ANZ leaps into rates reality

ANZ Bank has cleverly moved to quell the mounting hysteria about the major banks' response to this week's 25 basis points reduction in official interest rates, while creating a mechanism for distancing its future rate decisions from the Reserve Bank's.

By passing on the full 25 basis points the bank has shielded itself from the ill-informed rhetoric of Wayne Swan, radio and television shock jocks and the cynicism of some of the tabloid commentators, including those in the supposedly broadsheet press who should and probably do know better.

At the same time, however, ANZ announced that it will in future review its pricing of loans to its retail and small business customers on the second Friday of every month – it could reverse the rate cut next month if it wished, independently of whatever the RBA did or didn't do. The real test of ANZ's resolve, and the effectiveness of its new approach, will come when it does move its rate independently.

The reality of the banks' funding is that movements in the official cash rate have virtually no impact on their cost of funds at all. The cost of their customer deposits and the wholesale funding that they raise – a significant proportion of it offshore – determines that cost, a fact that has been confirmed by the RBA.

Convenience and history and, for a long time, coincidence created the convention that the banks would make decision on their key mortgage and deposit rates in response to RBA announcements on the cash rate.

The financial crisis, which led to a spike in their wholesale funding costs and a dramatic increase in the competition for deposits as the banks sought to reduce their dangerous reliance on the volatile wholesale debt markets, saw the start of a divergence, not in timing but in magnitude, between the RBA decisions and the banks' responses.

If bank rate decisions were set rationally and weren't distorted by the politics surrounding them, the cost of credit would move almost on a daily basis – and certainly in different cycles to those of the official rates. ANZ has taken the first step in that direction (and, presumably coincidentally, followed my colleague Alan Kohler's advice this morning; see The big four's cloak and dagger dance, December 8).

ANZ's lead will almost certainly be followed, if not immediately then in due course.

All the banks have been chafing at the linkage imposed on them to the RBA decisions and all have pondered breaking it. They might have to choose a different day to ANZ, or a different frequency, to avoid accusations of collusion but the prospect of confronting and changing the misconceptions about their funding costs and avoiding the regular bouts of bashing they receive for not instantly moving rates in line with the RBA should be compelling.

Contrary to conventional wisdom, and despite some movements in mortgage rates that have been either larger or smaller than the RBA's, the banks haven't passed on the entirety of their increased funding costs since the financial crisis erupted in 2008.

Also contrary to conventional wisdom, they aren't, taking into account both the highly leveraged nature of financial institutions and their sheer size – $2.7 trillion of assets and nearly $140 billion of shareholders' funds – outrageously profitable. As Wayne Swan is fond of saying, they are among the most profitable group of banks in the world – but that isn't saying much, given the state of their global counterparts and, in any case, as any American or European could tell you, is a hell of a lot better than the alternative.

Whether Swan and the tabloids like it or not, the banks are under rising pressure to increase, rather than decrease, their interest rates.

The renewed crisis in the eurozone has effectively shut down funding markets but beforehand, wholesale funding costs were rising. The volatility in those offshore funding markets has made customer deposits even more important as a stable source of funding, which makes it difficult to offset the increased cost of wholesale debt with lower rates on deposits.

Contrary to some assertions, margins in the majors' retail banking businesses actually fell last financial year and were under increasing pressure as the year progressed.

The impact on margins overall was offset by better margins in their business banking activities, but margins are more or less in line with where they were pre-crisis – when competition was far more intense, thanks to the availability of absurd amounts of credit at absurdly low prices – which would tend to signal that the banks aren't actually exploiting the increased dominance they have of the domestic system.

Thanks mainly to National Australia Bank, they have also surrendered (very reluctantly) hundreds of millions of dollars a year of fee income by axing or reducing some of the most unpopular exception fees.

Over the next few years, the banks, already carrying far more capital and liquidity (both of which have an opportunity cost) than they did pre-crisis, know that even more stringent and costly prudential standards are going to be progressively imposed on them. Some of those will be passed onto customers, regardless of what the RBA does with official rates.

ANZ was the first bank to respond to Tuesday's rate cut. While there have been a number of conspiracy theories for the delayed response, it is a difficult decision to reduce mortgage rates when funding costs are rising and inevitably the majors would have hoped that one of their peers would be bold enough to come out with something less than a 25 basis point cut and attract most of the flak for doing so.

The delay certainly wasn't, as one journal put it, to "reap" millions of dollars a day in profits by holding off as long as they could.

A better way of expressing that might have been to say they were avoiding losing millions of dollars a day, although even that would be too simplistic given that some of the cost of the rate cuts and increased funding costs will, competition for deposits allowing, flow through to depositors and big and small business customers, blunting the impact on shareholders. If they face a margin squeeze, the majors will also increase their attacks on costs, with implications for staff and service providers.

The national obsession with housing and mortgage rates always characterises debates about interest rates in one dimension. If those with mortgages are given a benefit not paid for by reduced funding costs, shareholders, depositors, staff and other customers will all end up helping to fund it.