Friday, August 15, 2008

Q&A: Can the banks afford to cut rates right now?

The answer is yes.

Occasionally The Age devotes an entire page to 'Q&A'. I wrote today's:

The big banks say they are not sure if they can pass on to mortgage holders all of the next cut in official interest rates.

The Reserve Bank says they can, the Prime Minister says they must, and the bank’s critics say they are creaming in so much money that they can afford to cut right now.

Who’s telling the truth?

Economics Correspondent PETER MARTIN goes in search of the answers...

Are the big five creaming in money like never before?

You bet. The Reserve Bank says that over the latest six-month reporting period their profits after were up 12½ per cent on the year before. Not bad work in the middle of an international credit crisis. By contrast in the US and Europe bank profits are down around 70 per cent.

But haven’t the National Australia Bank and the ANZ set aside hundreds of millions of dollars to cope with the losses expected from the US sub-prime mortgage crisis?

Yes. They were unwise to buy US mortgages, and unwise to place their faith in the credit agencies that rated them AAA. But their core business – loans to Australians – is doing well. Only 0.4% of Australian bank mortgage holders are behind on their payments by more than three months. In the US the figure is 2.2%, and in the UK: 1.3%.

Things might get worse for Australia’s banks, but the Reserve Bank says that even so their after-tax return on equity this half year will remain at around 15% “not that far below the average of the past decade”.

What’s their secret?

Their competition has been blown away. Most of non-bank mortgage lenders are no longer in that business. The RAMS brand name has been bought by Westpac. Aussie sells loans on behalf of banks themselves. The non-bank lenders that remain write only about 4% of new loans, down from 13 per cent a year ago.

What killed the non-bank lenders?

Costs. Non-bank lenders funded nearly all of their mortgages by bundling them up and selling them to overseas investors. After the US sub-prime crisis, those overseas lenders refused to buy Australian bundles at almost any price.

It no longer mattered that Aussie mortgages were rated AAA. The foreign funders had discovered that could mean little.

It became so-expensive for the non-banks that even with the banks pushing up their rates by 0.55 percentage points more than the Reserve, most could no longer compete.

But what about the banks? Aren’t they in the same boat?

In part. It depends on the bank, but roughly half of each bank’s mortgages are funded from the same place as the non-banks.

The rest are funded from sources such as deposits. That money has been pouring in.

Bank deposits are up 18 per cent. Term deposits are up 40 per cent. The Melbourne Institute survey has found that more people now say that bank deposits are a wise place for their savings than either real estate or shares. Bank deposits are more popular than they have been in two decades.

But aren’t banks having to pay more to get these deposits?

Yes. Bank deposit rates are closely aligned to 90-day bank bill rates, and they have been soaring, but by nowhere near as much the cost of overseas funds.

And just recently the 90-day bank-bill rate has been diving.

By how much?

It is down around 0.5 per cent in just the last three weeks.

In the words of the Reserve Bank’s Assistant Governor Philip Lowe the dive “has significantly reduced the banks' marginal cost of short-term funding.” They are in a good position to cut rates.

By how much?

The Reserve Bank’s Deputy Governor Ric Battellino said Thursday that their cost of mortgage funds has probably fallen 0.25 to 0.30 percentage points.

So they could afford to pass on in full the Reserve Bank’s expected 0.25 per cent cut in interest rates?

If the banks were could afford to keep providing mortgages before their costs fell, they can probably afford to keep providing them while cutting their rates 0.25 percentage to 0.30 percentage points.

Does it follow that they probably afford to cut their mortgage rates now, without waiting for the Reserve Bank to cut professional interest rates at its board meeting on September 2?

Yes, with two important caveats.

One is that they would need to cut their deposit rates, but given that deposit rates typically move with bank bill rates that should not be difficult.

The other is that the main reason that 90-day bank bill rates have fallen is that because the Reserve Bank has been planning to cut interest rates. Bank bill rates can be thought of as an educated guess about the Reserve Bank’s rate movements in the months ahead plus a margin for risk.

Should the Reserve Bank not cut interest rates as expected on September 2, bank bill rates would shoot back up and so would the bank’s costs. Cutting rates early would have been unwise.

But we know that the Reserve Bank will cut interest rates on September 2. In a break with tradition its Deputy Governor actually said so at a parliamentary hearing yesterday. It would be safe for the big banks to cut their mortgage rates early, so why don’t they do it?

One of them yet might. It would get a massive marketing advantage. But at a cost.

Inside the banks their accountants use term “lagging profits” to refer to the money they make by delaying cutting what they charge for as long as possible after the prices they pay have been cut.

Bank’s aren’t charities. As the head of the Commonwealth Bank explained yesterday, “I don't think we live in a communist country.”

Are there any real limits on what banks can charge?

Oh yes. If they charge too much more than their costs the non-bank lenders will find it profitable to compete against them again. They may have retreated for now, but big bank margins would bring them back.

Could the government shame the big banks in cutting rates?

That’s what the Prime Minister, the Treasurer and Reserve Bank appear to be trying to do.

Should they be? Aren’t big bank profits good for us?

They are if we own bank shares. And through our super funds most of us do. In a strictly legal sense each bank’s board of directors is responsible to its shareholders rather than its customers. It helps to pay attention to the customers, but if competitors are leaving the scene there is less risk that they will go elsewhere.

That risk is shrinking month by month. The Adelaide Bank has merged with the Bendigo Bank, and St George is planning to merge with Westpac.

Are big bank profits good for us more broadly? Do they help keep the banking system healthy?

That’s exactly what the Reserve Bank argued at the parliamentary hearing Thursday. The Deputy Governor said that if the banks had not passed on their extra costs, their profits would have fallen quite sharply and made it harder for them to raise funds on overseas markets.

As he put it: “Their cost of funds would have gone up and it is not clear that in the end interest rates to borrowers would have been any lower. There are some advantages to the community in having stable and profitable banks, so I think we want to be careful saying we want to squeeze down the bank’s profits. There can be unintended consequences for borrowers.”

So the Reserve Bank wants to put pressure on the big private banks, but not too much?

That’s right. It is probably not that unhappy that the banks will wait until it cuts its rates on September 2 before cutting theirs.

What would the Reserve Bank do if the private banks ignored it and refused to pass on the pass on the full extent of the September 2 official rate cut?

It would simply cut official rates again. What matters to the Reserve Bank is the level of rates actually paid by ordinary Australians. If it needs to cut official rates again in order to get the private banks to cut those rates, it’ll do it.

How far might the Reserve Bank cut?

Its first cut will be either 0.25 per cent or 0.50 per cent. But it will keep cutting until it gets the outcome it wants.

On Monday it defined that outcome as promoting “sustainable growth consistent with the medium term inflation target”.

The bank is relaxed about the inflation target right now. Inflation is due to hit 5 per cent later this year, but it expects the weak economy to pull it back to 3 per cent by mid-2010.

It is much more concerned about sustaining economic growth.

Sure the economy is weakening, but didn’t the Reserve Bank want that?

It did, but it doesn’t want to bring on a recession. No central bank does.