Australian banks have featured in the news cycle for much of the year to date in 2018, with their operations having come under great scrutiny throughout the Royal Commission. What’s more, Australia’s obsession with housing has turned interest rate watching into a national sport of sorts, with many of us tuning in on the first Tuesday of every month to see if the RBA will tinker with the Cash Rate. Why do we follow the RBA’s movements? It’s because we’re all eager to see whether the interest rates on our property, personal and business loans are likely to change, which ultimately affects the bottom line of the household budget.
In the last few weeks some of Australia’s banks have started to lift their variable rates by between 0.10% and 0.20%. To date, only the smaller lenders have done this as they traditionally can’t operate on the same economies of scale as the BIG 4. It is almost certain that the BIG 4 (CBA, Westpac, ANZ and NAB) will follow suit over the coming weeks and months. The duopolistic nature of the Australian Banking landscape doesn’t lend itself (pardon the pun) to rigorous competition as the sector is dominated by four enormous and broadly similar organisations.
So to reiterate, Australian banks have already, or will shortly increase their variable loan rates despite the RBA leaving the cash rate at the historical low of 1.5% for the past 22 months. To the average consumer, this is hard to get your head around. If the RBA cash rate remains unchanged, how can the banks justify increasing their lending margins, especially when they are already some of the most profitable enterprises in Australia, pay huge executive salaries, and their conduct and ethics have come under great scrutiny of late?
The answer we’re told, comes down to a few factors which make up a bank’s cost of funding. Like any business, banks incur costs with the raw materials being “money”. The banks “rent” the money they lend from a variety of sources at varying prices.
At the most basic level, consumers deposit money with their bank, which is then lent out to another consumer with a prescribed profit margin. This pays the banks overheads and adds a slight risk premium for the privilege of using depositor funds. The interest the bank pays to depositors is just one of the many costs of funding. This system may have worked perfectly a hundred or more years ago but since then, financial markets have evolved in complexity and scale. We are a large nation of great wealth but few people. As a consequence, Australian banks never have enough domestic deposits to meet the demand of borrowers.
As interest rates have been so low for so long, individuals and fund managers have chased higher yields in other asset classes such as stocks and real estate, in turn, depleting deposits. Lenders are now having to lure back these deposits by offering higher interest rates on select products, which ultimately increases their cost of funding.
One of the main methods Australian Banks use to fill their short-term funding requirements is through borrowing from overseas debt markets at wholesale rates, which they then lend within Australia at a profit margin. This method of funding was cheap for a period of time but has recently become more expensive as global central banks begin lifting their baseline rates, as has been happening in the US and elsewhere. As Australia is typically a net importer of financial capital, our credit market is highly exposed to movements in global rates and fiscal policy changes.
The result of these increases to Wholesale funding costs, as recently demonstrated, is that the banks pass them onto consumers by hiking rates on variable loans and new lending.
If this trend persists throughout the whole lending market, it will have the effect of increasing rates across the board and may further deter the RBA from increasing the Cash Rate, provided all other economic benchmarks remain consistent with the bank’s policies.
It seems as though interest rates are only looking to go north based on cost of funding fundamentals and the relative strength of the Australian economy at this point in time. That being the case, it would be worth your while speaking with a knowledgeable broker about fixed loan options currently available, as a way of hedging against potential future rate increases. Our finance specialists at Red & Co. understand all your property needs. For residential enquiries, contact Shoheel Khan on 0418 110 870 or [email protected]. For commercial enquiries, contact Greg Turner on 0417 698 345 or [email protected].