Don't bank on mortgage rate cuts

Amidst all the smoke generated by the interest rate battle between the big banks and the government, Bendigo Bank chief executive Mike Hirst in his KGB interview details a major change in the component costs of bank funding. As a result, those expecting big mortgage rate falls are likely to be wrong.

Historically in most years, overseas wholesale funding has been cheaper than local term deposits. It is a complex sum because of the great variety of interest rates and currencies that banks offer on local term deposits.

But on Hirst's sums it is now fractionally cheaper for banks to borrow on the local term deposit market than to go offshore. And the signs are that overseas borrowing costs will rise further, which will widen the gap.

Hirst says movements in the Reserve Bank's official rates are not the major force affecting Bendigo Bank's cost of funds. Of course, if a Reserve Bank official rate cut sends the rates offered on local term deposits lower, then it reduces the cost of bank funds and that cost reduction can be passed on. But while overseas funding costs are higher, falls in local term deposit rates may be curbed.

So let's make a few simple assumptions. The Reserve Bank cuts interest rates by half a per cent over three months and the overseas wholesale rate does not change from current levels. In theory, term deposits should fall by half a per cent, along with other bank deposit rates linked to the official rate. In that situation, there is a clear case for at least a partial mortgage rate reduction.

But that will widen the gap between high-cost overseas rates and local term deposits. Will any bank seek to borrow overseas when the local term deposit rate is so much cheaper? Someone is going to bid for local funds by lifting local deposit rates rather than go overseas. Everyone else must follow or be left out. So in that scenario, local term deposit rates will not fall by anything like the official rate fall. Any bank lowering their mortgage rates substantially will do so at the cost to margins and shareholder return.

Bendigo Bank has no desire to cut mortgage rates under this scenario but my guess is that Mike Hirst will do what is required to be competitive. Bendigo is only a small bank but its great advantage is that it used its community affiliations to tap the local deposit market, which is now the cheapest source of funds.

The problem with Australian banks is that their chief executives do not understand how to explain their problem simply to the public. Few senior bank executives are courageous enough to go on talkback radio. Mike Hirst could not be any clearer on how the banks are likely to be affected but my guess is he will want to keep his head down so as to escape the wrath of Treasurer Wayne Swan.