, the 30 day rate on CDs is currently very close to 4.75%. When the Reserve Bank hiked last week, markets were caught by surprise and the CD rate, which had been 0.20% lower jumped up in response to the central bank’s move. The correlation between these short-term borrowing rates and the Reserve Bank’s cash rate is not perfect, but on average over time, they are quite closely linked. So, the cost of this component of the banks funding can be expected to move in line with the cash rate, but should not increase significantly more than the cash rate.

Things are a bit different when it comes to long-term debt. For a start, most bonds are fixed rate: the interest the bank pays investors does not change even if the Reserve Bank cash rate goes up or down. However, while a fixed rate may suit investors, most of the bank’s assets have variable rates. Banks deal with this mismatch by using interest rate swaps (and other derivatives) which effectively convert their fixed rate borrowing into floating rate borrowing. The diagram below gives a simplified version of the mechanics of an interest rate swap. The bank enters into a contract with another party (typically another bank) to receive a fixed stream of interest payments in return for paying a variable or “floating” rate of interest. The floating rate is reset periodically, usually quarterly or semi-annually, with reference to a published rate which tracks short-term bank borrowing costs. The swap is set up to ensure that the fixed rate payments it receives match the payments it has to make on the bond. In this way, the fixed rate the bank pays on the bond is effectively turned into a variable rate from the bank’s perspective.Swap Diagram

Interest Rate Swap

This starts to make the cost of long term borrowing look a lot like the cost of short-term borrowing, but there is another factor: credit risk. If an investor buys a 5 year bond issued by, say, ANZ then it runs the risk that ANZ will collapse some time over the next five years. As compensation for this risk, the investor will demand an extra “premium” on the interest rate. This premium, also known as the “credit spread” or “credit margin” was fairly small before the global financial crisis, but shot up when investors suddenly realised that banks were not so safe after all.

Fortunately for banks (unlike their poor customers), they only had to pay the higher margin on new bonds. Even today, banks would still be paying off bonds issued before the crisis which have very low margins compared to the new bonds they are issuing. The average term of bonds issued by banks is around 3 years and the chart below shows how credit spreads have behaved over the last 12 years* along with a 3 year rolling average which gives a reasonable indication of the overall credit spread Australian banks are paying.

Financials Spreads

Credit Spreads for Financial Institutions (1998-2010)

The first thing to notice is that, although credit spreads have reduced since the peak of the financial crisis, the rolling average effect means that the effective cost of wholesale funds is still going up. Having old, cheap bonds maturing is adding to their cost of funds more than the fall in current spreads is saving them. On this point, at least, it would appear that banks are telling the truth!

But what about all of their borrowing outside Australia? Contrary to Verrender’s argument, Australian banks are not getting huge benefits by borrowing in countries with lower interest rates. Anyone with memories long enough to recall the notorious Swiss franc loans taken out by farmers and other small businesses in Australia in the late 1980s would appreciate that low interest rates do not count for much if the Australian dollar drops, thereby pushing up the amount of money you owe. Banks have no interest in running this sort of currency risk and so, much like their interest rate risk, they use swaps to hedge themselves. A “cross-currency swap” can be understood with a very similar diagram to the one above. Simply replace “Fixed” with, say, “US$ interest” and “Floating” with “A$ interest” and you have the picture for a cross-currency swap. This means that hedging is not a matter of paying some sort of small insurance fee, rather it effectively converts foreign interest rates to Australian interest rates. Even though perhaps half of the term funding raised by Australian banks is sourced offshore, it may as well be raised locally as far as the costs are concerned.

But how much is this increase in spreads costing the banks? As mentioned above, long term wholesale funding provides about half the wholesale funding for Australian banks, which is in turn about half of their total funding. So, a back-of-the-envelope estimate can be made by taking 25% of the 3 year rolling average. While I am at it, I will also project the rolling average forwards, assuming that credit spreads stay where they are today.

Low Funding EstimatesEstimated Impact of Term Spreads on Bank Funding Costs

This suggests that banks will see their funding costs continue to rise for about another year, but the overall impact of elevated costs in wholesale markets is only about a 0.45% increase. Compare this to what has been happening to mortgage rates.

