Banks caught in a new credit crunch

IN THE end, it came down to a damage-limitation exercise, damage that ironically was being increasingly self-inflicted.

As the weekend loomed and with the public relations battle being rapidly lost, the big four banks knew there was little to gain by holding off any longer in response to the Reserve Bank's decision on Tuesday afternoon to cut interest rates.

The fact that they were still prevaricating two days later over how much to cut and which of them would be the first to go just underlined their willingness to risk the inevitable and fierce backlash that would follow by not passing on the full 0.25 percentage point reduction to their customers.

This week's apparent indecision or what was really reluctance to do the same was in marked contrast to what happened just four weeks ago.

Then, the two biggest banks, the Commonwealth and Westpac, announced within a short period of each other and not long after the RBA's 2.30pm Melbourne Cup Day cut that they would follow suit and reduce their interest rates by a quarter of 1 per cent. What better way to celebrate the race that stops a nation than with a rate cut to help kickstart a nation.

ANZ left it to the next day to do the same, decisions that prompted their rival, the National Australia Bank, to become the odd one out by only passing on part 0.20 of a percentage point rather than the whole lot.

NAB was vilified, not surprisingly perhaps, given it had sought to make a virtue of being the odd one out by projecting itself as the consumers' friend just a year before on the back of its "breaking up with the big four" discount home loans campaign.

In little more than a day, NAB had handed back some of its hard-fought PR gains over what appeared, in public anyway, to be a miserly amount just five basis points, or 0.05 of a per cent.

As small as that seemed, it was, in fact, a significant turning point in what has become a hugely competitive battle for market share among the major banks as lending growth has faltered in the second coming of the global financial crisis. Prior to last month's shenanigans, NAB had been very successful in grabbing market share through the use of a classic retail-style price war. And in doing so, it was prepared to sacrifice some of its profit margin to buy that volume.

The most recent figures from the industry regulator of lending trends showed NAB had grown its share of the new home loan market by 1 per cent over the year to October.

In contrast, ANZ was basically flat while the market leaders, Commonwealth Bank and Westpac, which between them claim half of total mortgage lending, both fell.

And when combined with credit card, other personal loans and business lending, NAB had shot ahead of the pack, showing overall growth of 1 per cent, while the others had all gone backwards.

But all of this has come at a cost, a factor highlighted in prescient comments made just a week ago in The Age by banking analyst Brett Le Mesurier of brokers BBY.

"From their [NAB] accounts to September it looked to me like it was a pure 'price versus volume' trade-off," he said. "So more volume, lower price. And you multiply the two and you end up no better from a growth perspective." But it wasn't just about the growth or the quality of that bigger market share. It was also about the cost of funding that growth. Put simply, NAB's lower-priced mortgages have been hurting its bottom line since its own cost of borrowing is no cheaper than its rivals.

Hence why the fourth-largest of the big four sought to claw back some of the interest rate cut pushed through by the RBA on November 1.

As small as the reduction might seem to the outside world, it was worth tens of millions of dollars in the long run when it comes to covering the cost of borrowing the money to pay for the lending to customers in Australia.

As such, it hasn't been the cost of the new lending that has been the cause for huge concern. Given that credit growth has slowed markedly over the past 18 months, a fair slab of this financing has been covered by deposits the banks have sucked in from the very same customers who have been reluctant to borrow more.

From a funding and credit rating point of view this is a good thing, albeit that deposits are no longer the cheap form of financing they used to be. In fact, the battle in the lending market has been matched by an equally ferocious and expensive fight for deposits that has only added to the pressure on the industry's profit margins. Nonetheless, the primary issue for the sector is the cost of what is called wholesale funding.

That is money borrowed from domestic or overseas investors, which in the boom years of the early to mid-2000s was dirt cheap and was directly responsible for fuelling the banking sector's double-digit lending and profit growth.

But the credit crunch of late 2007 and the full-blown financial crisis a year later saw the cost of such financing soar to unprecedented levels from 16 basis points, or 0.16 of a per cent over short term money rates, to as much as 200 basis points or 2 full percentage points above.

And when credit markets actually froze, the federal government had to lend its AAA credit rating to the banks to keep the money flowing. That too came at a much higher cost and with a fee attached as well, which has since proved to be a nice little earner for Canberra.

Put in the language of this week's rate cut, the jump in funding costs three years ago was equivalent to almost eight rate increases of the same amount.

This also provided the context for the decision by the RBA to lop four whole percentage points off the official cash rate over a period of eight months from September 2008 in what was a successful effort to stave off a GFC-prompted recession.

