Should banks be compelled to pass on interest rate cuts?

Banks increasingly choose not to follow the lead of Reserve Bank of Australia Governor Glenn Stevens on interest rates. AAP

As Reserve Bank of Australia board members gather today to ponder Australia’s cash rate, financial markets are having a bet each way the RBA will cut rates amid the release of data reflecting a softening in key non-mining sectors of the Australian economy, but more favourable inflation figures.

But these days, Australian home owners can no longer rely on their banks to pass on the joy. So The Conversation asked: should banks be compelled to pass on interest rate cuts - yes or no?

Kevin Davis, Research Director for the Australian Centre for Financial Studies, and Professor of Finance at the University of Melbourne says no.

No, because the cost of funding isn’t directly related the level of the Reserve Bank’s cash rate. Banks get a fairly large proportion of their funding from international wholesale capital markets. They borrow for terms such as three years which involves locking in a credit spread above risk free rates. The interest rates they pay depends on what the market is willing to provide that funding at.

At the moment European capital markets seem to have frozen, so to raise funding from those markets is going to involve quite a significant credit spread.

What we saw during the global financial crisis was that the linkage between the domestic cash rate – the short-term overnight rate the Reserve Bank targets and which banks borrow and lend between themselves in the overnight cash market doesn’t bear a really close relationship with their cost of funding.

Over the past decade Australians have assumed banks will automatically pass on interest rates as banks had fallen into the habit of adjusting their loan interest rates pretty much in line with the RBA’s cash rate.

Mortgage holders have become used to interest rates falling in line with a cut in the cash rate. AAP

For the 10 years up until 2008, the margin between the housing loan rate and the cash rate was stable at about 180 basis points, or 1.8%. But if you go back to the 1990s that that wasn’t the case. There was growth in competition at that time from the growth of mortgage originators and securitisers and the margin between the cash rate and variable housing interest rate fell quite substantially during that period.

But the 10 years prior to the Global Financial Crisis was a period in which the world economy and global markets were pretty stable. There weren’t many new developments in terms of increased entry of new competitors or other shocks to disturb the relative pattern of interest rates. And so, to some extent, the banks are hoist on their own petard, in terms of consumer and political expectations, from of having fallen into the trap of shifting interest rates every time the RBA shifted the cash rate. People got used to that as the norm.

Arguably, if the RBA does cut interest rates, then it is likely that part of the reason will be recognition of the turmoil in Europe and higher borrowing costs in international capital markets. That will be one of their considerations as well as looking at inflation and the state of the Australian economy.

I’ve previously argued elsewhere that it’s not clear that the current contractual arrangements for mortgage interest rates are the ideal model. Banks have complete discretion to change mortgage interest rates on variable rate loans, and when there are changes in bank funding costs that change is passed on to the home borrower. One can argue that it should be bank shareholders and management that should bear those risks and are better placed to manage such risks than households. On the other hand, that system worked pretty well during the GFC where banks passed on the risks of higher funding costs to end users (borrowers) who seemed to be able to bear them.

Of course, Australian banks appear to have high rates of profitability by international standards, and could absorb higher funding costs. But the reduced profitability would be at the expense of shareholders – and many of those are “mums and dads” in another guise as members of superannuation funds. To the extent that Australia needs to raise funds from international capital markets – and we do to finance our balance of payments deficits – we cannot avoid higher borrowing costs in those markets impacting upon is in some way.

Josh Fear, social researcher, University of Canberra says yes:

Official cash rate movements have historically provided an opportunity for banks to boost profits at the expense of mortgage customers. If rates are on the way down, banks can increase their margins without borrowers noticing an immediate rise in repayments.

If rates are going up, then borrowers will expect to pay more anyway. Any objections can be addressed with the weasel words like “funding costs”, which only financial insiders really understand and consumers cannot be expected to evaluate properly.

It is instructive to observe how differently banks explain their actions depending on whether interest rates are moving up or down. When interest rates are rising, we hear that they need to need to pass on their increased costs in full – as simple as that. (Remember Westpac’s facile banana smoothie video?)

When interest rates are going down, the world is suddenly a much more complicated place where simple explanations do not apply. Watch out for all sorts of jargon as banks try to obscure the real reason they do not pass on rate cuts in full.

So how do we discourage banks from engaging in this kind of manipulation and opportunism? Borrowers are unlikely to switch providers once they are locked into a loan, so we cannot rely on consumers alone to ensure that banks behave fairly. This is where government can play a role – for example by restricting the kinds of loan contracts that banks can ask borrowers to sign.

If such contracts stipulated that the interest rate margin is to remain constant over the life of the loan, then banks would be unable to use cash rate movements as an excuse to gouge customers. They would need to make future expectations about interest rates clear at the outset - which would deliver greater competition in the mortgage market, which everyone (perhaps apart from the Big Four) agrees is a good thing.