Bashing banks for a rate cut

As the big four banks remain silent on whether they'll pass on the Reserve Bank's 25bps rate cut, the heavy criticism they've been copping is mostly unfounded.

The timing of the Reserve Bank’s reduction in official rates couldn’t have fallen more awkwardly for the major banks, sandwiched as it was between last week’s modest downgrading of their credit ratings and the looming European Union summit at the weekend.

The S&P move highlighted the now well-understood vulnerability of the banks to the freezing of offshore wholesale funding markets, while the summit may well represent the last chance for those teetering markets and the wider European financial system.

As the clock kept ticking today none of the banks was prepared to be the first to respond to the RBA rate cut, knowing that anything less than a full 25 basis point pass-through would see them vilified. Indeed, even before they have actually done anything, they’ve already been vilified. Bank bashing is a populist sport.

The uncomfortable silence of the banks would suggest that they don’t want to pass on the full 25 basis points and are hoping that one of their peers will lose patience first and wear the brunt of the storm that will ensue – much as NAB did last month when it kept a mere five basis points and retained its status as the major with the lowest headline mortgage rate.

The pre-emptive belting they have already received from those who regard them as soft targets would also suggest that the banks have failed, despite a lot of effort by them, and some support from the RBA, to convince the politicians, media and public that there is no material direct linkage between the official cash rate and their own cost of funds.

Treasurer Wayne Swan, who should know better, was urging the banks to pass the RBA cut on in full today and warning them that they would face the wrath of their customers if they didn’t, in effect making a direct and misleading linkage between the cash rate and their funding costs.

Given that households are in an anxiety-induced savings mode, the better argument might have been that the banks would get the resultant savings back in the form of increased deposits and, to the extent that they didn’t, some lift in consumer confidence and spending would ultimately be good for their customers and ultimately their own businesses. Unemployment and business failures are the traditional key threats to bank profitability.

At present, however, the majors are pre-occupied with unconventional threats – the prospect of a Eurozone, and perhaps global meltdown. Funding markets are highly volatile and, at times, effectively closed. Even when they have been functioning the cost of funding on offer would, if accepted, signal desperation – which no bank would want to risk, unless it were in dire need.

Privately, the majors are talking quite freely about how long they could survive without access to any wholesale funding, despite having significantly reduced their reliance on those markets since 2008. February appears to be the point where they’d have to start asking the RBA for emergency liquidity support.

Unless and until the Eurozone is stabilised and debt markets normalised, the majors will remain nervous and defensive and very protective of their status, as a group, as among the handful of the world’s most stable and highly-rated banks. To retain that status, which protects their access to funds when markets are functioning, they have to protect their profitability.

Passing on a 25 basis point cut might appear a relatively painless decision to make, given the customer backlash that will develop if they don’t.

With owner-occupied housing loans totalling more than $600 billion on their books, however, the four majors would transfer about $1.5 billion of profits from their shareholders to borrowers if they did. If the rate cut were also passed onto customers that have borrowed for investment housing, the annualised cost would be around $2.2 billion, or nearly seven per cent of their combined profits last financial year

Given their critical need to maintain their elevated levels of deposit funding, which have reduced their reliance on wholesale money, they can’t necessarily offset some of that impact by reducing deposit rates.

With the RBA deemed likely to cut rates further and more heavily if the Eurozone continues to teeter, the stakes for the majors are potentially very significant.

All the banks experienced a significant squeeze on margins as the last financial year progressed, as funding costs inched up and lending volumes fell away. The accelerated response to the Basel III reforms being imposed by the Australian Prudential Regulation Authority, and their own existing big post-2008 holdings of excess capital and liquidity, will also put a rising floor under their funding costs over the next few years.

Whereas in 2009-10 it was Westpac and CBA, which had gorged on the surge in home lending sparked by the Rudd Government stimulus packages, that were under real pressure from their funding costs, this time it is NAB that has the most difficult decision to make.

Its peers essentially kept the growth in their asset bases in line with the growth in their holdings of deposits last financial year, but NAB, thanks to the success of the Breaking Up campaign, grew its lending at multiples of the system’s growth and beyond the rate of growth in its deposits. The retention of those five basis points last month was an indicator of margin pressure and an increased exposure to wholesale markets.

Tactically, its peers may wait for NAB to blink first and move so that they can end its boast of having the lowest headline mortgage rate and devalue the big investment it made in the Breaking Up campaign. NAB would be very aware of that risk and presumably will either pass on the full 25 basis points or wait for them to show their hands before it moves.

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