After the lull that followed the US subprime-generated crisis of 2007-09, the European sovereign debt debacle this year has propelled wholesale funding costs to equally crippling levels.

Which is why Mike Smith, the chief executive of ANZ, Gail Kelly of Westpac, Cameron Clyne of NAB and, prior to his retirement last week, Ralph Norris of the Commonwealth Bank, have all been warning recently of another looming wholesale funding crisis. Except that it is no longer looming.

Smith's deputy, Phil Chronican, left no one in any doubt the euro-zone disaster played heavily on this week's decision-making.

The size of ANZ's cut which eventually fell into line with the RBA had been "one of the most difficult we have made in recent times," said Chronican. "The significance of the crisis in Europe has real consequences for the global economic outlook, for the Australian economy and for bank funding costs."

His comments were matched almost word for word by Westpac's new retail banking chief, Jason Yetton, who faced making himself one of the most unpopular people in the country if he too had not passed on the rate cut in full. "The unstable and deteriorating economic situation in Europe poses significant risks to global financial markets," said Yetton in just his second full week in the job. "This is placing pressure on both the availability and cost of raising funds overseas to support mortgage and business lending in Australia."

If Yetton was feeling the pressure, then it was positively stifling for Commonwealth Bank's new chief executive, Ian Narev, whose predecessor was pilloried for his decision on Melbourne Cup Day last year when he almost doubled the rate increase imposed by the RBA.

As head of the country's biggest lender, which has traditionally taken a lead on interest rate announcements, Narev was handed the sternest of tests within a week of taking over from Norris.

He has refrained from public comment but he is known to have sweated over the decision, one Weekend Business understands included the prospect of withholding a Norris-size amount in reverse with all the dumping from a great height that would have accompanied it.

Luckily for Narev, ANZ's move to cut first gave him cover to avoid playing Scrooge just a fortnight before Christmas, even though it leaves him and his counterparts such as Clyne at NAB, who also dodged a bullet with the ongoing headache of what to do about a very real and costly problem.

As ANZ sought to make clear on Thursday when it broke the deadlock over which of the big four would take the initiative and by how much, the gap between the cost of all forms of local wholesale funding, including deposit pricing and that of the RBA cash rate, has been rising since September 2007.

According to a chart published by ANZ, that difference is now 18 basis points, or 0.18 of 1 per cent. Put that way it is, perhaps, easier to understand why NAB looked to grab some of that price differential back last month given that it hadn't followed the Commonwealth Bank and Westpac, who had moved earlier with their by-now-notorious Melbourne Cup and Banana Smoothie super-sized RBA rises.

Funding costs, though, are one thing: profit protection and profit increases are an altogether different matter. Especially in the eyes of the public who have seen the major banks turn in record earnings, year after year a collective $24 billion by the big four alone this year despite the worsening global financial environment.

This is the tightrope the banks have been walking over the past few days.

On the one hand they have been weighing up the case to pass on the whole cut, including the need to rebuild consumer confidence and prime the pump for new credit growth that inevitably will feed through to their own profits over time.

To that should be added the pressure from an increasingly desperate Treasurer and Prime Minister, who can see the economic and equally important political dividend that would result, albeit that lower rates also mean there are losers too, in the shape of depositors and retirees who depend on their interest-bearing income.

On the other is the banks' need to satisfy shareholders who are looking to receive higher dividends, which can only be paid out of bigger profits, which, in turn, will drive their share prices higher and make their owners wealthier. Throw in the fact that many of these people just so happen to be members of the general public, because their superannuation money is invested in the banks, only goes to make that case harder.

It makes for an interesting dilemma, especially when bank-bashing as a national sport has once again been thrust to the fore.

Knowing that the banks can't win against that backdrop, ANZ has opted to try to broaden the argument and underline just how much other factors influence interest rates, not just the RBA's moves, by announcing it will publicly set its rates on every second Friday of the month.

In some cases that could see it wait a full week and a half before responding to an RBA decision as it weighs up what it should do.

To UBS banking analysts Jonathan Mott and Chris Williams, ANZ's decision was a defining moment in the setting of home loan costs.

Highlighting the move to formally decouple standard variable mortgage rates from the RBA's decisions, Mott and Williams said it would allow real rather than perceived costs to be taken into account. It would also give the banks greater flexibility to manage their margins.

But they also had a warning for the wider public. "This is likely to result in increased interest rate volatility for consumers and businesses," they added.

We will know soon enough if that is the case.