Banks, banks, banks

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.

Possibly Related Posts (automatically generated):

58 thoughts on “Banks, banks, banks

  1. Magpie

    Hey, Stubborn,

    Let me first state that in this matter I’m a bit of an agnostic, meaning that I am not fully won by the side that sees in this a simple grab for cash (although, frankly, I tend to lean to this side).

    Further, you know I ain’t no fan of Mr. Hockey, either. But I think some background on Hockey’s position is required:

    (1) Hockey initially called for the Treasury (!?) to make sure banks followed the cash rate fixed by the RBA:
    Hockey reiterates banking rate call. SMH. 22-10-2010.
    http://news.smh.com.au/breaking-news-national/hockey-reiterates-banking-rate-call-20101022-16xrg.html

    (2) Everybody and their dog opposed Hockey’s position (and maybe one should include Mr. Abbott, who refused to comment on it).

    (3) In view of the overwhelming support received, Hockey backed down and came up with his 9 Point Plan.
    Joe Hockey’s Nine-Point Plan. SMH. 28-10-2010.
    http://www.smh.com.au/business/joe-hockeys-ninepoint-plan-20101028-174jw.html

    The other thing I’d like to comment is this:

    “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.”

    In that passage you are explaining the remarkable “plain” in the “Australian Mortgage Spread to the Cash Rate 1990-2010” chart.

    Frankly, in principle, I’d be surprised that Mr. Costello’s mere “sabre-rattling” could explain that much. I’m not denying this, only stating that it seems a bit unrealistic, to me.

    Finally, are the vertical scales right? I mean, were spreads negative during 1990?

  2. Stubborn Mule Post author

    Marco: I think Costello helped to cement the link to the cash rate, but certainly wouldn’t argue that was the only factor. The competition from non-bank lenders had a major role to play and the relative stability of outright interest rates (compared to the prior decade or two) would have helped too.

  3. Stubborn Mule Post author

    As for the negative spread, that is a bit strange…I will have to do some research to explain it, but the RBA data does have cash at 17.81% in Jan-90 and the mortgage rate at 17%.

  4. Magpie

    As a follow-up on this subject:

    Here’s an opinion piece that you might find interesting. It includes the Hockey second proposal (the 9PP, about which I particularly have nothing to object to, btw).

    Although it starts from the position that banks are indeed taking advantage of the situation, the basic idea seems neutral.

    Richard Denniss. Piggy banks telling porky pies over the costs of borrowing. SMH 05-10-2010.
    http://www.smh.com.au/opinion/society-and-culture/piggy-banks-telling-porky-pies-over-the-costs-of-borrowing-20101104-17fpr.html

  5. Stubborn Mule Post author

    Marco: unfortunately, once again the accusations of lies are based on fallacies. The following is just wrong:

    Banks source the money they lend us in a variety of ways, including our savings accounts (on which they pay us a pittance), from overseas lenders (on which they don’t pay the official interest rate) and from the Australian money market (where they do pay the official interest rate). 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.

    When banks are criticised on spurious grounds, it’s easier for them to shrug the criticisms off. Apart from anything else, does this kind of argument mean that if their margins are under pressure we should meekly accept the rate increases? I’ll talk more about it in later posts, but from my point of view, whether or not banks’ margins are under pressure is beside the point. More significant in my view is that the standard Australian mortgage product is quite anti-competitive. Again, more on that soon.

  6. Stubborn Mule Post author

    Reading a bit further down the article the points improve. All the arguments about clarity for borrowers shopping around for the best deal are far more important than the excitable accusations that banks are lying.

  7. Stubborn Mule Post author

    Preliminary back of the envelope estimates: bank margins are still going back, but they’ve clawed back something like 0.30-050% more on mortgages than the increase in their funding costs.

  8. Danny Yee

    For me, the most interesting thing about these charts is how badly the banks treat productive investment (small businesses) as opposed to non-productive investment (mortgages for the purchase of existing properties). This seems like a (socially) maladaptive allocation of capital.

