Why banks won't be offering rate relief

Both Bendigo and Adelaide Bank's Mike Hirst and Commonwealth Bank's Ian Narev have acknowledged that the marginal cost of funding has been easing. That doesn't necessarily mean much for borrowers.

Hirst said as he announced his bank's result that rates on deposits could fall as other sources of debt became cheaper and more accessible. By other sources he means wholesale funds, the cost of which has been falling as fears about the fate of the eurozone have receded, at least for the moment.

Narev last week made the distinction between the marginal cost of funds and their average cost. Yes, the cost of customer deposits and wholesale funding has been falling but, he said at last week's earnings announcement, the average cost was still rising and wouldn't peak until December this year.

That's obviously a function of the term funding raised during that period post-crisis when spreads did blow out. With the banks deliberately trying to lengthen the average maturity of their funding bases there's quite a lot of longer term funding within their liability structures.

More recently, in an effort to reduce their exposures to wholesale debt markets, having experienced the vulnerability of those markets to external shocks, the banks have bid up the relative cost of retail deposits.

All the major banks are probably going to be roughly in the same position as Commonwealth Bank, with their average cost of funds starting to fall back towards the end of this year or early next year, although its peers are more reliant on wholesale funding than Commonwealth Bank given its disproportionate share of deposits.

Even when their average funding costs do start sliding, however, there is no certainty that borrowers will be the beneficiaries.

Hirst has a bank that is largely funded by retail deposits. The majors are now majority funded by deposits (pre-crisis they were only about 40 per cent deposit-funded) but they are all seeking a higher proportion of deposit funding because of the scare they received during the crisis – and because the new prudential regulations they will be subjected to involve rules around the stability of their funding.

While the intensity of the competition for deposits has abated slightly in recent months, partly because it was starting to appear that the majors were churning deposits rather than increasing the pool, that could change.

The resurgence of sharemarkets reflects investor hunger for returns and the substantial rise in Australian bank shares, where dividend yields are solid and franked, a hunger for income. There does appear to be a drift occurring from bank deposits into equities and bank shares in particular from income-seeking investors.

If the majors wanted to stop that drift – and deposits tend to be relatively short in duration and therefore large volumes can be lost quite quickly – they would have to offer higher rates on their term deposits, particularly for the "stickier" longer term deposits.

If average funding costs were sliding they could afford that, although there could be a temptation to pass the benefits of a lower cost of funds through to shareholders.

It tends to be overlooked that low interest rate environments aren't particularly good for bank earnings, given that they have to pass on rate cuts ahead of the movements in their average cost of funds. They also experience lower returns on their cheaper deposits and non-interest-bearing cash balances in customer's accounts, as well as on their own shareholders' capital (which has been rising since the crisis).

As their returns on equity continue edging down they will be under some pressure from the market to boost net interest margins and earnings.

The banks have been criticised for not passing on the full Reserve Bank reductions in official rates last year to home loans. Those decisions were motivated mainly by the higher cost of their deposit bases – they redistributed some of the benefit of falling interest rates from home owners to depositors.

It is unlikely that will be reversed in the near term, if ever. Indeed, if the shift back out of deposits continues, and average funding costs do look certain to start to decline towards the end of the year and into next year, there could be more of the same with banks continuing to retain a few basis points of any further Reserve Bank rate cuts in order to reduce the impact on their deposit rates and ultimately their levels of deposit funding.

Given the national obsession with home loans, particularly among politicians, that wouldn't make them any more popular. But trying to retain the higher quality domestic deposits rather than revert to higher levels of wholesale funding is in the system's interests. And prioritising, at the margin, the rewarding of savers over borrowers is probably still in the interests of a wider economy with quite high levels of private debt.