As published in The Australian on 29 April 2017
Home loan rates are rising but term deposit rates are actually falling. What is going on?
Customers seem increasingly less important in the equation. After all the cash rate has remained on hold at 1.5 per cent since August 2016.
The pressure to continually increase profitability among banks is intense and a key indicator of bank profitability is known as the net interest margin. Simply, it’s the difference between the bank’s cost of borrowing funds and the income it receives from lending those funds.
As a bank analyst, I used to look for a net interest margin of 2 per cent or higher to provide a level of comfort. Lower than that and a small bank could come under pressure, particularly if there’s an increase in unemployment or a recession as both could signal that arrears on loans would increase, as would defaults, bad debts and eventually raised losses.
Net interest margins have come under pressure as new regulations force the banks to hold greater allocations to liquid assets, which earn very low returns.
To get higher net interest margins, banks need to either reduce the cost of funds or increase the loan rates. Think about how a very small reduction in a mortgage rate can mean thousands back in your pocket and then multiply it and you start to get the picture of how small increments in the net interest margin can lead to improved profits.
Over the last few years, banks have been able to borrow in international markets by issuing bonds in US dollars, Sterling or Euro at cheap rates. Then on election of President Trump, benchmark US government rates – known as Treasuries – rose on the promise of massive spending, increasing employment and a cut in taxes. The market anticipated that interest rates would rise, and bank borrowing costs also rose.
This sent other global benchmarks higher including our domestic Bank Bill Swap Rate. As a result, higher fund costs are a genuine issue for Australian banks, even though the cash rate has not changed.
So you may not like it, especially if you have high cash holdings in your portfolio, and SMSF operators traditionally have a bias towards cash. But the key issues you need to watch are:
- Benchmark interest rates that help set the rate of interest banks have to pay on borrowed funds have fallen. In turn the cost of existing floating rate debt is cheaper for the bank, so banks don’t need to pay more for deposits.
- Australian consumers are loyal and many don’t bother shopping around or want the hassle of changing banks, so they remain with existing banks. The banks know this, as does the regulator, APRA, which acknowledges the fact and deems retail deposits as “sticky”. That is, a more reliable source of funding than from wholesale or institutional clients, which are much more likely to swap institutions to get a better return.
- Banks are forever trying to maximise net interest margins, a small increase can lead to higher profits and thus higher dividends and performance payments. They are, after all, in the business of making money.
Many of the banks have raised borrowing rates. In the last week, CBA increased its fixed rate mortgage lending rate by 0.25 per cent and rates for investment home loans by 0.25 to 0.5 per cent per annum. The higher rates will act as a partial break on a runaway property market but add nicely to the bank’s net interest margin.
On the other end of the margin equation, deposits have been declining.
The average one year deposit rate rose marginally in the days following Trump’s success. Since then, the average one year term deposit rate has declined by 0.15 per cent per annum, even though the cash rate remains unchanged.
Term deposit rates are dropping