  9. Stubborn Mule Post author

    @Danny: it’s interesting that politicians must see more mileage in taking up the cause of struggling homebuyers than struggling small businesses. It’s much harder to summaries in a single chart, but margins have certainly been pushed up for large corporates too. Presumably they’re even harder to feel sorry for! Mind you, borrowing costs for large corporates were extremely low prior to the financial crisis.

  10. Magpie

    Danny,

    Let me act as devil’s advocate here: under most conventional criteria, SME are greater risks than homebuyers. If so, then banks would be entitled to charge a premium risk. This could explain the differential in interest charged to SME, as compared to homebuyers.

    You may well be right about this originating a misadaptive allocation of capital. However, obviously, this none of the banks’ business. Their business is to make money for their shareholders (and their managers, clearly).

    Now, addressing Sean’s reply, presumably large corporations are better risks. Why would banks lend them money at higher rates?

    BTW, it seems Swan is warming up to Hockey’s proposal:

    Swan won’t rule out Hockey’s bank plan. ABC.
    http://www.abc.net.au/news/stories/2010/11/06/3058925.htm

  11. Magpie

    Sean,

    “All the arguments about clarity for borrowers shopping around for the best deal are far more important than the excitable accusations that banks are lying.”

    I myself think that Denniss’ personal reasons are largely irrelevant for what’s substantial here: Hockey’s 9PP.

    For instance, one of Hockey’s points, as reported in the SMH in the note linked above, was:

    “7. Let’s direct APRA to explore whether the risk-weightings on business loans secured by residential properties are punitive. Many small businesses tell me that they do not receive sufficient financial benefit from pledging their family home to secure their borrowings;”

    What’s more, regardless of Denniss’ financial reasoning in support of Hockey’s proposal, his political reasoning seems quite astute, to me.

  12. Paul Wallbank

    Some good points there Magpie, one thing I’ll like to weigh in on is those SME margins.

    While you’re right SMEs are a higher risk, that would justify higher rates for unsecured loans. For loans secured against property or cash, the rates should be similar, or even less than, mortgages.

    As the graphs above show secured SME loans are at similar rate with unsecured, which is risk free money for the banks.

    To add insult to injury for the small business sector, those unsecured rates are really nominal only because it’s been almost impossible to get an unsecured small business loan out of a bank for at least 20 years.

    The distortion of Australian bank lending towards housing has been a integral part of sector’s business model for at least two generations which has only been encouraged by poorly thought out regulation (Basel I), ignorant politicians and clueless financial reporters.

  13. Stubborn Mule Post author

    @Marco: I agree that the later points to make a lot of sense (and aim to catch some of those thoughts in a post soon). My frustration here is just that mixing up good ideas with inaccurate criticisms may undermine the good ideas. Then again, I might be too pessimistic there…the good ideas may prevail regardless.

    I was also going to make the same point Paul did: whatever the increase in perceive riskiness of SMEs may be, the increased margin on secured loans do look rather harsh.

  14. Magpie

    Paul and Sean

    “I was also going to make the same point Paul did: whatever the increase in perceive riskiness of SMEs may be, the increased margin on secured loans do look rather harsh”.

    Like I said, I’m just playing devil’s advocate here.

    Beyond any other consideration, the situation we are discussing involves only 4 major players, that on top have access to a lot of economic expertise. What would prevent them from identifying an opportunity to achieve rent profits?

    Besides, we’ve all seen how, after the banking fees class action started, suddenly banking fees fell. What does that suggest?

    But let me play a bit more:

    “While you’re right SMEs are a higher risk, that would justify higher rates for unsecured loans. For loans secured against property or cash, the rates should be similar, or even less than, mortgages.”

    True. But this is contingent upon how much of the loan is covered by the collateral advanced.

    As Sean has argued before, LVR for home-buyer mortgages are high. Unless an SME came up with a collateral as good, they would still need to pay higher interests.

    Besides, in an environment where housing prices are (or were, until recently) going up, isolated defaults shouldn’t be necessarily a bad thing for the lenders.

  15. Paul Wallbank

    Magpie, you’re spot on with your observation about LVRs. For secured business loans you have to stump up 100% security. Which means these loans are more secure than mortgages.

    If a business owner doesn’t have real estate equity or isn’t prepared to hock their home they are told to put an equal amount into a term deposit.

