The inconvenient truth for bank bashers

If one accepted the one-dimensional view of the banking system that Wayne Swan always parrots when the Reserve Bank cuts rates then National Australia Bank, Westpac and Commonwealth could be rightly criticised for not passing on in full the RBA's latest 25 basis point cut to the cash rate.

The system, of course, isn't one dimensional. It isn't all about housing loans. Indeed only a relatively modest proportion (roughly a third) of households have a mortgage and more than two-thirds of those households are in the top two income quintiles.

There are a lot more people with deposits in the banks, many of them self-funded retirees or pensioners supplementing their meagre incomes with interest from their savings, and those people are at least as deserving of the treasurer's concern as those with home loans.

There are also, of course, the funding, profitability and stability dimensions within the banks themselves as well as the reality that while the RBA can shift the yield curve up or down by moving the cash rate around it can't fix the spreads relative to the cash rate at which the banks raise their funds, either domestically or offshore.

While funding costs have been falling in an absolute sense, that's not necessarily the case in the relative sense that actually matters to the banks. For them the determinant of the profitability of their loan books is the relationship between their average cost of funds and the yield from their loan books rather than the particular rates.

While wholesale funding spreads have come back over the course of this year the cost of wholesale money also only affects the cost of the incremental dollars of funding raised rather than the banks' entire funding bases, which will contain borrowings of up to five years or more.

Whether it is the funds they raise offshore or in domestic wholesale markets or the deposit funding they can attract from customers, the absolute cost of funds has fallen after spiking during the financial crisis.

Even in the most recent series of bank results for the year to September, however, it was evident that net interest margins are continuing to contract. All of the majors saw their net interest margins squeezed, with NAB and ANZ experiencing double-digit basis point declines.

A significant factor in that margin compression has been the concerted effort by the major banks to reduce their reliance on offshore wholesale funding and short term funding in particular. Pre-crisis less than 30 per cent of their funding came from deposits. Today it is around 60 per cent.

Since the crisis erupted households, in a flight to safety, have increased their holdings of deposits by more than $225 billion, which has helped the banks in their quest for more stable funding.

In the past two years competition between the major banks has been re-directed from the traditional battleground of mortgage volumes and market shares to deposits – from the asset side of their balance sheet to liabilities and from borrowers to depositors.

With the demand for credit generally subdued and growth in deposits tapering as rates have declined – and all the majors still well short of their longer term targets of 80 per cent-plus deposit funding – the contest for deposits is likely to remain strong for quite some time and therefore the ability of the majors to do as Swan keeps exhorting them to do isn't as easy or virtuous as he portrays.

The impact on the banks isn't simply the relatively higher cost of attracting deposits but also the opportunity cost to them created by the low interest rate environment on non-interest-bearing or low-interest-cost customer funds.

In other words, when banks don't pass on the full movement in official interest rates to mortgage holders it isn't necessarily the case that the amount retained flows to their bottom line and onto shareholders.

Some of that, sometimes all of it, flows to the other bank stakeholders, like depositors or non-housing borrowers. It is also misleading to use, as many do, wholesale funding costs alone as a guide to bank funding costs when a majority of their funding now comes from deposits.

There is, of course, a profitability dimension, which is always controversial. With the banks now required to meet far stronger minimum capital adequacy thresholds and hold far more and higher quality (and higher cost) liquidity, their returns on equity are sliding back into the mid-teens.

As the new prudential regime continues to be implemented, and they hold even more capital, returns will be under even greater pressure in what is likely to be an environment of relatively low credit demand for quite some time and which will create competitive tensions and disciplines on both sides of the banks' balance sheets.

There is a limit to how far the banks can allow their returns to fall before it jeopardises their cost of both debt and equity. It is in the financial system and the economy's interest for the banks to be solidly (albeit not excessively) profitable and stable.

One assumes the treasurer knows and understands that, along with the reality that in a falling interest rate environment there are constituencies other than mortgage holders, like depositors and small businesses, that are as deserving, if not more deserving, of some relief. That is, of course, a more complicated story to tell, without the perceived political benefits or emotional satisfaction of a good bout of bank bashing.