Finance

Why the banks WON’T pass on the rate cut: Bartholomeusz

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When the Reserve Bank cuts official rates next month for the first time in nearly seven years, all hell is going to break loose when the major banks fail to pass on the full reduction.

When the Reserve Bank cuts official rates next month for the first time in nearly seven years, all hell is going to break loose when the major banks fail to pass on the full reduction.

It is already apparent from the noises the banks are making, and the apparent agitation within the RBA in response, that neither expect to see the banks reduce their home loan rates to the full extent of the reduction in official rates. That in turn has led to speculation that the central bank may initially cut its target rate by 50 basis points, rather than the conventional 25 basis points, in order to give the banks some headroom.

The banks know they are going to be pilloried, particularly by the shock jocks and tabloids, if they don’t replicate whatever the RBA does. Despite that, they will almost certainly confirm the populist perception that all banks, particularly the big ones, are greedy and more concerned with their profits than their customers.

To understand why the banks would be prepared to experience this outpouring of contempt, it is necessary to consider what has happened to them during the credit crisis, now a year old.

To minimise the risks of a liquidity crisis, banks diversify their funding sources and durations, trying to get a balance between retail and wholesale money as well as short, medium and longer term funding. The balances will vary between the banks.

For most of the majors, around 50% would be funded from retail sources, with perhaps 20% to 25% short term wholesale funding and maybe 20% long term wholesale. The remainder comes from sources like securitisation.

Spreads for both short term and long term money have been highly volatile since the crisis began but have certainly blown out dramatically when compared with pre-crisis settings. The longer the term of the funding the bigger the blowouts have been.

Before the crisis, the spread over the cash rate for short term money was about three basis points. Until recently, when spreads dropped back to single digits in expectation of a reduction in official rates, they had been running at more than 20 basis points after being as much as 70 basis points earlier this year.

It used to cost banks 10 basis points over the bank bill swap rate for three-year funding and less than 20 basis points for five-year money. Post-crisis it has been closer to 100 basis points for three-year funding and 130 basis points for five-year funds.

The cost of retail deposits has moved with the overall market but they have also risen because smaller banks with lower credit ratings than the majors – who can’t access wholesale funds in this environment – have had no choice but to buy in retail funding, pushing up the cost of deposits.

If the RBA does cut the cash rate it will have some impact on the banks’ cost of short term funding. But it will have no impact on the cost of their longer term money and, even if the spreads demanded by the providers of wholesale term funding were to narrow, it would remain the case that the banks have already locked in higher-cost funding for three to five years – on average around the three-year mark – over the past year of the crisis.

During that period more of the pre-crisis funding would have been displaced by expensive post-crisis money. Each month the average cost of term funding would have been rising as the banks raised new funds at a far higher cost. On some estimates the overall blended cost of funds for the majors has been rising by at least two or three basis points a month.

Even retail deposits won’t necessarily become any cheaper if the RBA reduces official rates because the smaller banks will still need to attract a materially disproportionate share of those deposits to stay in business. Retail deposits are also invested over a range of terms, so the higher recent rates would to some degree remain embedded in those deposits for months, if not years.

Thus, whatever the RBA does, and no matter how much it cuts official rates, a significant proportion of their book will have its cost locked in – some of it for months but a significant proportion for years. The longer the crisis continues, the more of that higher-cost longer term funding will be embedded in the book.

The banks, of course, do remain profitable – exceptionally so by the admittedly crisis-ravaged standards of their global peers. All four majors have retained their AA credit ratings – they are among only 18 banks worldwide that have that rating. Only AA-rated banks have been able to readily access any meaningful term debt in wholesale markets.

The obvious conclusion would be that they could take a hit on their margins – shift some of the pain from customers to shareholders – in order to reflect fully the RBA’s intentions.

The banks would argue that they already done that, with the 50 basis point increase in their mortgages rates above the movement in official rates not sufficient to fully recover the increase in their funding costs. Be that as it may (and it will vary from bank to bank) the banks will be wary of sacrificing margin, and not just because their share prices have already been smashed.

The credit ratings agencies might now be discredited (again) for their role in the sub-prime debacle, where securities they rated as AAA became junk overnight, but they are still powerful.

In re-affirming ANZ’s rating recently, Moody’s said that the bank would need to maintain or rebuild its margins to maintain a stable ratings outlook.

None of the majors are going to do anything that would jeopardise their rating – at best a negative outlook would probably further increase their funding costs and at worst a downgrade would probably shut down their access to wholesale funding, which could put them at risk.

And that is why they’ll wear the ignominy of moving rates at a different pace to the RBA, and why the RBA will have to consider strategies that takes the likely response of the majors into account when it sets its targets for reductions in short term rates.

This article first appeared on Business Spectator

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