    This has been standard practice for years. I’ve been told this by my banks on three occasions in the last 15 years when I’ve been looking at funding various business ventures.

    This is why I say that secured SME loans should actually be at a *lower* rate than mortgages as there’s less risk in these loans than a residential mortgage given the secured business LVR is 100%.

    Danny’s point is spot on about the misallocation of capital but I don’t hold my breath for either the banks or governments to do anything about this.

  16. Stubborn Mule Post author

    @Paul: 100% security doesn’t make these loans more secure than regular mortgages. Typically banks will only lend up to a loan to value ratio (LVR) of 95%, which means that the security is more than 100% of the loan. On top of that, mortgages with LVRs over 80% require mortgage experience (paid for by the borrower). I would in fact expect that for many small business loans the security would likewise have to be more than 100% of the loan value. So, I expect that in many cases the amount of security for secured SME loans would be similar to that of many home loans. But security is only part of the story. One way to look at the risk of the loan is to split it into (a) probability of default and (b) loss given default. With similar security, the loss given default on SME loans may be similar to home loans, but it is likely that the probability of default would be higher. On top of that, the management required for SME loans is generally higher than for mortgages.

    Looks like I’ve ended up being the devil’s advocate now!

    Anyway, having said all of that, there may be a lag in banks funding costs, but there is not a lag in credit risk and I find it hard to see that SME risk is much higher now in Australia than two years ago, so the increase in margins on secured SME loans does seem big compared to the increase on mortgages. Maybe the question is, why were spreads on these loans only 0.2% higher than mortgages a few years ago? A possible answer is that the market was more competitive in 2006 than it is today.

  17. Paul Wallbank

    My bad about the LVR, but it doesn’t change my point that the vast majority of small business loans are essentially risk free for the banks given the loans are fully secured against the proprietors’ or directors’ property or cash assets.

    We should also keep in mind that the banks have historically been much quicker to call in security when a business, or the economy, has been in trouble, making the business loan market much more liquid than other sectors.

    I’d happily accept the banks making a fat spread were they taking any risks, but in small business lending they generally don’t take any risks at all.

  18. Ramanan

    Sean,

    I have a few points about one of the questions you have asked

    “If bank lending creates deposits, why do they need to borrow in offshore markets at all?”

    I think this is because banks operate internationally through the correspondent banking channel. If you import a Kindle, the bank will debit your account and its own “Nostro account” in another country will get debited, but in USD not AUD (at some exchange rate). In the simplest case (“circuit”), your bank goes into an overdraft position and needs funding. In the general case, your bank’s management may require a prudent level of USDs in its nostro account and has to attract dollars to fund this.

    There are of course other complications because of which banks look for funding – such as lower rates or demand in the equity markets.

  19. Stubborn Mule Post author

    @Ramanan: some good points there. I’m still mulling over the best way to write the post on that question. I’m thinking of breaking it into two parts: one is why banks cannot in general simply raise new loans to “create” the deposits the require (this is essentially about liquidity…loans do create deposits, but those depositors may withdraw their funds and the bank cannot simply trigger repayment of the loan on the other side of the balance sheet) and second the issue of offshore funding, which has a liquidity dimension, but also (at least in the case of Australia) a balance of payments one too.

  20. DD

    I would like to pick up the commentary on the interest rate differences between home loans, secured business loans and unsecured business loans.

    As noted here, home loans have typically shown the lowest risk of default and correspondingly the lowest interest rates. The risk of “default” for a business loan is not at all related to whether the loan is secured or not. That the Bank holds security is of benefit only in the instance where the business cannot meet its obligations ie whether there is a loss given default. The difference in interest rates between unsecured and secured business loans is therefore about whether the Bank has anything to sell if there is a default.

    The difference in interest rates between home loans and secured business loans is due to two factors:
    1. historical rates of default (mentioned in the above paragraph) and
    2. the costs of managing defaulting loans

    There is a lot of analysis and thought applied to rates of default. What we don’t often hear about is what happens between a loan being repaid normally and that loan being closed post-default. There is often a significant period of time between those states. It is during that time that management costs for the bank blow out and the recoupment of these management costs forms the other part of the interest rate differential between home loans and secured business loans.

