Where does the money go?

A regular Mule reader drew my attention to an article in the Sydney Morning Herald (also published in The Age) which attempts to defend Australian banks from some of the criticisms levelled at them in recent months. It is something of a laundry list of points, some accurate, some dubious and has little in the way of hard data behind it.

What my correspondent was more interested in, however, was that one powerful argument was missing. If banks had not bolstered their margins by raising mortgage rates by more than the Reserve Bank cash rate rises, the Reserve Bank would in all likelihood have increased the cash rate by even more. This contention is supported by the Reserve Bank’s own board meeting minutes from the 2 November meeting. Discussing the considerations which led to the November rate hike, the following observations appear:

Members noted that lending rates might increase by more than the cash rate, but this tendency would not be lessened by delaying a change in the cash rate. Lending rates had been rising relative to the cash rate since the global financial crisis, and the Board had taken this into account in setting the cash rate. It would continue to take account of any changes in margins in its decisions in the period ahead.

From this it seems clear that if the banks had kept to moving their mortgage rates in line with the cash rate, the cash rate would now be higher and the end results for borrowers would be much the same.

Of course, if this had happened, bank margins would have been squeezed, which leads to this question from my correspondent:

Where banks don’t increase margins but RBA increases base rate more so overall level the same, where does the “banks’ profit” go? RBA [Reserve Bank of Australia]?

This question gets to the heart of how banks work.

While we tend to think of banks as lenders, it can be more useful to think of them as intermediaries between borrowers and lenders. The real lenders are the banks’ depositors and bondholders. Banks pay interest on deposits and bonds and charge a somewhat higher rate interest on their loans. The difference between the interest they pay and the interest they receive is their net interest margin which, along with fees and charges, is their source of profit. In the wake of the financial crisis, the market for deposits has become very competitive and bond investors now demand higher returns on bank debt compared to lower risk alternatives (such as government bonds…at least if the government in question is not European!). Both of these effects have resulted in the interest banks pay increasing by more than the amount the Reserve Bank’s cash rate has increased. Banks have attempted to recoup the resulting increases in the interest they pay by passing through bigger increases to their borrowers (you can read more of the details in an earlier post on bank funding costs).

So, if banks had kept their mortgage rates strictly in line with the Reserve Bank’s cash rate, their margins would certainly have been smaller than they are today. If that had happened, where would the money have done? It does not go to the Reserve Bank: while they set the target rate, the Reserve Bank itself does very little lending at that rate. Rather they ensure that any lending overnight from one bank to another is done at or very close to the target rate by promising to lend or borrow large amounts at rates only slightly above or below the target respectively. No, the real beneficiaries of the higher rates are the ultimate lenders: depositors and bondholders.

Anyone with a balance in a superannuation fund is likely to have a certain amount invested in bond funds which would invest in, among other things, bonds issued by banks. Self-funded retirees and others seeking to keep their investment risk to a minimum may have money in bank term deposits rather than shares or property. All of these people lend money to banks and benefit through higher earnings when interest rates go up*. The banks do get some of the benefit themselves. Some deposit balances are paid little or no interest and so when the cash rate rises, these deposits represent an increasingly cheap source of funds for banks, although these low interest balances represent a much smaller proportion of banks’ funding than they used to.

The effect of changing interest rates is thus an exercise in wealth redistribution between the ultimate borrowers (including those borrowing to buy a home), the ultimate lenders (depositors and investors) and the banks themselves. What we have seen over recent months can be seen as a bit of a tussle between banks on the one hand and depositors and investors on the other as to who should get how much of the higher rates borrowers are paying.

* There is a timing issue for bond investors: fixed rate bonds actually fall in value when interest rates go up, but from that point onwards the ongoing earnings of the investment are higher.

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12 thoughts on “Where does the money go?

  1. Zebra

    Great article to finish off an excellent year on the blog Mule. Your reader asked a very astute question. From what you are saying if the banks hadn’t increased their margins and the RBA had increased the base rate even more to achieve same overall lending rate, then this would have resulted in higher profits to new depositors, and new and existing bond holders (the latter through higher yields). So the whole argument about bank lending rates is between the profitability of banks’ shareholders vs profitability of banks’ debt holders. How very Modigliani-Miller. A lot of hot air expended over nothing, at least as far as mortgagees are concerned.

    Looking forward to an exciting and controversial new year in 2011 on the Stable!


  2. Stubborn Mule Post author

    Zebra: of course all Mule readers are very astute. This one particularly so, I suspect!

    One of the things that has intrigued me about the bank-bashing is that the mining industry have managed to convince many Australians that a profitable mining industry is good for the whole country, but banks have completely failed to do the same thing. I can’t help feeling that behind this is the idea that miners make their profits at the expense of foreigners who buy the stuff, while banks make their profits from ordinary Australians. A lesson in capitalising on xenophobia perhaps?

  3. Zebra

    Mule: also most people pay mortgages directly at some time in their lives but don’t see the costs of mining in a monthly statement. Nor do they rightly attribute their ability to leverage this asset so highy to the banking system. Having worked in mines and banks I can say the chief difference is that banking is indoor work with no heavy lifting.

