Examining the RBA's deep cuts

The debate about the degree to which 'greedy bankers' pass on rate cuts is getting out of hand. Since the GFC, bank margins on loans have shrunk, and the RBA cuts deeper to get mortgage rates down.

Can we please stop the inane discussion about the extent to which the banks pass on Reserve Bank changes in official interest rates?

It is irrelevant to the macro-management of the economy and to the end point of what interest rate borrowers actually end up paying and what deposit rate savers end up getting.

Want to know why?

The RBA adjusts official interest rates with full knowledge of banks funding issues be they positive or negative. If the RBA wants to deliver some genuine interest rate stimulus to the economy but knows banks funding costs are rising, it will cut the official interest rate by a bigger amount than it would otherwise do.

Let’s look at the 150 basis points of cuts in official interest rates in the last year.

The RBA wants to make sure the interest rate that mortgage holders and business borrowers actually pay is materially lowered as it deals with low inflation, a softer labour market, the over-valued Australian dollar and significant global economic risks.

At the same time, it knew the banks were facing funding cost pressures which show up in higher deposit interest rates relative to official rates and rising wholesales funding costs.

As a result of this and given its desire to give some interest rate relief to borrowers, it slashed interest rates by a greater amount than if the banks had no such funding cost pressures.

The results show up in the data. The 150 basis points of cuts in official interest rates over the past year have translated to "only” 120 basis points of lower mortgage rates and 110 basis points in lower overdraft lending rates for business.

If there was no change in bank funding costs, I would bet Gail Kelly’s salary that the RBA would have not cut the official interest rate as much as it has. A 3.5 per cent cash rate might have been enough to deliver the 6.6 per cent mortgage rate we see now, rather than the 3.25 per cent cash rate that the RBA delivered last week. The RBA would have cut about 25 basis points less.

See the issue?

The RBA cuts are aimed at having an impact on the real economy with full knowledge of how much it costs a bank to raise the money that it lends to you and me. The RBA frankly doesn't give two hoots about the mechanism with which to get rates lower for retail borrowers, as long as it gets there.

And let’s just have a look at how the net interest margin of these "mean and greedy banks” have trended in recent times. The chart below is from the RBA and it shows all too clearly that since about 2003, well before the GFC was unleashed, the net interest rate margin has been in an extremely tight band between about 220 and 250 basis points.

According to the most recent observation it is slap bang in the middle of that range at around 235 basis points. Which just goes to show how generous the banks have been in not passing on the cuts on official interest rate to depositors.
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And here’s the final point. Some time in the not too distant future, market conditions will settle down and bank funding costs will start to fall. A global economic and markets recovery might see that happen. In these circumstances, a bit of competitive pressure might see a bank of two cut their lending rates in the absence of an RBA move in official rates. If this reduction in interest rates that borrowers pay is not what the RBA wants given its particular view on inflation, it will inevitably hike the official interest rate to neuter this change in market conditions.

So let’s concentrate on the fact that the standard variable mortgage rate is around 6.6 per cent, the rate more or less the RBA wants to see. The fact it had to cut the cash rate to 3.25 per cent to get it there is only of passing interest in terms of banks margins, profits and the real economy.