    In my experience as a lender to both home borrowers and businesses the management usually goes like this:
    Home Loan – regular, say monthly, contact with the customer – do they have a job yet? has their divorce been finalised? Have they secured finance elsewhere? have they listed the house for sale? There are generally only a few specific actions that can be undertaken to finalise a defaulting loan.
    Business Loan – regular, weekly or even daily contact – the bank personnel will work with the business owner actually running the business – what payments are you making today? what did you sell yesterday? what accounts have you collected? what equipment can be sold? how many staff do you require? Can you move to cheaper premises etc. Banks will work with customers to trade out of problems and this is enormously time consuming and therefore expensive in terms of bank salary costs.

    This can go on for years and this is why business loans are more costly to manage even if they are secured.

  21. Magpie

    Hey Paul

    “If a business owner doesn’t have real estate equity or isn’t prepared to hock their home they are told to put an equal amount into a term deposit.”

    Why would anyone put AU$ 100 in a term deposit, to get a credit line for AU$ 100? The interest you would be earning is less than the interest you would pay for the credit line. And, at least if you’re self-employed, I believe you’ll pay taxes on the interest you “earn”!!

  22. Paul Wallbank

    Hey Magpie,

    I agree with you, the logic of placing in a term deposit the same amount as the loan is bizarre. Although I can imagine there might be some tax or legal circumstances it might be suitable.

    Try calling your bank and asking them for a business loan, they’ll ask if you have any property equity you’re prepared to secure it against and if you say “no” they’ll suggest this as the alternative.

    It’s happened to me personally twice with St George (pre Westpac) and ANZ. I know plenty of other people who’ve had the same conversation.

    On the other hand, if you go to them saying you want buy a doughnut franchise for 200k and you have 300k in home equity to secure it against they can’t approve you quickly enough.

    As I say, risk free money.

    I guess it’s a variation on the “equity maaaaaate” generation of bankers we currently have.

    DD,

    I’m not going to get into an argument with you except to point out two things;

    The first is most small business loans are “tick and flick”. The bank simply doesn’t care as long as the lone is well covered as per my doughnut franchise example to Magpie. They make up any further administration costs on a quite impressive range of fees charged on business accounts.

    Second, if we do accept your point that business loans have higher overheads then what the hell is the story with a 100% jump in 2009? Did every business lending manager get a David Murray sized bonus for their caring work?

  23. Magpie

    Paul,

    Perhaps I’m paranoid by nature, but this might be a little more than bizarre: it sounds like a legal subterfuge to deny loans to SME. Kinda Catch 22 situation.

    If you have any contacts with journalists, or with consumer groups, this could be a topic for them.

  24. Stubborn Mule Post author

    One possible scenario in relation to the term deposit as security: the term deposit may not belong to the borrower, but to someone who is prepared to stand as guarantor.

  25. Paul Wallbank

    Magpie, it’s nothing new. This has been the situation with small business loans for as long as I’ve been working in this space.

    The term deposit is the security they ask for if you don’t have, or aren’t prepared to give, home equity as security.

    It’s not a conspiracy, it’s just the nature of the Australian banking system. Basically if you don’t have home equity, go elsewhere.

    The real concern with this is should we have a Steve Keen or US style meltdown of the residential housing market, we’d see most secured small business loans being called in which would further accelerate the spiral.

    Which is another reason why our governments are hell bent on propping up residential property values, and you really can’t blame them.

  26. Ramanan

    Sean (@November 8, 2010 at 9:01 am),

    Makes sense. I guess one way to explain is to divide the banking sector into a “loan bank” and a “deposit bank”. The loan bank makes all the loans and all deposits move out to deposit banks through the central bank payment system. The loan bank would then have to issue CDs and/or borrow overnight to reduce costs of central bank overdrafts. It also adds other markups to price loans (such as borrowing long term, issuance of term deposits, raising money through equities etc) in order to achieve a target profit.

    For the case of Australia – and I am merely speculating – it seems to me that the term deposit rates are high and this may be the reason that banks’ markups have increased. Banks of course hedge their currency exposures but they are still indebted in foreign currencies. They may be doing this to attract capital inflows and hence be less indebted in foreign currency if there is good inflow.

