Banks dovetail towards a prudent past

Last week's response by three of the four major banks to the Reserve Bank's 50 basis point reduction in official interest rates has revealed a broad new convergence in their domestic strategies. That doesn't mean they are colluding.

The decision by National Australia Bank to retain 18 basis points of the cut, while enabling it to narrowly maintain its boast of having the lowest headline mortgage loan rate, when combined with the Commonwealth and Westpac decisions, have resulted in the narrowest spread of home loan rates since NAB initiated its ‘'Breaking Up'' campaign early last year.

Assuming ANZ doesn't do something radical on Friday, when it announces its decision, the headline rates offered by the majors will range from NAB's 6.99 per cent to Westpac's 7.09 per cent, with CBA (7.01 per cent) and ANZ (currently 7.42 per cent) between them.

NAB's move was revealing. It did just enough to be able to have a rate starting with a six in the knowledge that it would be very painful for any of its competitors to undercut it.

The next closest home loan rate before the response to the RBA decision was CBA's, which was 10 basis points more expensive than NAB. To get below NAB, CBA would have had to pass on the entire 50 basis points and Westpac and ANZ would have had to do even more.

The fact that NAB held onto as much of the reduction as it did, however, suggests that after a year of sacrificing net interest margin to change customer perceptions and generate growth in its home loan market share and volumes – which it has – it is feeling the pinch. NAB also cut its online deposit rate by 50 basis points.

CBA was the most benevolent of the majors, at least so far, passing on 40 basis points, while Westpac reduced the rate on its standard variable home loan by 37 basis points. If ANZ does fall within the outliers, the gap between the cheapest (NAB) and most expensive (Westpac) standard home loan offered by the majors will have shrunk from 15 basis points to 9.01 basis points.

Interestingly, Westpac hasn't yet altered its online deposit rates, which provides a framework for understanding the factors at play in the various rate decisions.

When NAB launched the aggressive Breaking Up campaign in 2011 the financial crisis was receding and, while the banks still had unsettling recent memories of the turmoil in the wholesale funding markets they were reliant on, they, too, appeared to have stabilised.

NAB chose to compete on price because its retail bank had become virtually irrelevant post-crisis.

Westpac, with the St George acquisition, and CBA, with Bankwest, had bulked up their retail banks and then gorged themselves on the first home buyers' boom to the point where NAB and ANZ were completely outsized. That scale differential and the efficiencies it proffered was a threat to the smaller banks in the longer term.

The massive surges in the size of their mortgage books, however, was causing Westpac and, to a lesser extent, CBA, some funding-inspired indigestion. The rate of growth had outstripped the growth in their deposit bases, making them more reliant on the wholesale funding markets they now knew represented a risk.

NAB used the leverage provided by its lack of scale against the bigger banks, undercutting them on price in the knowledge that it would have a leveraged effect on them, in terms of both profit and their funding requirements, if they tried to respond.

ANZ, with less of an emphasis on price, also grew at above-system rates as Westpac and CBA focused on keeping the growth in their lending in line with their ability to increase their deposit funding. Both the Sydney-based banks have been very disciplined in the past two years in ensuring the growth in their loan books has been almost entirely deposit-funded.

In recent weeks Westpac's Gail Kelly has been saying very clearly that that remains Westpac's focus, indeed she is seeking to shift the culture of her bank from one of being a lending organisation to being a funding organisation – one that prioritises deposit-gathering.

That's a recognition that the Australian banks can't rely on offshore wholesale funding – indeed that it would be dangerous to do so – and therefore need to compete far harder for deposits if they are to maintain any lending growth.

It is a ‘'back to the future'' moment, one where the majors have retreated to a past where prudent bankers funded their lending from their customer deposits in an era before disintermediation and the emergence of deep and global wholesale debt markets.

Westpac appears to have adapted its pricing strategies best to the new environment.

Kelly is using her secondary regional brands – St George, Bank SA and Bank of Melbourne – to match its peers on loan rates – while pricing Westpac's loans at a premium.

That's partly driven by the Westpac focus on relationships and multi-product selling, which makes customers "stickier", but the more obvious rationale for offering the most expensive headline home loan rate is that it provides scope to offer the most attractive term deposit rates, where price is the killer differentiator.

It is the major banks' focus on attracting deposits – and the pressure that has put on their pricing – that has been exerting increasing pressure on their net interest margins.

It was instructive that the net interest margin of ANZ's domestic business fell 13 basis points in the March half, but Westpac's was down only 5 basis points.

It would appear that of the margin reductions the majors are experiencing, roughly two-thirds comes from the pricing of deposits and about at a third from wholesale funding costs.

NAB's interim result will be out this Thursday but it is inevitable that a combination of the lowest home loan rate and the competition for deposits would have squeezed its net interest margin – and the decision to retain 18 basis points of the RBA rate cut when Westpac kept just 13 points and CBA only 10 would suggest that the pressure finally got to NAB.

If all the majors are pursuing similar funding strategies they will pursue broadly similar lending and pricing strategies.

If Westpac is an outlier for too long and attracts a disproportionate share of deposits, the other banks will have no option but to rebalance the relationship between their deposit and lending rates in favour of depositors.

That kind of convergence wouldn't be evidence of an oligopoly but, oddly, of competition. The competition for the foreseeable future, however, shouldn't be particularly visible where the politicians think it should be – on home loans – but will be focused on shoring up the obvious vulnerability in their balance sheets and, indeed, the system at large.