Mortgage Spreads from 1998

Australian Mortgage Spread to the Cash Rate 1998-2010

The increase in mortgage rates over and above the cash rate has been about 1.2%, which is a lot more than 0.45%. So, while it may be true that wholesale funding costs are still increasing, it would appear that banks have already charged home buyers far more than the increase in costs the banks have suffered.

There is another source of costs for the banks that we need to consider: customer deposits. As wholesale funding costs rose during the financial crisis, banks began to compete aggressively for customer deposits as a (somewhat) cheaper alternative to wholesale funds. So, it is only fair to take the cost of customer deposits into account as well.

Customer Deposits

It is certainly true that on some of the customer deposits there is little or no interest paid, but there are also customer deposits which, particularly in recent years, pay very decent rates of interest. These include corporate deposits: imagine if a large mining company were to deposit a lazy $100 million into their account with one of the majors and was offered no interest…how long would it take for that money to move to another bank prepared to pay something very close to wholesale funding rates? Not long.

On this basis, we can reasonably assume that the cost of raising at least a portion of the banks’ customer deposits has risen as much as the increase in wholesale funding costs. To be generous, I will assume that all of their customer deposits have experienced this cost increase (although there are, of course, still plenty of low interest deposit balances out there…have a look at your own savings interest rates). Based on this assumption, I have recalculated the estimates of the increase in bank funding costs (i.e. taking 75% of the rolling average increase in wholesale spreads).

Spread Impact (High)

Estimated Impact of Wholesale and Customer Spreads on Bank Funding Costs

This revised estimate gets to an increased cost for banks of 1.3% which, given that the calculation is definitely too generous on the customer deposits side, is reasonably comparable to the increases passed through to mortgages.

However, the increases passed through to other types of loans (small business, credit cards, corporate loans, etc.) have been even bigger than those passed through to mortgages. So the only conclusion that can be drawn from this beer coaster is that:

  1. The banks are not lying when they say their margins are still increasing, but
  2. They have already gone beyond recouping these increased costs from their customers.

* Data source: Merrill Lynch. This data is the average asset swap spread across the financials sector and includes non-bank financial institutions and thus the spreads for the Australian major banks would, if anything, be slightly lower. I have now also got hold of data on some individual bonds issued by the majors and I will also analyse that to confirm it fits the same pattern.

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13 thoughts on “Bank funding costs

  1. pfh007

    Nice work with the Beer Coaster Mr Mule!

    Your point about the increased competition for customer deposits is well made as it is now very easy to maintain a ‘web only’ account of the type pioneered by competitors like ING Direct but now offered by most of the banks. Those accounts are currently offering close to the Reserve Bank Cash rate for small amounts and more than the Cash rate for larger amounts. ING Direct is current offering 5.5% on balances greater than $150K with a teaser rate of 6.25% for new customers.

    Any people who are still leaving more than token amounts in the stingy savings accounts of the major banks should consider making the move to web based alternatives.

    The obvious point to be made in this context is that low Reserve Bank Cash rates discourage people from increasing their saving deposits so there is a definite upside from increases in the Cash Rate. The pool of domestic savings should increase and thus lessen the need for overseas sources of funds for domestic lending. In principle there is nothing wrong with importing capital rather than accumulating it domestically but the events of 2008 show that there are real risks associated with that strategy.

    Perhaps during periods of low inflation a factor to be taken into account by the Reserve Bank when setting the Cash Rate is the level of domestic savings. If domestic savings are too low or falling that may be an indication that the Cash Rate is too low.

    Setting the Cash rate by reference to inflation or employment may not be sufficient in a low inflation environment.

    As to the things that should be included in the calculation the current (or desirable) level of domestic savings, I will leave that to others to judge.

    Unfortunately, the obsession down under with debt and leverage means that discussion of why people save and efficient simple means by which they might save sustainable over their lifetimes is considered old fashioned.