    Normally it is said that the current account balance is equal to the capital account balance and the details are left in the air. Of course all payments respect accounting identities and hence the equality has to be satisfied at all times. However, one may wonder what happens if there aren’t sufficient FDIs and/or FII flows. The residual is picked up by the banking sector. (For the UK, this is quite huge according the “Pink Book”. )

    I believe that Australian banks may actually be facing higher costs of funding and they are honest about this.

  27. Magpie

    Sean and Paul,

    Well, I accept what you guys say. Maybe that’s how things are done here.

    But I’ve seen overseas something that, to me, looks similar:

    Come the black guys to the nightclub’s door. “Can’t come in”, says the bouncer. “Why not?” asks the black guy. “Not dressed properly”.

    And no matter how the black guys dress up, they’re never properly dressed.

    Over there they call it “discrimination”…

    Just my two cents.

  28. Zebra

    Marco,
    my understanding is that you are only charged a margin for a credit facility eg 50bp unless you use it. A term deposit offers higher interest than a normal savings/cheque account so the asset and the liability are not perfectly matched. This way they keep their cash in a (high interest) term deposit while having flexible access to “credit” to pay bills etc. It is really no different than using any other asset as security. But others may have different views (as usual).

  29. Zebra

    Not wishing to be seen to support banks but if I was a bank (if only!) and I had someone with a small business idea wanting to borrow money to start up a new business I’d either want to see incontrovertible evidence that the business would succeed (which apart from an established franchise in a new area I can’t see how you could), or a past history of successful business start-ups (which most people wouldn’t have) or security (and in the absence of property and/or a guarantor then a cash/term deposit).

    To suggest they should just fund, unsecured, every small business that comes their way gives a (almost) free option to the borrower. if it fails walk they away with no personal liability. I only have to note the number of shops that have opened and closed in my (relatively propseprous) area in the last year all of which would have looked like a good idea on paper, to see why banks approach small-business lending in such a cautious manner. The only alternative would be to charge every borrower much higher margins (like credit cards) to cover the inevitable high losses. Given the cashflow problems that afflict most new businesses this would seem to just increase the risk of failure substantially.

  30. Magpie

    James,

    “my understanding is that you are only charged a margin for a credit facility eg 50bp unless you use it.”

    I’m pretty sure you’re right about this. What I’m not so sure is that I said otherwise.

    “A term deposit offers higher interest than a normal savings/cheque account” […]

    Again, I agree.

    […] “so the asset and the liability are not perfectly matched.”

    Here I am confused. I take it the asset you mean above is the term deposit one advances as collateral to the bank (which we have been discussing here, btw). And the only liability we’ve been talking about is the commercial loan (say, credit line) one gets from the bank.

    As we have been supposing the same amount for both (say $100 collateral, $100 loan), aren’t asset and liability perfectly matched by hypothesis?

    However, they certainly differ in the amount of interests paid and received. Isn’t this the whole meaning of interest rate spread? This was the whole point of the discussion.

    “This way they keep their cash in a (high interest) term deposit while having flexible access to ‘credit’ to pay bills etc.”

    Again, I don’t quite follow: as you mentioned “pay bills, etc”, I guess you are assuming that the loan is intended to cover cash flow.

    This may be a perfectly valid particular scenario, but it’s not the general scenario I have been discussing. And, although I can’t speak for Sean and Paul, I don’t think they were talking about that particular scenario, either (please, Sean and Paul, feel free to correct me if I’m pissing out of the pot here).

    The general scenario I was discussing is: “Joe goes to the bank to ask for a loan to start a small business”.

    “It is really no different than using any other asset as security.”

    Provided one’s ready to pay for the difference between interests paid and received, that’s true. I suppose you’d agree there is a cost involved, right?

    What sounds excessive (at least to me, maybe not to you), though, is that one is forced to make a deposit as a requisite to get any loan.

  31. Magpie

    James,

    Something I forgot:

    Isn’t the higher interest rate paid by SME supposed to cover their higher risk?

    So, why are they charged a higher interest rate AND asked to cover 100% of the loan? If I put 100% of the amount I am getting as a loan and I default, the bank only needs to grab the deposit.