    You were kind enough not to point out my mistake that fixed bank bond holders actually lose out on a mtm basis when rates rise, not profit. Of course fixed mortgage holder actually benefit if they mtm their debt. They do in the sense they get a smug feeling (surely worth something?) that they fixed their mortgage at the right time.

    Which brings me to another point: when rates rise does all the MTM even out? Between the debtors, the bank, the lenders and any swap counterparties? My feeling is that it should all net to 0. Am I right?

  4. Ramanan

    … however, was that one powerful argument was missing. If banks had not bolstered their margins by raising mortgage rates by more than the Reserve Bank cash rate rises, the Reserve Bank would in all likelihood have increased the cash rate by even more.

    Always nice to read posts from you on banks. Nice point. I had thought of something similar when Basel 3 rules came out. There were talks about banks facing issues due to this, which is fair. But the new rules bias the central banks to lower rates – what do you think ? (At least in the beginning as banks build more capital).

  5. Danny Yee

    In a nutshell, higher interest rates benefit savers at the expense of borrowers; lower interest rates benefit borrowers at the expense of savers. With the banks taking some profit as an intermediary between the two.

    Is there any necessary correlation between interest rates and bank profits?

  6. Stubborn Mule Post author

    Ramanan I’m not sure how much difference the Basel rules will have on rates. Certainly in the US and elsewhere, rates will stay low while economic activity remains sluggish. Additional capital requirements may influence the timing to the extent that they restrict lending, but apart from the fact that the Basel capital changes are staggered over quite a few years, my sense is that slow credit growth as much due to a lack of demand for debt as a lack of supply. Still, to the extent that excessive lending over-heated economies (leading to inflation and higher rates), higher capital rules could mitigate those peaks. There are a lot of factors at play.

    Danny there is one causal link between interest rates and bank profits, namely that their margins on low/zero interest deposit balances increase as interest rates go up. There are also more indirect factors that can lead to a correlation. There is a correlation between rates and the business cycle (central banks tighten in the good times when economies become overheated and ease in the face of economic weakness) and between bank profits and the business cycle (bad debts tend to decrease in the good time and increase in the bad times).

  7. Ramanan


    Of course there are many factors at play.

    Yes, borrowing is always demand-led, as the Post Keynesians put it. There are rarely supply issues. And the loan rates are markups over the cost of funds to achieve the target profit. If the capital adequacy ratio is raised, it means banks will have higher cost of funds and hence banks will set higher rates. This may cause the central banks to keep rates lower than otherwise.

    But yeah, the demand for credit is going to be quite low for a while unless some miracle happens!

  8. Zebra

    an interesting point about bank profitability and low/zero deposit balances. I was recently made aware that a modest sum in an at-call savings account could attract more interest in a term deposit. I presume the teller had been told to make such customers aware of this. But, as far as I am aware, there is no difference in capital treatment between at-call and term deposits as Tier 1 capital. I wonder why the banks would be pushing this line – apart from wanting to lock me. Surely it would make more sense to only bring this up if I was withdrawing my funds. Any ideas?

  9. Stubborn Mule Post author

    Zebra: since deposits sit on the liability side, they do not affect capital requirements, not do they count as capital (only equity and equity-like liabilities do). However, they do have a big impact on a bank’s liquidity requirements. Unless a bank can convince regulators that their retail at-call deposits are very “sticky”, these deposits will be treated as liable (no pun intended) to disappear in a crisis, whereas term deposits will still be there. Australian banks have to stress-test their requirements for funding and, if necessary, raise additional longer-term funds to ensure they can survive stressed conditions. While a term deposit may seem expensive for the bank compared to the at-call balance which receives little or no interest, it is still much cheaper than issuing new bonds into the wholesale market.

  10. pfh007

    As there are now so few markets where a government ‘authority’ explicitly regulates the price of a ‘commodity’ it is interesting watching one where it does.

    Were bananas the commodity in question and there was a regulator perhaps the B-RBA ‘Banana Reserve Bank of Australia’ charged with the setting of the price of bananas we would discuss decisions of the B-RBA to ‘change’ the price of bananas quite differently to how decisions on interest rates are discussed.

    A decision by the B-RBA to drop the price of bananas in times of banana shortage would result in the shop shelves being cleared at the official price and a black market for bananas at a higher price. Producers of bananas would limit supplies to the normal ‘fruit shop’ channels so they could supply the more lucrative ‘back of the truck’ / public bar distribution channels.

    A decision to increase the price of bananas in time of plentiful supply would result in consumers limiting their purchasers via the normal ‘fruit shop’ channels in preference to the discount banana outlets or road side stalls.

    The politics of the price of bananas would be fierce – especially north of the Boarder.

    If this sounds bizarre (and it is) and something out of eastern europe circa 1950’s, it is worth remembering that this sort of regulation persisted in Australia in all sorts of markets (for example eggs and wool) until quite recently.

    Needless to say the economic impact of increasing or decreasing the price of money is far more significant than the cost of a few eggs.

    What is remarkable is the extent to which this powerful form of regulation with its obvious political implications is kept on a tight political leash by little more than a somewhat vague mandate to keep certain prices, measured in a very specific way, stable.

    It may only take a few firm gusts (mild inflation) and a weak government unwilling to ‘sell’ the economic implications of the regulatory decisions of the RBA to cause the delicate fig leaf of independence to flap in the breeze.

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