Flashpoint for Swan's rates row

After weeks of shadow boxing, Treasurer Wayne Swan and the heads of the country's big four banks won't be holding back their punches today if, as widely expected, the Reserve Bank decides to cut official interest rates at its board meeting.

The bosses of the big four banks will be quick into battle, arguing that they can't possibly afford to pass on the full rate cut. They'll argue that they now have to pay much higher interest rates to raise money offshore, because the European debt crisis has thrown global financial markets into disarray. And even though the Australian banks have reduced their dependence on foreign funding, they still need to raise around 22 per cent of their funds offshore.

What's more, the bankers will argue that their local funding costs are also climbing. In the past few months, competition between the banks to attract deposits from local savers has sharpened, which means that banks now have to pay higher interest rates for their local deposits.

The bankers will argue that if Swan pushes them to pass on the full cut in official rates to home loan borrowers, then they'll have no choice but to hit other customers, such as small businesses, with higher interest rates. This, they warn, will be bad for the economy and bad for jobs.

But Swan has little sympathy for the bankers' cries of woe. He believes that the big four banks are hugely profitable, and that they enjoy a return on equity that's much higher than most of their foreign competitors.

Australia's big four enjoy a return on equity of around 15 per cent, which is roughly on a par with the returns enjoyed by Canadian and Scandinavian banks. But the big US and European banks can only dream about making these sorts of returns.

Now that the big US banks have stopped making massive writedowns on their bad debts, their return on equity has settled at around the 10 per cent level. Meanwhile, many European banks are suffering massive losses as a result of their huge exposures to the bonds of debt-strapped eurozone countries.

Swan also believes that regulatory changes introduced in the wake of the financial crisis mean that the big four banks have now become much safer. Banks are now being forced to bolster their capital and liquidity buffers, and regulators have stepped up their monitoring of the banks. Because banks have become less risky investments, he believes that their shareholders should be prepared to accept a lower rate of return than what they demanded in the past.

Even more important, the financial crisis provided shareholders with the crucial proof that the Australian government was prepared to backstop the banking system in an emergency. In the wake of the collapse of the investment bank, Lehman Brothers, Canberra moved quickly to guarantee all bank deposits, as well as the banks' wholesale funding.

Swan believes that in exchange for this government guarantee, the big banks should be prepared to put up with tighter interest rate margins, which will translate into lower returns for shareholders. That's why, if the Reserve Bank does decide to cut interest rates today, Swan will be strong-arming the banks to make sure they pass on the rate cut in full.