  32. Zebra

    Marco,
    on the first point you are no doubt correct – banks don’t make small business start-up loans without collateral ( including any resaleable assets of the business) except under exceptional circumstances (as outlined in part 2 of my comment).

    As far as the interest rate charged even with 100% collateral (+ a suitable additional haircut) there is still a risk that in the event of a windup there will be a shortfall. For larger SMEs (MEs?) they may not ask for collateral because they have already a claim on the assets of the company and the amount of leverage is relatively modest. Resale of plant&equipment might be enough to repay the loan even if sold at a discount. For small businesses (e.g the donut stand of Paul’s example) if they didn’t ask for collateral then the interest rate to cover losses would be even higher. Generally though they will expect a haircut (over collateral) and the term deposit is an example where the haircut would, I’m guessing, be close to zero.

    For an exisiting (but small) business which needs a loan to expand then presumably they have some cash for working capaital and retained earnings and the term deposit is a way of formalising this as collateral while still giving them access to working capital. Since, eventually, banks do lend money to successful SMEs without requiring term deposits this applies to newish businesses where the failure rate is very high.

    I am not sure how else you expect a bank to judge if a startup business is credit-worthy? Even if all the paperwork is in order the failure rate of start-up businesses, due to market factors (ie wrong product/time/place) is very high (I think over 50% in first couple of years). The bank doesn’t look at the business plan and ask why they think one more juice bar in the Bondi is likely to succeed. Or if they do the proprieter probably thinks they don’t “share her vision”. I imagine the level of self-delusion amongst start-up business people is higher than, say, public servants. They all expect to be the next Bill Gates. Like I said without some collateral this would make small busines loan costs skyrocket, way about credit card levels, whiuch assume a “low” failure rate of about 10-20%.

  33. Magpie

    I had not read DD’s comment, so let’s see if I understand his/her reasoning:

    “The difference in interest rates between home loans and secured business loans is due to two factors:
    1. historical rates of default (mentioned in the above paragraph) and
    2. the costs of managing defaulting loans”

    Using Engauge Digitizer on the “Australian Interest Rate Spread to the Cash Rate 1990-2010” chart above, I found the following spreads:

    As of SB uns SB sec Home mortgage
    2000 2.36709 1.91139 1.83544
    2005 2.62025 2.01266 1.81013
    2010 4.87342 4.11392 2.87342

    So, the difference between SB sec(ured) and Home mortgage is risk premium + overhead and it goes like this:

    As of risk premium + overhead
    2000 0.07595
    2005 0.20253
    2010 1.2405

    Basically, then, based on this data, for a few months around 2000 there wasn’t that much difference between an SB Secured Loan and a Home Mortgage (see chart, above); this would mean that both risk premium and overheads at the time were insignificant.

    This in itself is curious, as one would have thought that SB loans (secured or not) are inherently riskier than Home Mortgage loans, while one would expect overhead costs to be increasing, and less volatile.

    By 2005 risk premium + overhead was nearly three times as high. What changed between 2000 an 2005 that could explain that? After all, by 2005 nobody suspected that a recession was in sight, so in 2005 things didn’t look worse for SME as compared to 2000.

    This means that risk premium increase between 2000 and 2005 must have been near 0. Did overheads increase that much between 2000 and 2005?

    Okay, let’s see the difference between secured and unsecured SB loans.

    DD says: “That the Bank holds security is of benefit only in the instance where the business cannot meet its obligations ie whether there is a loss given default.”

    I am not sure that I understand this (perhaps a clarification would be useful and it would certainly be appreciated), but if the difference between secured and unsecured SB loans is not due to either risk premium relative to Home Mortgage or overhead costs (as DD said in the first passage I quoted), then how are we to justify the differences below?

    As of unsecured – secured
    2000 0.4557
    2005 0.60759
    2010 0.7595

    PS: Stubborn, have you thought about finding the correlation between these spreads and ROI? I know correlation does not necessarily imply causation, but sometimes correlation does suggest causation.

  34. Zebra

    “That the Bank holds security is of benefit only in the instance where the business cannot meet its obligations ie whether there is a loss given default.”

