Westpac and the art of war

Westpac's decision to increase its home loan rates by 20 basis points more than the Reserve Bank's 25 basis point increase in official rates has unsettled, not only Wayne Swan, but its rivals, who are concerned that Westpac is turning what might have been a point of vulnerability into a competitive weapon.

It wasn't just the instant 45 basis point increase in mortgage rates that has taken the other three majors aback, but also Westpac's decision to pass on only a 25 basis point increase to its business customers and unveil steep increase in the rates it is offering on term deposits and online savings accounts.

Where it appears the other banks may have been prepared to follow the RBA cycle and avoid the political and community backlash that accompanies above-cycle increases, the likelihood now is that they will raise rates by more than the RBA but less than Westpac. All the banks spent much of today considering how to respond to the Westpac move.

The Westpac move, while provocative and politically dangerous given that the federal government and the Australian Prudential Regulation Authority have before them a host of issues that could impact the majors, appears to be a mixture of necessity and strategy.

It has been acknowledged by the RBA that there will be more out-of-cycle moves by the banks because of the continuing increase in their average cost of funding as pre-crisis borrowings mature and are replaced by more expensive post-crisis retail and wholesale funding.

Until yesterday the banks, while raising their rates by more than the official increases, had contained those increases by absorbing them in lower margins on home loans. They have benefitted from higher volumes as non-bank lending capacity evaporated and have also offset the squeeze on home loan margins by the re-pricing for risk of their corporate and SME loan books.

However, Westpac and Commonwealth have developed a particular problem. Both have been extremely aggressive in winning home loan market share, to the point where they are dominating the writing of new home loans and stripping share from NAB and ANZ.

Home lending can be justified despite the compression of margins on the basis of long-term customer relationships and the non-housing business and income that it generates. Westpac and CBA have grown their books so dramatically, however, that they would be starting to feel the squeeze on profitability.

Asset growth has to be funded. All the banks have been trying to reduce their reliance on wholesale funding, particularly offshore funding, by attracting retail deposits. The cost of retail deposits has been bid up aggressively. The home loan strategies adopted by Westpac and CBA means they need that funding even more than their rivals, which perhaps explains why Westpac lifted 12-month term deposit rates by 230 basis points yesterday.

There is a chicken and egg relationship between mortgages and retail deposits. The more growth in a home loan book the more retail funding is required. The more a bank has to pay to attract a disproportionate share of deposits the more pressure there is to recoup that cost through wider home loan margins.

The discipline on the cost of home loans has, until this week, been the odium and risk of a political backlash of a bank that was to aggressive in its pricing. By opting to run that risk but adopting a multifaceted strategy in the process Westpac has changed the sector's dynamics.

The biggest threat to both Westpac and CBA as a consequence of their drive into home loans has been the potential margin squeeze as funding costs continue to rise without the banks being able to fully recover those costs through higher home loan rates. That had left them vulnerable to price competition from NAB and ANZ, for whom the consequences of sacrificing margin for share would be significantly less dramatic because of their far lower home loan shares.

Westpac has turned that situation on its head. It will have a more profitable home loan book and can use that to both fund an attack on retail deposits and a more aggressive position in business lending.

The more intense and costly competition for deposits makes it difficult, if not impossible, for the banks with the smaller markets shares to significantly under-cut Westpac on mortgage rates. They are watching closely to see what CBA, with its even larger mortgage book, does in response.

The Westpac moves do suggest that the strategies of all the majors can now be dictated by Westpac and CBA unless the two smaller banks are prepared to absorb considerable pain for a considerable period by absorbing losses of margin on their own home loan books that would be amplified by the bidding up of the cost of retail deposits.

The aggression does, of course, invite a response from politicians and regulators already concerned about the crisis-driven consolidation of the sector that has greatly increased the four major's dominance of the system.

There is particular concern that the crisis has enabled Westpac (post St George) and CBA (post BankWest) to create a two-tiered system rather than the more balanced sector that existed pre-crisis, where the majors were also disciplined by competition from a range of regional banks and non-banks.

Exactly what the government could do to the banks isn't certain, but one only has to look at the legislation proposed to hobble Telstra to recognise that the potential for retaliatory measures is real.

Real or quasi re-regulation, changes to the deposit and wholesale funding guarantees, government support for regional and non-bank funding and more onerous capital and liquidity rules than those already being contemplated are among a multitude of measures that could be adopted if the government were minded to.

Westpac's competitors would be tempted to take the near-term hits to their profits and leave Westpac stuck out on a limb, winning political and consumer kudos in the process. That would, however, give Westpac the longer term strategic advantages it appears to be seeking. Hence the probability that they'll have a bet each way.