    Afterall, if the level of interest on simple net based savings accounts was appropriate, the need for complex supperannuation arrangements might be greatly reduced.

  2. Bruce

    Bank offshore funding has been increasing since 1990.

    Indeed, the property boom of the noughties would have been impossible if Aussies did not bid prices up with foreign funds.
    Nevertheless, this is unsustainable. Foreign funding increases the primary account deficit- the primary account being the second main contributor to the current account (along with the trade balance).

    Further, as you state Mule, the supply of credit for business and housing will become a lot more volatile in the future, due to the perception of risk via foreign creditors. The buffer of borrowing domestically has been removed.

    There’s no reason why Aussie rates will not go above 9% in the next 3 years. With more volatile rates will come volatile business conditions and house prices.

  3. Magpie


    I appreciate the effort put into this piece, for which you only deserve praise.

    Your conclusions seem sensible, as usual, and I do not object to them, partly due to my knowing you are a sensible fellow; partly because they somehow sound sensible. Unfortunately, I can hardly make any other comment.

    For, in truth, I feel none the wiser about how banking finances work (and now, painfully aware of that; which is a good thing!).

    I think I get the general “3-year rolling average” idea: the aggregate funding cost in year t+3 is some kind of combination of costs from previous years t+2, t+1, t.

    However, I gained no insight whatsoever about how the Interest Rate Swap and the Cross Currency Swap work. In fairness, this is a reflection of my own ignorance. Other readers, clearly, will find this much clearer than yours truly.

    Short of explaining with a numerical example how those thingies work, the only way around I can suggest is something like a kind of simplified Balance Sheet:

    “Long-term liabilities:________$X=$Y+$Z
    Local currency:____$Y
    Foreign currency:__$Z”

    Now you apply Procedure A to $Y and simply state:

    “Procedure A is a black box: you feed it this, and it outputs that (if you don’t believe me, well, just check it out here (link to ‘Procedure A for Magpies/Dummies and some such’). Now you plug the output here” ;-)

    Sorry for not being able to offer a more valuable comment!

  4. Stubborn Mule Post author

    That piece by Peter Martin makes a much strong claim than I have in this post. I have conceded that bank funding costs may well have increased by more than the RBA cash rate, but that this increase has been more than offset by increases in interest rates to borrowers. Although I am yet to dig through the figures (soon perhaps!), the commentary on the APRA report says that their funding costs have not even increased as much as the RBA rate. Since I remain convinced that wholesale funding costs are still averaging up as a result of older, much cheaper bonds maturing, I can only see two explanations here. Either a) the commentators have got it wrong or b) banks have not fully passed through increases in interest rates to their customer deposits.

  5. Pete

    Interesting piece from the ABC today quoting Reserve Bank deputy governor Ric Battellino on his take that competition among banks is still thriving, but just for deposits rather than loans:

    “People are saying there’s not as much competition in banking as there used to be. I’m not sure that’s correct. I think what’s happened is the nature of the competition has changed.

    “So if you go back through the period in the second half of the ’90s and early this decade, when funds were plentiful, the banks were competing to lend the money, so people saw a lot of competition on the loan side.

    “But now what’s happened is because the availability of funds to banks is actually quite tight, the competition is all on raising the money and so it’s the depositors that are getting extraordinarily good deals, whereas if you go back 10 years ago it was the borrowers who were getting the extraordinarily good deals.”


  6. Pete

    Stubborn, I’ve been mulling over this question for a week now and have done a fair bit of reading on the net to try to fill my knoweldge gap but I still don’t have my head around it – so apologies if this is a dumb question but it’s eating at me!

    I think I now understand the principal behind interest rate swaps – essentially this is just a stright trade of fixed debt for variable.

    However, with currency swaps everything I’ve read would seem to indicate that the total amount of AUD in the mix must be neutral in order for the swap to make sense. How can this be the case if the Aussie banks are “bringing in” currency from overseas? To swap a foreign currency debt surely there must be an equivilent AUD debt to swap it for – and wouldn’t that leave the total funds available for distribution within Australia unchanged?