    I think that means the bank holds the security as collateral but the borrower gets any benefit of that security (interest+principal repayment) except where there is a loss given default.

    One reason why Sec-UnSec grew from 2000-2010 could be that there were more secured loans and perhaps this is related to the housing bubble. More SB borrowers used the increased equity in their property to borrow against. This would have left lower quality lenders without security to borrow against (“You mean you forgot to buy a house in 1995 when it cost $15 for a 4 bdrm waterfront mansion in Mosman!”). Or not.

    Keep digging Crow. I think your on to something. And it just possibly smells a little like greed.

  35. Stubborn Mule Post author

    Since the focus has been on CBA in particular, with their 0.45% rate hike, I looked at their overall net interest margin. For 2010 it was up about 0.1% from 2008 (they have certainly seem their profit margins on customer profits decline as that sector has become very competitive, so the overall number does hide a larger increase from lending), but it is still lower than 2006. I haven’t dug deeper into returns than that as yet.

    P.S. Magpie: I am a fan for Engauge Digitizer, but the data’s all on the RBA website too. Also, I can upload my data files and R code if you like.

  36. Stubborn Mule Post author

    As for the analysis of the returns on SME lending, my read of DD’s comments is the greater administrative cost of dealing with delinquent/defaulting business loans compared to mortgages is one factor explaining why the rates on even secured business loans are higher than on mortgages. It does not really explain the relative changes in these rates over the last few years. My own guess is that changes in the competitive landscape would be a factor. I’m more familiar with corporate lending and around 2006 there were certainly plenty of banks that considered the margins on corporate loans to be so low that, once you took into account the cost of capital that has to be held to support the risk, it wasn’t really economic. They still did it though for a number of reasons, including the hope of getting access to other, more lucrative business (such as underwriting bond issues, currency hedging, etc) and in some cases simply because market share overall was seen as valuable to banks’ broader business, even if they didn’t make that much out of particular corporate loans. Of course, the world has changed since the global financial crisis, the competitive heat has gone out of corporate lending (not just because some banks have collapse, but because many banks are concerned about their own liquidity and have rationed the amount of lending they do) and so spreads have widened significantly. On top of that, the worsened global economic environment has led to a reassessment of the riskiness of the loans as well. Whether or not similar explanations hold for SME lending, I’m don’t know.

  37. Pingback: Standard variable rate mortgages

  38. Magpie

    Stubborn and Zebra,

    >“That the Bank holds security is of benefit only in the instance where
    >the business cannot meet its obligations ie whether there is a loss
    >given default.”

    “I think that means the bank holds the security as collateral but the borrower gets any benefit of that security (interest+principal repayment) except where there is a loss given default.”

    Yeah, that much I do understand. In the case of a Home Mortgage, if you default, the bank just seizes the house/flat (the collateral) and auctions it. If the proceeds are more than what you owe, you get the difference. If not, then you still owe the shortage.

    There is a risk: the re-sale price of the collateral might have gone down (at least in theory, or in the US). As in this case the borrower is still in debt, then we would have to consider administrative costs, too.

    What I don’t understand is this: if you’re putting as collateral a term deposit for 100% of the loan, and you default, then the bank only needs to seize the term deposit. There’s no risk whatsoever of losing money, no commission to an auctioneer, no ads, no fees, nothing. Just a “sign here” and the bank owns the term deposit.

    In this case, the only thing remaining is to deduct whatever equity the borrower had (i.e. the “re-sale price” cannot go down, as it can in the Home Mortgage case). If anything, it’s the borrower who risks losing money.

    In that case, a 100% term deposit-secured SB loan would be less risky, not more, than a Home Mortgage loan. Consequently, it should pay a lower interest rate, not a higher one.

    I guess I was expecting some complicated explanation: for this or that legal reason there is a risk not accounted for in the argument above.

    But there could be something else here: if non-secured SB loans only involve a mark-up on interest rates with respect to secured SB loans (due precisely to the lack of security) then why the mark-up seems to be increasing?

    PS: I’ll have a look at the RBA data, although I loathe their website and I have another project of my own cooking.

