When the outcome of the Reserve Bank board meeting tomorrow is announced, among the most keenly interested will be the treasurers and chief financial officers of the major banks. It has become very obvious in the past month that they are becoming anxious about their net interest margins and hanging out for cover for an increase in their home loan rates.
A 25 basis point rise in official rates would bring some relief but there is also a very real prospect that the banks will defy Wayne Swan’s warnings and, if the RBA moves, add 15 or 20 basis points of their own.
While Swan has said there is no justification for a rate rise outside or beyond the RBA’s cycle, and the RBA itself has said the rise in the banks’ interest income over the past two years has been sufficient to fully recoup their increased funding costs, the banks beg to differ.
They argue, quite rationally, that their average funding costs continue to rise as pre-crisis wholesale funding matures and has to be replaced with more expensive borrowings. The competition for deposits might have eased slightly recently but they, too, are more expensive than they were pre-crisis. The Commonwealth Bank has estimated that its average funding costs are rising at a rate of about two basis points a month.
In its most recent Financial Stability Review the RBA noted that, while there had been a rebound in the net interest margins of their Australian operations, the majors’ interest spreads could come under pressure as a result of the refinancing and margins compressed if risk spreads on long term funds were to increase substantially without being passed through to borrowing rates.
A notable feature of the big banks’ most recent quarterly earnings announcements was that June quarter net interest margins fell away quite sharply relatively to their level a year or even six months earlier – Westpac lost 24 basis points of margin in 12 months and CBA 14 basis points in the June half.
It was also noticeable that for the two biggest mortgage lenders, growth in household lending fell away quite sharply in the June quarter – the margin squeeze created by their unwillingness to raise mortgage rates out-of-cycle was forcing a form of credit rationing.
With the Federal election out of the way, one impediment to a move on mortgages is out of the way and all the rumblings from within the banks signals that they have been trying to prepare the community for a rate rise with or without the cloak of an increase in official rates.
A complicating issue is the position taken by NAB in the past. NAB already has the cheapest mortgage rack rate, having made a branding virtue out of staying in synch with the RBA last year. If it maintains that strategy a bank that passed on more than the official rate hike would look uncompetitive and wouldn’t be popular with its customers.
The discussion about cost of funds and margins won’t disappear with whatever the banks do in response to the RBA decision. They already face higher funding costs and will have to deal with the Basel III requirements for more and higher quality tier one capital and higher quality and more expensive liquidity.
The Australian banks comfortably meet the proposed new Basel III capital requirements, with their minimum Tier one ratio of 4.5 per cent plus a buffer of 2.5 per cent. The Australian system has a Tier one ratio of about 9.5 per cent.
They will, however, be watching developments in Europe with interest. Today a Swiss banking commission will publish its recommendations for new prudential requirements for its banks and is expected to impose a minimum core capital ratio of at least 10 per cent and perhaps as much as 12 per cent, if not more, on Switzerland’s two global banks, UBS and Credit Suisse.
The Australian banks and their regulator, the Australian Prudential Regulation Authority, are justifiably proud of their status – proved well-deserved during the crisis – as among the soundest and most highly-rated of the international banks.
To ensure continuing access to global wholesale funding markets on competitive terms the banks need to maintain their ratings. If there were to be a contest by other systems to see which system emerged as the most conservative in the post-crisis pre-Basel III environment, it would be difficult for the Australians to avoid participating.
So far they have been able to improve their returns on equity largely because of their sharp improvement in their bad and doubtful debt experiences. Holding higher levels of capital and more high-cost liquidity permanently will impose pressure on their returns. If they had to hold even more to remain competitive with the most conservative systems the pressure would become even greater.
Either their shareholders would have to accept lower returns themselves or the increased costs and opportunity costs would have to be passed onto customers, or perhaps shared between the two groups.
Expect the discussions about margins and funding costs and shareholder returns to continue well past the next few RBA board meetings and into the longer term as the global regulatory response to the crisis continues to develop and starts to be implemented and, for the better-placed systems, pre-empted.
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