Predicting the setting for the banks’ standard variable housing loan interest rate used to be simple. Before the subprime crisis in the US and the subsequent GFC, the variable rate was simply the RBA target overnight cash rate plus 1.8% or, in “bankspeak”, a spread of 180 basis points.
However, since January 2008, the spread has been getting larger, now standing at 315 basis points. Each increase in the home loan rates by the banks that has been greater than the RBA monetary policy move has been explained away as being due to increased funding costs, particularly the cost of raising funds overseas. This has not been received well by a sceptical public, particularly when a recent Societe Generale report claimed that funding costs had actually declined.
So where do the banks raise the funds to issue loans? Has the composition of this funding changed since 2007, and has the cost increased or decreased?
Traditionally, banks loan out the deposits they receive, and the cost is simply the interest they pay out on the deposits. The difference between the loan rate and the deposit rate of interest, the interest margin, can be thought of as their profit margin. However, Australian banks do not get all their loan funding from deposits, the amount of deposits is not large enough to satisfy our demand for credit. So Australian banks have to borrow money from elsewhere to be able to lend out. This can either occur here in Australia or in the international financial markets. This has been particularly good for Australians as funding sources from debt sources, particularly short term debt, has generally been cheaper than deposit sources.
As we can see in the graph above, prior to the onset of the GFC, the major sources of funding were deposits (38%), and short term debt (33%). The loss of liquidity in the short term debt market due to the GFC forced the banks to change their funding composition to sources that are more expensive. Funding from deposits now take up about 52% of the total, short term debt funding has fallen to 20%, and long term debt funding has increased to 20%.
So, how much more expensive? Since mid-2007, the average the cost of deposits have risen about 130 basis points relative to the cash rate, and long-term debt cost rising about 100 basis points on average relative to the cash rate. The cost of short-term debt has generally not changed relative to the cash rate. Most of these changes occurred in late 2008 and 2009, and until about August 2011 the cost of the banks’ debt funding cost have moved largely in line with the cash rate.
However, with the onset of the European debt crisis and the possibility of Greece defaulting on its debt, costs have again increased relative to the cash rate. As we can see in the Australian bons spread graph, the spreads on AA domestic bonds increased from about 120 basis points to over 200 basis points, with spreads in the overseas markets moving somewhat higher.
This means although the cash rate had fallen, the increase in the risk spreads on debt funding effectively eliminated that reduction in cost, particularly when it appears that approximately 60% of new long term debt funding was sourced from overseas (according to RBA bond issuance statistics) in the last half of 2011.
Similarly with deposit funding, since August 2011 the cost of deposits has risen about 25 basis points relative to the cash rate.
Combining these factors, it implies that overall cost of funding for the banks did increase over the last half of 2011. Glenn Stevens did note this in his March monetary policy media release that “capital markets are again supplying funding to corporations and well-rated banks, albeit at costs that are higher, relative to benchmark rates, than in mid 2011”.
So where are bank funding costs are likely to move over the next year? It is perhaps instructive to take a look at the spread between the banks average discounted variable home loan rate and the average “specials” deposit rate rather than just focus on how higher the variable home loan rate is over the cash rate. While not exact, it is a good proxy, giving an indication as to whether banks costs have increased or decreased.
According to the above graph, prior to the GFC the “normal” average margin was 157 basis points. Post GFC, the average is 100 basis points, so banks’ cost of funding has been higher post GFC. We can also see that banks’ costs increased again from the middle of last year and only just starting to decrease again.
However, the current margin of 135 basis points is still 20 basis points lower than normal pre-GFC levels. This suggests that with the current concerns over whether the Greek bailout will work, it is quite likely that we will see further adjustments upwards in loan rates or reductions in the deposit rate relative to the cash rate over the next year.