Why mortgage rates aren't coming down

Despite the reduction in bank funding costs, mortgage rates are staying put. After the GFC liquidity scare, banks are more worried about managing their balance sheets than embarking on a rates war.

The Reserve Bank’s decision to again sit on its hands and leave the cash rate unchanged yesterday will inevitably lead to increased agitation for the banks to move – reduce – their home loan rates independently. While that’s conceivable, it is unlikely.

In fact even before the RBA’s latest board meeting there were renewed calls for the banks to move on the basis that their funding costs have fallen significantly in recent months relative to the cash rate.

That has been the case. The relative cost of wholesale funding has fallen sharply from its financial crisis peaks and the banks have been issuing covered bonds at the smallest spreads experienced since they first started issuing them in late 2011. The cost of term deposits have stabilised relative to the cash rate, albeit at levels well above those that prevailed before the crisis.

There are analysts who say the banks should be able to make more money from mortgages than virtually at any time in their history because funding costs have been falling so steeply. If that were the case, one would have to ask why they aren’t flooding the market with cheap home loans and why their spreads and margins don’t reflect that super-profitability.

The problem in concluding that the fall in the banks’ cost of funds creates the scope for reductions in mortgages rates is that when looking at the movements in their cost of funds over the past year we’re actually looking at their incremental cost of funds.

While it might be conceivable that a bank would, for tactical reasons (Who's the bravest of the big four? March 5), look at the marginal cost of its funding to buy some market share in a particular segment, that wouldn’t be a sustainable strategy — pursued too vigorously and broadly it would eventually marginalise the bank’s loan book.

The banks, in setting their lending rates, are more concerned about their overall funding base and its cost – its average cost – than their incremental funding costs.

Since the crisis and the scare they received when wholesale debt markets seized up and their over-reliance on offshore funding markets exposed their biggest vulnerability, the banks have been steadily increasing the average maturity of their funding, reducing the proportion of short term funding and lengthening the maturities of their overall books. That means there are still higher cost debt issues from up to five years ago yet to run off.

The banks have also been aggressively lifting the proportion of retail term deposits, although the overall downward shift in the yield curve has seen that trend flatten as depositors have gone elsewhere – into the equity market, for instance – in pursuit of higher yields.

In a low rate environment, the other influence on bank margins is the loss of income on their own shareholders’ funds and on their non-interest-bearing or low-interest-bearing customer accounts.

Commonwealth Bank’s Ian Narev put the incremental versus incremental funding cost arguments in perspective when he said CBA’s average funding cost relative to the market benchmarks was still rising and wouldn’t peak until towards the end of this year.

Rationally once the average cost of funds starts to fall the banks will have the capacity to cut rates of their own volition, if they choose to.

If the banks had, as some charge, been ‘’gouging’’ their customers when they failed to fully pass on the RBA’s rate cuts last year that should have been reflected in increased interest spreads and margins and, given the incentives, significant growth in their interest-generating asset bases.

In fact their spreads and margins have been broadly steady over the past year, with shifts up and down of a couple of basis points, a conclusion supported by the RBA’s own analysis and re-stated in last month’s statement of monetary policy.

In their most recent financial statements and updates it has also been evident that the banks’ are experiencing only very modest balance sheet growth.

That’s partly a function of the very weak demand for credit from customers focused on reducing their own leverage and partly because most of the banks are only increasing their asset bases by the amounts of deposit-funding they can raise.

There are prudential and regulatory reasons why the banks are continuing to try to reduce their reliance on wholesale funding and are controlling their asset growth to improve their regulatory capital and liquidity ratios. The post-crisis increase in the regularity impost on banks is substantial and still being implemented.

As discussed previously, the other missing ingredient in the debate about bank profitability and mortgage lending is the reality that borrowers for housing are, as a group, a much smaller constituency than depositors.

Many depositors, particularly older customers, rely on income from their savings to pay their routine expenses and as the yield curve has shifted down significantly they have been hurt; borrowers, in terms of the nominal rather than relative cost of a loan, have benefitted significantly.

The shift in the banks’ focus from assets to liability management hasn’t been sufficient to do much other than take some of the edge off the impact of falling interest rates on depositors. If it is the banks’ social licence to operate that people are concerned about, it should be the plight of depositors not borrowers that should be the focus of discussion.

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