Bank Backlash
In Australia, every time there is an interest rate announcement from the Reserve Bank of Australia (RBA), there is an inevitable backlash against the banks for raising their interest rates above the RBA’s increase, not passing on the full RBA cut, or like what happened in early February 2012 – increasing their own interest rates independent of any movement from the RBA.
Here at burningpants, we have decided to compare Australia’s interest rate regime to our international peers the US, and the UK, to see whether we are getting the short end of the stick in terms of the interest rate that we actually pay the banks, and the interest rate that is set by the RBA.
In Australia and the UK the mechanical method for targeting interest rates by the RBA and Bank of England, comes from the interaction between the central bank and commercial banks (CBA, Westpac, ANZ and NAB).
Commercial banks are required to hold a certain percentage of short term treasuries which are issued by the central bank, and lent to banks at the official cash rate in order to undertake open market activities. As a large portion of commercial banks’ funding is drawn from borrowing from the central bank, the official cash rate has a direct effect on the rate which commercial banks will loan at. The remaining funding for commercial banks’ loans comes from deposits, bonds and equity, and is subject to a market rate.
In the US the system is similar, where the Federal Reserve lends at the Federal Fund Rate, which is passed onto consumers who hold variable rate mortgages in the form of the prime rate (the Federal Fund Rate plus 3%).
The chart above shows interest rates for the US, the UK and Australia since 1999, and reveals Australia has the most stable interest rate regime of the three, with annualised volatility of 3.3%, compared to 6.7% in the UK, and 7.4% in the US.
We can see how the US housing bubble played out where several years of very low interest rates allowed housing prices to increase in value, incentivising banks to lend to riskier and riskier borrowers in order to maintain profits. This bubble caused the global financial crisis (GFC), which caused downward pressure on interest rates in order to stimulate growth. We can see this in the historically very low official interest rates in the US and the UK.
In contrast, the economy in Australia weathered the global financial crisis better than most advanced economies, avoiding recession having ridden the GFC out on the coattails of the Chinese dragon’s hunger for Australian mineral exports. The Australian economy was ticking along well enough to justify increased interest rates in 2009 and 2010.
Following the GFC, there has been a growing gap between the official target cash rate promoted by the RBA in Australia, and that of average Australian Equity home loans.
The graph below shows how this gap is growing, with average Australian Equity Home Loans represented by the red line, the target cash rate represented by the blue line, and the difference represented by the green line. The difference was a stable 1.8% up until 2008, when citing increased funding costs on international markets the banks began to increase their rates independently of the RBA.
The latest estimates have the difference at 3.1%, though we could expect this gap to continue to increase considering that all of the major banks have increased their variable mortgage rates in February 2012, while the RBA left the cash rate on hold.
The independent movement of the banks is leading to a situation where the RBA’s impact on monetary policy is less effective than it has been in the past.
Australian bankers, such as Ian Narev, CBA’s new CEO, have stated that international markets have increased the cost of funding for Australian banks, and this is why the difference is appearing. However at the same time Australian savings rates have increased in response to recent economic turmoil.
The real question remains whether the current gap will continue to grow, or remain at a stable level once these global sources of capital start to become cheaper.
Note: All data referenced in this report was accessed from the RBA statistics website in February 2012.
burning pants says:
Thanks Craig,
We ran out of space on this one, but you are right. We will aim to answer your points in a future blog.
Craig Offenhauser says:
Great article!! but you posed the final question and did not attempt to answer it !!!! Why is that?? That was disappointed!! I expected the arguments for and against the differential increasing or declining within the current global macro economic conditions of today, both short term ( very hard! ) , and medium term, ( even harder ! ).