  39. Stubborn Mule Post author

    One thing to note is that the rates used in the chart labelled “secured” are described in the RBA spreadsheet as secured by residential property. I don’t know whether the rates for loans secured by term deposits would be the same or not.

    Some key questions seem to be:

    1. What proportion of SME secured loans are secured by term deposits rather than property?
    2. Of those, what proportion are secured by term deposits in the name of someone other than the borrower?
    3. How do interest rates on loans secured by term deposits compared to loans secured by property?

    I don’t know the answer to any of these questions, but will endeavour to find out. One point to note in relation to #2 is that I suspect that when the term deposit is provided by someone other than the borrower, I would not be at all surprised to discover that the bank may often fail to be able to crystallise that collateral in the event of default. The “we didn’t understand what we were committing to” response would be common (and probably accurate too in most cases) and I think it would sometimes work.

    If I learn any more, I will report back!

  40. Zebra

    Marco, Sean et al,
    perhaps you can look at this the other way. Commercial loans (and personal loans too I guess) are the standard business of a bank but home mortgages traditionally represented an effort by the general populace who aspired to the 1/4 acre block+double front house so for political reasons they didnt charge as much. In other words as house were not seen as a profit making exercise (way back in the 1960s), unlike businesses, banks couldnt gouge mortgagees as much as small business borrowers, who believe the profit cashflows of their business will repay the loan.

    I think a fair comparison would be the rates for property investment loans (which are higher than owner occupier home loans) vs fully guaranteed SB loan (ie. with a term deposit, in borrowers name, at lending bank)

  41. Magpie

    Stubborn and Zebra,

    I agree with points one to three.

    But I don’t think you really believe this:

    “I suspect that when the term deposit is provided by someone other than the borrower, I would not be at all surprised to discover that the bank may often fail to be able to crystallise that collateral in the event of default. The ‘we didn’t understand what we were committing to’ response would be common (and probably accurate too in most cases) and I think it would sometimes work.”

    I wouldn’t bet on that, would you? :D

  42. Stubborn Mule Post author

    I certainly wouldn’t recommend anyone betting on getting off like this, but equally I am confident that it does happen, particularly if combined with some kind of (fairly common) error such as incorrectly executed documents.

  43. Paul Wallbank

    Zebra, no-one’s saying the banks should lend to anybody with a business idea; the discussion is around the premium charged to SMB borrowers.

    The funny thing is the banks will lend to anyone with a dumb business idea as long as there’s sufficient home equity to cover the loan and any foreseeable costs should the borrower default.

    Franchising is the best example of this where all four major banks at various times have been involved in less than arms lengths relationships with franchise chains. In many cases totally unsuitable franchisees received finance because they had plenty of equity to cover their loans.

    Again, zero risk and plenty of upside for the bank. Tough titties for you and I who took out a loan to buy that mobile mule washing franchise.

    On the matter of the security not being available the banks have that sussed as well. That earlier example of $300,000 home equity for a $200,000 doughnut shop loan was deliberate.

    Should you default on your $200,000 loan, the bank will load up a truly spectacular range of fees, charges and costs that will blow the 200k out to 300 in quick time.

    There’s few Australian SMB loans where there is any risk whatsoever to the bank.

    The more I think about this subject, the more I wonder why the banks aren’t more profitable than they currently are.

  44. Magpie

    Stubborn,

    “I certainly wouldn’t recommend anyone betting on getting off like this, but equally I am confident that it does happen, particularly if combined with some kind of (fairly common) error such as incorrectly executed documents”

    Don’t need to be cautious and not recommend this to me, believe me! ;D

    Other than the US foreclosure fiasco v 2.0, do you have any reason to believe this could happen in any measure? Like, in Australia?

  45. Stubborn Mule Post author

    Magpie I certainly have no reason to believe that it would happen on a large scale. I don’t think there are any systematic flaws in the system here. Apart from anything else, although I am yet to get any figures, I still suspect that the % of SME loans secured by term deposits would be very low. My point was simply that problems can and do happen so that, even with a term deposit lodged as security, the loan would not be entirely risk free, although certainly lower risk than a loan secured by property.

  46. Pingback: Bank funding costs

Leave a Reply