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An edited version was published in the Australian Financial Review, 5 August 2016
Banks must satisfy the interests of three groups of stakeholders when making pricing decisions on interest rates. Borrowers want the lowest interest rate on their loans; depositors want the highest interest rates they can get; and shareholders want a solid return on their investment. Satisfying all three groups inevitably requires careful balancing.
Banks make their pricing decisions in a highly competitive market for financial services. This competition benefits Australians, who enjoy a wide choice of financial institutions and financial products. Strong competition ensures financial products and services are keenly priced.
More than 150 authorised deposit-taking institutions operate in Australia. Around half are banks, including retail banks, investment banks and mutual banks. The other half are credit unions and building societies. Canstar data highlights the high degree of competition, listing 91 institutions offering almost 3,000 housing lending products, 1,300 deposit accounts, 196 credit cards, and 185 business lending options.
The argument that banks should fully pass on the cut in the RBA cash rate to borrowers overlooks the fact that banks obtain the money to fund these loans from a variety of sources. Around 40 per cent of Australian banks’ funding is from domestic household deposits. A further 20 per cent is from domestic business deposits. The remaining 40 per cent is from bank debt including bills, promissory notes and bonds, issued both domestically and offshore.
Only a small portion of these various funding sources have interest rates that are directly linked to the RBA cash rate, which is the interest rate charged by the RBA on overnight money lent to banks. Most bank funding is longer term. As a result the overall average cost of funds to banks changes only slowly in response to RBA cash rate adjustments.
The cost of funds also reflects commercial decisions made by banks. Domestic depositors have been winners in recent years. Before the global financial crisis, the average interest rate across term deposits was between 1.5 per cent and 2 per cent below the official cash rate. Since May 2012 the average interest rate on bank term deposits paid has been above the RBA cash rate. The lift in term deposit rates by some banks this week leaves some term deposits offering rates more than double the cash rate.
Banks are also operating in an environment of escalating regulatory costs, including increased capital requirements, and increased compliance costs to meet escalating reporting demands of domestic and international regulators.
Some of these increased prudential requirements stem from international initiatives to strengthen the global financial system and some have arisen from the recommendations of the Financial System Inquiry to ensure Australia’s banks are unquestionably strong.
Over the year to September 2015, the major banks increased total shareholders’ equity by $30 billion or 16 per cent. This comprised share capital, reserves and retained profits.
Despite these pressures, banks are passing on most of the cash rate fall to borrowers. Over the past three years alone, including the adjustments this week, the cash rate has fallen by 1.25 percentage points and banks have passed on 0.95 percentage points (76 per cent) to the standard variable home loan rate.
The final set of stakeholders are shareholders. Most Australians hold shares in banks, either directly or through their superannuation or investments in managed funds. The return on equity of Australia’s major banks is not exceptional. It is similar to major banks in Canada and middle of the road for listed Australian businesses.
On this point, the Government has endorsed the recommendation of the Financial System Inquiry that Australia’s banks should be unquestionably strong on a global basis. The Federal Government, in its response to the FSI, noted the importance of banks’ resiliency during global shocks. Solid profits are an important contributor to resilience as they facilitate stronger capital backing and a higher capital base as a springboard to future expansion and growth.
The pricing decisions of the banks this week reflected the need to look after the interests of all stakeholders. Home buyers are enjoying the lowest home loan rates in over 50 years, savers are able to achieve rates well above the cash rate, and shareholders are receiving returns that help to strengthen the resilience of the banking system in an increasingly volatile world. Overall, Australia is well served by its banks.