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Rates of wrath: understanding the Big Four’s actions on interest rates

Decoupled: The Reserve Bank of Australia’s decision to hold interest rates has been ignored by the banks. AAP

Last week, the Reserve Bank defied market expectations to announce the 4.25% cash rate would remain unchanged. But the surprise decision by Australia’s Big Four banks to act independently of the Reserve Bank and raise their standard variable interest rate- even as they announce record profits - has caused much ire among customers and Treasurer Wayne Swan.

Are these interest rate hikes justified? Professor Kevin Davis from the University of Melbourne argues that although the banks are looking to protect their profits, the rising cost of funding - not to mention structural challenges in the sector - are driving the increases.

Australian banks have justified interest rate hikes as a necessary, arguing global repricing of bank debt has made wholesale funding more costly. Is this the main motivation behind the rate hikes, or does Wayne Swan’s “bank bashing” have some merit?

I think it’s certainly the case that Australian banks are experiencing changes in the costs of various parts of their funding. Part of the problem in this area is that it’s very hard, for anybody outside of the banks’ treasuries, to really know exactly what the cost of funds for banks are. The reason for that is because they raise funds for deposits by borrowing in international capital markets. I think for the moment, what one can say, is that given the state of nervousness in international capital markets, the cost of raising funds has probably gone up. But at the moment, the banks also are in a situation where they’re rolling over a lot of the borrowing that they did during the global financial crisis under the federal government’s guarantee.

Could you elaborate on that guarantee?

After Lehman Brothers collapsed, in October 2008, the federal government introduced a scheme whereby Australian banks borrowing in international capital markets could, for a fee, get a government guarantee over those borrowings. That enabled them to continue accessing capital markets in a time where it was almost impossible to do so otherwise, particularly as other governments had commenced providing similar guarantees. The Australian banks borrowed quite substantial amounts of money over the next year or thereabouts in those international capital markets, paying the fee to the government for a guarantee. A fair proportion of those borrowings would be due now or in the next year, and the banks have to replace those borrowings by borrowing without the guarantee. So, one of the issues is the extent to which the cost of that replacement funding is greater than what they were paying on those previous borrowings.

It’s a bit hard to work out what the exact effects are. I think one can safely say that the banks wouldn’t be seeking the political bashing that they’re getting, and we would need to accept that their actions indicate the cost of funding has gone up.

Treasurer Wayne Swan has urged unhappy customers to ditch their banks. AAP

Does the considerable reliance on overseas funding by Australian banks present a structural problem?

It’s a structural problem in the Australian economy more generally, as we are running a current account deficit on our balance of payments. There has to be capital inflows in some form to finance the deficit. Historically, this has primarily been done by the Australian banks, because it’s been easy for them to borrow in international capital markets. Having said that, they’ve reduced their reliance on international capital over the last few years. One of the relevant issues of the moment is the much slower growth in Australian financial markets, in terms of lending growth. There is much less need for banks to borrow in international capital markets because, in a sense, their balance sheets aren’t growing at the rates that they were before the global financial crisis, when they were relying very heavily on international capital markets to support their growth.

How will the capital reforms and liquidity requirements in Basel III affect Australian banks?

There are two major reforms in Basel III. One is the capital requirements. I think, in the case of Australian banks, that there’s not a lot to get concerned about because our banks already have pretty high capital ratios. Even though APRA is implementing a much more rapid timetable of bringing in those changes, the Australian banks are well-placed to meet those. It’s not really clear to me that those increased capital requirements will be a major driver in terms of increasing the cost of funding for banks, partly because our dividend imputation taxation system reduces the tax benefits of debt/deposit funding.

A more relevant issue is the liquidity requirements. There are two liquidity requirements: one is the liquidity coverage ratio, requiring banks to hold a certain amount of highly liquid government securities, which, however, aren’t in large supply in Australia. The Reserve Bank has introduced a facility where the banks - rather than competing in the capital markets over the short supply of eligible securities - can pay a fee for an overdraft facility with the central bank.

The other liquidity requirement is the stable funding ratio. Shorter term borrowing in international capital markets isn’t viewed as a stable source of funding. There are pressures on the banks to move towards getting more domestic term deposit funding, but that’s also a limited market. Whether those things increase the cost of funding by much is, again, a difficult question - but I wouldn’t have thought it’s a major issue either.

ANZ was the first of the Big Four banks to independently raise rates. AAP

Back to interest rates - clearly banks have a duty to maximise shareholder returns and protect profit margins. But given rising levels of public resentment, could this decision actually harm them? Will we see people switching en masse to non-bank lenders?

Certainly, all the political hassle doesn’t help the banks with their reputation. It is the case that the government has introduced legislation to make it easier for borrowers to switch banks, so that people with housing loans - who don’t like what the banks are doing - are able to switch. One of interesting things to note is that a major source of competition in the housing loan market is securitisation, whereby capital markets fund mortgage loans created by mortgage originators, or by banks or other institutions. One of the things we can see at the moment is that there’s been not much activity in that market in terms of standard securitisation issues since the start of the year. What that suggests is that those securitisers aren’t able to get funding at cheaper rates than the banks claim they’re facing and, because of that, they’re not able to make loans on competitive terms with the banks. The capital market situation is such that the securitisers aren’t able to compete at current housing loan interest rates, which the banks could point to and say that it reflects the problems they’re facing as well. Now, that might change quite rapidly if international capital markets settle down - but that’s a big “if”.

There have been concerns over the lack of competition in our financial sector. Is this is a valid claim, or is the level of concentration the price we pay for a robust and stable banking industry?

There’s always a debate about the interrelationship between concentration and competition. The Australian banking sector is probably a bit more concentrated than most other banking sectors. Australian concentration has gone up, in terms of the small number of institutions that dominate our loan and deposit market since the global financial crisis. There’s certainly quite a lot of competition in particular markets amongst the banks, and that competition points to the level of concentration not suggesting there is an absence of competition.

But at the same time, we do know that the Australian banks are quite profitable. The Australian banks are probably in the upper end in the profitability stakes internationally; of course, given the state of most banking sectors in the rest of the world, it certainly isn’t very hard. My impression is that Australian banks probably have higher profitability than banks elsewhere, which may reflect the state of competition and concentration. On the other hand, a lot of people say that it’s better to have a profitable banking sector than a broken one.

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