Banks damned if they do and damned if they don't

In the end, it came down to a damage limitation exercise.

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 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 backlash that would follow by not passing on the full 0.25 per cent reduction to their customers.

This week's apparent indecision 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 they would follow suit and reduce their interest rates by a quarter of one per cent. What better way to celebrate the race that stops a nation with a rate cut to help kickstart a nation.

ANZ left it to the next day, leaving National Australia Bank as the odd one out by only passing on part of the rate cut - 0.20 per cent - rather than the full 0.25 per cent.

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 with its "breaking up with the big four" 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 at least, 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 between the major banks as lending growth has faltered in the second coming of the global financial crisis.

Before last month's shenanigans, NAB had been 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 showed NAB had increased its share of the new home loan market by 1 per cent over the year to October. ANZ was flat, while the market leaders, Commonwealth and Westpac, which between them claim half of total mortgage lending, both fell.

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

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

"From their [NAB] accounts to September it looked like 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 lend to customers in Australia.

As such, it hasn't been the cost of the new lending which has been the cause for 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, though deposits are no longer the cheap source of financing they used to be. In fact, the battle in the lending market has been matched by an equally expensive fight for deposits, which has only added to the pressure on profit margins.

Nonetheless, the primary issue for the sector is the cost of wholesale funding - money borrowed from domestic or overseas investors.

In the boom years of the early to mid 2000s this 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.

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 higher cost and with a fee attached, which has proved to be a nice little earner for Canberra.

Put in the context of this week's rate cut, the jump in funding costs three years ago was equivalent to almost eight rate increases of 0.25 per cent.

This also provided the context for the decision by the RBA to lop four 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 financial crisis-prompted recession.

It is against this backdrop - particularly the cost of wholesale funding relative to the cash rate, which the RBA controls and which affects the price of short term domestic money - that the banks have sought to highlight the real driver of their own interest rates.

After the lull that followed the global financial crisis of 2007-09, the European sovereign debt debacle this year has propelled these costs to crippling levels.

Which is why Mike Smith, the chief executive of ANZ, Gail Kelly of Westpac, NAB's Cameron Clyne and, before his retirement last week, Ralph Norris of the Commonwealth Bank, have all been warning of another looming wholesale funding crisis. Except for the fact 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 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 bank funding costs."

His comments were matched by Westpac's new retail banking chief, Jason Yetton, who faced making himself one of the most unpopular people in the country if he 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 the 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, 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, with the problem 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 in cutting interest rates and by how much, the gap between the cost of all forms of local wholesale funding 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 one per cent.

Funding costs 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 in 2011 - despite the global financial environment.

This is the tightrope the banks have been walking.

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

To that should be added the pressure from a Treasurer and Prime Minister who can see the economic and political dividend from a cut in interest rates, albeit that lower rates also mean there are losers - in the shape of depositors and retirees who depend on interest income.

On the other hand is the banks' need to satisfy shareholders who are looking for 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 many of these shareholders just so happen to be members of the public because their superannuation is invested in the banks.

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 the PR battle, the ANZ tried to broaden the argument and underline just how much other factors influence interest rates, not just the RBA's moves, by announcing it will set its rates on the second Friday of each month.

In some cases that could see it wait a full week and a half before responding to an RBA decision.

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

Highlighting the move to decouple 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: "This is likely to result in increased interest rate volatility for consumers and businesses."

We will know soon enough if that is the case. The first test of the ANZ's new interest rating setting will happen on January 13 - a month when the Reserve Bank, like the rest of the country, is on holiday and does not traditionally meet.

As one rival banker said after ANZ's announcement: "It's all well and good when rates are on the way down, but what happens when they go up?"