  7. Stubborn Mule Post author

    Peter: certainly not a dumb question!

    The first thing to appreciate with derivatives like swaps is that, while they may have the effect of converting one sort of debt into another, it does not mean that both sorts of debt have to actually exist. What do I mean by that? Go back to the case of the interest rate swap. A commercial bank issues a 5 year (fixed rate) bond, which is bought by a managed fund. So far, the bank and the fund manager between them have brought some fixed rate debt into existence. Now the bank decides it actually wants to floating rate debt, so it enters into a swap with, say, an investment bank. The investment bank then has interest rate risk (if interest rates go up it receives higher payments from the commercial bank and so makes money and, vice versa, loses money if interest rates go down). So far, no new debt has been created. Although the commercial bank has now “synthesised” floating rate debt with the combination of the bond and the swap, no one has actually provided floating rate debt directly. Furthermore, the investment bank may then decide to hedge its risk using futures contracts…still more derivatives, but still no floating rate debt to be seen. So, the interest rate swap is just a swap of the interest rate risk associated with debt not a swap of the debt itself.

    A similar situation arises with cross-currency swaps: they are essentially used to convert the risk of foreign currency debt into the risk of domestic currency debt. It does not mean that both a 5 year (say) US$ loan and a 5 year A$ loan have to exist. There is, however, one important extra feature of a cross-currency swap: the exchange of principal. Assume again that the commercial bank issues a 5 year bond which is bought by a fund manager, this time a US$ bond. The commercial bank then receives, say, US$100 million from the fund manager. The commercial bank then enters into a cross-currency swap with the investment bank. The very first thing that happens when the swap is that the two banks “exchange principal”, which means that the commercial bank pays the US$100 million to the investment bank and the investment bank pays A$101 million (based on the current exchange rate of around that A$1 is around US$0.99). From then on the commercial bank pays an Australian rate of interest on A$101 million to the investment bank, which in turn pays back a US rate of interest, which the commercial bank passes on to bond holders. From the point of view of the commercial bank, that’s it. They have gone to the offshore markets, but effectively ended up borrowing in A$. But from a macroeconomic point of view, the A$ still have to come from somewhere. The investment bank would have used the US$100m to buy the A$101 million in the currency markets, but ultimately, someone somewhere was prepared to take A$. The important point, however, is that there is no need for this provision of A$ to have any resemblance to a 5 year loan. Australia typically imports more than it exports, spending more than it gets in. For this to happen, there have to be foreign investors who are happy to hold A$ financial assets. The fact that Australian interest rates are much higher than other developed countries helps a lot in this regard, and it is likely that many of these investors are holding short-term instruments like bank certificate of deposits.

    So, in a round about way, you are right. The swap does not magically negate the need for US$ to be brought into the country, but there are endless strings of transactions between the fund manager who buys US$ bonds issued by Australian banks and the investor who ultimately buys A$ investment assets to fund our current account deficits.

    I hope that didn’t end up being even more confusing! Perhaps a post on swaps is called for at some point.

  8. Senexx

    in prosperous times, when corporate cash flow rises beyond what is needed to pay off debt, a speculative euphoria develops, and soon thereafter debts exceed what borrowers can pay off from their incoming revenues, which in turn produces a financial crisis – Minsky

    Are the local banks here going to create a similar financial crisis here to as what happened overseas. Whilst I’m not sure we’ve seen a speculative euphoria from the banks, the rest is certainly there.

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  10. Stubborn Mule Post author

    Senexx that’s a tough one! It’s always easier to identify a bubble after it bursts. For everyone saying that things are getting overheated, there’s someone else arguing that it’s reasonable. About 18 months ago, I argued that while Sydney property prices were looking a little toppy, I didn’t expect a crash (on the basis that the trigger conditions…high unemployment, etc…were not there). I did expect prices to be stable or drift down, but they’ve continued to rise, which increases my nervousness, as does the still very high level of private sector debt. Still, interest rates are higher here now than they were in the US when their bubble was fuelled and they’re only going up not down. I find this one hard to predict.

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