Will they or won’t they? Today ANZ meets to resolve whether it should lift its lending rates even though the RBA has left its underlying benchmark rate, known as its ‘target cash rate’, unchanged.
Roughly 60 per cent of all bank funding comes from retail deposits, which price off the RBA’s cash rate. This pricing is almost 1:1 when it comes to at-call deposits, and a little less than 1:1 as it relates to term deposits (I will explain why in a second).
The great thing about retail deposits, which are the major banks’ primary source of funding, is that mums and dads don't charge the banks a ‘credit’ or ‘risk premium’ like more sophisticated wholesale investors do. This risk premium refers to the extra return required by investors in recognition of the very small chance that a bank could go belly-up. Critically, this low probability risk of failure changes every day.
Around 30 per cent of the banks’ funding comes from local and offshore ‘wholesale’ or institutional investors (with the rest originated from shareholders that take equity risk).
The price of wholesale funding has three key components: the underlying ‘benchmark’, or ‘swap’, rate over the same term that the bank secures the funding (or loan). So if CBA is issuing a 3-year loan to an institutional investor, the underlying benchmark rate will be three year interest rates. These rates are basically the market’s best guess as to the average cash rate over the next three years.
This is exactly why the RBA’s former head of domestic markets, John Broadbent, recently "scoffed at statements by ANZ Australia boss Philip Chronican that the overnight cash rate influenced only about 20 per cent of funding costs. "That’s fundamentally bollocks,” Mr Broadbent said, according to The Australian Financial Review. Mr Broadbent continued, "Banks’ funding costs are not entirely determined by the [RBA’s] cash rate, but the major determinant is either the present level of the cash rate or expected changes in the cash rate.” Very true.
There are nevertheless two other factors at play. These are the above-mentioned credit or risk premiums that investors add on top of their expectation of the RBA’s future cash rate. Both relate to bank risk. One is a proxy for generic bank risk, and the second is issuer (or bank) specific (or, more particular, the risk the bank defaults on its obligations).
All you really need to understand is that CBA pays a premium interest rate above the underlying benchmark rate, which is set to compensate investors in CBA loans for the risk of CBA defaulting.
As an example, when CBA issued its $3.5 billion covered bond to Australian wholesale investors in January, it paid 1.75 per cent per annum over the standard benchmark rate. Since that time, wholesale bank funding costs have fallen, and the same covered bond only costs about 1.35 per cent per annum over the benchmark rate. That represents a significant 0.40 percentage point decline in bank funding costs.
Of course, you can have an increase in the banks’ risk premia combined with a decline in the underlying benchmark rate that actually reduces overall funding costs. We saw this occur in 2011 with long-term interest rates in Australia hitting record lows while the banks’ risk premia were rising.
The real question for both the major banks and the public is whether the banks should ‘eat’ or absorb any funding cost increases, or whether they should have the ability to force mums and dads (and their corporate customers) to absorb them.
In an op-ed for the ABC this week, Mark Bouris and I noted that there was a curious puzzle that characterized Australia’s highly concentrated banking system. Specifically:
"In all properly-functioning financial markets there is an inexorable trade-off between risk and return. The higher the risks you take, the higher the returns you generate. But in Australia this maxim has been turned on its head: in Australia, the supposedly lowest risks banks with the highest credit ratings – the majors – are somehow able to yield the highest shareholder returns. In contrast, the smallest banks, with the lowest credit ratings, produce much lower returns on equity. This complete reversal of the inverse relation between risk and return is the purest possible illustration that taxpayer subsidies are being used for the benefit of the banking oligarchy to the detriment of meritocratic democracy.”
Contrary to a lot of incorrect media commentary, it would be easy for the major banks to say, 'You know what, we will absorb any funding cost increases, and simply deliver our shareholders lower returns given that we are now government guaranteed, and thus carry far lower risks'. In risk-adjusted terms, their shareholders will be just as well off as they were before the GFC.
In this context, the Sydney Morning Herald’s Jessica Irvine points out today that the major banks’ returns on equity are way beyond what similar ASX-listed utilities yield their shareholders. So this begs the question: why are the major banks different?
After complaining so loudly about higher funding costs, and ignoring the alternative option that they merely deliver shareholders lower returns commensurate with their risks, ANZ might look a little silly today if it did not hike its lending rates somewhat. The ensuing question is then what the rest of the oligopoly does. The best answer I have seen thus far is in this video skit of two major bank CEOs discussing their response to the ANZ’s decision.
The truth is that the major banks have no competitors because of their unique too-big-to-fail status. Since they have credit ratings that are lifted higher than their smaller rivals on the basis they – and not their peers – will be beneficiaries of taxpayer bailouts, they can raise money more cheaply than any other lender in Australia. That is, the majors have a fundamental comparative advantage – a materially lower cost of funds – that is effectively impossible to compete with. Only government policy can remedy that.
Christopher Joye is a leading financial economist. The above article is not investment advice.
This article first appeared on Property Observer on February 10. Republished with permission.