How a rate hike could save the banks

The big four are clearly betting on a lower cash rate to help fill a funding gap. But if they want to fix the problem permanently, they'll have to lift their own rates.

Australia has one of the strongest banking systems in the world because our banks didn’t play the silly overseas banking games of lending to people, organisations or governments who were unable to repay loans. But we have a weakness – our so-called ‘funding gap’ – and it's time to bring that weakness into the open, given that ANZ is this week deciding whether to lift mortgage interest rates.

Australian banks’ funding gap is the money they need to raise from the expensive overseas inter-banking market. It’s expensive because global banks no longer trust each other, as no one knows the extent of bank exposure to high-risk securities.

To determine the size of the Australian funding gap I needed help, and not everyone will agree with the method of calculating the difference between bank loans and deposits (excluding wholesale deposits). But the methodology shows that we have a massive $625 billion funding gap.image
In times gone by this funding gap could be filled overseas at interest rates that were lower than Australian rates. Now the overseas borrowing costs have risen sharply and are slightly above the local term deposits rates. It is the rising cost of filling the funding gap that is causing the banks to think about lifting mortgage rates despite the Reserve Bank’s latest steady interest rate stance.

At the moment, all the focus is on overseas borrowing maturities because when the old low-cost loans mature they must be replaced by higher-cost loans. And there have been periods where the overseas markets are not open, which requires banks to hold liquidity to see them through.

The graph above shows that Westpac has the largest funding gap, followed by the Commonwealth Bank, partly reflecting the major drive both banks undertook to increase housing market share some years ago. Both slightly improved their position in the last six months.

ANZ and NAB have a lower exposure but both edged up the size of their funding gap in the last six months – particularly ANZ. But both banks are smaller than CBA and Westpac.

The sharp rise in ANZ exposure underlines the importance to ANZ of having mortgage rates that reflect costs.

As I have written many times before, the Commonwealth government can borrow that $625 billion far less expensively than the banks can. If the federal government borrowed the money and loaned it to the banks, Canberra would make a healthy profit but would inevitably have greater influence over bank operations and levels of profit.

Alternatively, the banks could become much more aggressive at raising local term deposits. But to do that requires higher interest rates and major promotions. Currently, along with the falling official interest rates, term deposit rates are falling. The banks are offering in the vicinity of only 5 per cent for one-year money. A few months ago it was over 6 per cent.

On the other hand they are aggressive in bidding for four and six-month money and are offering between 5.7 and 5.8 per cent. The banks are clearly punting on lower interest rates. But if they want to tackle the funding gap on a permanent basis they will have to lift their rates, because at around 5 per cent superannuation money will start to drift away from banks to infrastructure, bank shares and other high-yielding securities.