Cheap credit squeezes banks

Bank profitability is likely to come under growing pressure in an environment of very cheap credit, as lenders reap lower returns from deposit accounts and surplus capital.

Bank profitability is likely to come under growing pressure in an environment of very cheap credit, as lenders reap lower returns from deposit accounts and surplus capital.

The major banks rushed to pass through the Reserve Bank's 0.25 percentage point cut to customers on Tuesday, with Westpac lowering mortgage rates by 0.28 percentage points. Money markets imply there is a chance of another cut over the next year.

But while home loan customers may welcome the reduction, an extended period of very-low interest rates is likely to drag on the profits of the big four.

Credit Suisse analyst Jarrod Martin said when official interest rates fall to historic lows, bank earnings tend to suffer because banks cut their mortgage rates but cannot cut interest rates on transaction accounts that pay no or minimal interest. This makes deposit accounts less profitable for banks.

At the same time, he said banks tended to make lower returns on their excess capital, which is invested in fixed-income assets such as government bonds. "Falling interest rates in general are negative for bank earnings," Mr Martin said.

Westpac's aggressive move to cut mortgage rates also reflects competition among lenders to sign up new customers, which could drag on profits.

With mortgage credit growing at less than half the pace at which it expanded before the global financial crisis, banks are trying to entice customers with lower standard variable rates or discounts as part of package deals.

Recent research by Mr Martin showed banks were reducing their standard variable interest rates by up to 1 percentage point for mortgages of more than $500,000.

However, households have so far been reluctant to take on more debt. Aside from increased activity among property investors, there has not been a strong bounce in borrowing during the latest cutting cycle, pressuring banks to offer customers better deals.

Analysts have said Westpac, which has the highest standard variable mortgage rates of the big four and has been losing market share, may need to make further cuts to rates in order to lift growth.

Low interest rates are also a function of a weaker economic climate - which can squeeze bank profits if it results in a sharp increase in the number of borrowers who go into default.

The unemployment rate rose to 5.7 per cent in June, but the government's economic statement last week predicted it would climb to 6.25 per cent this financial year, the highest since September 2002.

However, analysts believe banks could cope with an unemployment rate above 6 per cent without big losses from bad loans, as many borrowers have been making mortgage repayments in excess of the minimum, giving them a buffer if they were to lose their job.

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