Shutting down a SocGen banking analysis

A Societe Generale interest rate strategist made the headlines with a series of comments about funding costs for Australian banks. While some of the facts were correct, their interpretation was not.

What would a Tokyo-based interest rate strategist for a French bank know about Australian bank profitability? Not that much, apparently.

Yesterday afternoon the websites of the Fairfax broadsheets splashed a story across the top of their home pages quoting from a research note written by Societe Generale’s Asian Pacific head of interest rate strategy, Christian Carrillo, who they reported as saying that it was ‘’almost mathematically impossible’’ for the total funding costs for the Australian banks to be rising.

‘’The claim that the recent increase in mortgage rates is due to higher funding costs is very dubious,’’ he is said to have written. He said it appeared the increases in rates, of between six and ten basis points, were aimed at protecting the banks’ profit margins.

‘’Our calculations suggest that almost all sources of funding of Australian banks, except long-term overseas, are cheaper than their post-GFC highs and have kept falling since the second half of 2011 in absolute terms,’’ he said.

‘’Australian banks are essentially an oligopoly. They control most of the market anyway. They can effectively set rates where they want to.’’

As it happens, strictly speaking some of the Soc-Gen analysis – that in absolute terms, the costs of most sources of bank funding have fallen as central banks around the world, including the Reserve Bank, have reduced official interest rates – might be correct, but the conclusions drawn from it are not.

While not completely irrelevant to the issue of bank profitability, the absolute cost of funding isn’t what drives bank profitability. Rather it is the relationship between the banks’ cost of funding and the rates they charge their customers – the spreads.

It is almost impossible for anyone outside the individual banks themselves, or their regulators, to calculate overall spreads with any precision. It is clear, however, from the most recent round of bank quarterly results, and Commonwealth Bank’s December half results, that bank margins are running about 10 basis points lower than they were in the first six months of 2011.

Mr Carrillo doesn’t have to take the banks’ word for that erosion of spreads and margins. The Reserve Bank has been saying consistently in all its publications and in speeches by its senior officials that the banks’ interest rate spreads have been reduced.

In the minutes of the February RBA board meeting, released today, the RBA said that its board members were informed that while sentiment had generally improved there had been a ‘’marked’’ re-pricing of bank debt globally.

‘’Following the dislocation of bank debt markets globally in the latter part of 2011, issuance had picked up significantly in January but the spreads at which bank debt was issued were significantly higher than in the middle of 2011."

‘’The Australian banks had issued sizeable amounts of covered bonds in a number of offshore markets in recent weeks at these higher spreads. Furthermore, the cost of swapping funds raised in offshore markets into Australian dollars had increased in recent months.

‘’There had also been two large issues of covered bonds in the Australian market which had re-priced the local bank debt curve significantly higher. Over the same period Australian banks continued to compete actively for deposits, which resulted in the reductions in most deposit rates not fully matching the recent reductions in the cash rate.

‘’Collectively, these development had increased banks’ overall cost of funding relative to the cash rate and had narrowed the difference between banks’ lending rates and funding costs,’’ the minutes said.
That’s a quite unequivocal statement by the RBA that bank funding cost increases have compressed their spreads and decreased their relative profitability.

It is well understood in this market that until they unilaterally re-priced their home loans the marginal dollar of home lending by the big banks was loss-making. With those out-of-cycle increases, new lending is probably break-even or perhaps very marginally profitable for those banks with the higher mortgage rates.

Home lending is relatively low margins at the best of times, with the banks reliant on the sheer volume of lending to generate solid profitability. With volume growth – in home and business lending – weak, profit growth in the past six months has diminished to the point where it is virtually flat-lining.

As noted previously, while some bank critics point to a widening of net interest margins since the nadir of the original global financial crisis and their return, before the recent blow-out in the spreads on their debt issues, to pre-crisis levels, it is somehow over-looked that the lead-up to the GFC saw intense competition from regional banks, foreign banks and non-banks based on unsustainably cheap short term funding. If margins today are similar to those that existed pre-crisis, there’s clearly no evidence of oligopolistic pricing.

The Australian Bankers’ Association was quick to point out today that the regional banks, and even the Greater Heritage Building Society, had also raised their rates this month – Bendigo and Adelaide by 15 basis points – which also tends to undermine Mr Carrillo’s opinion that the rate rises were evidence of oligopolistic behaviour.

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