Home Loan Interest Rates – Who and What Dictates It
Why the banks charge more than the cash rate.
It’s been years now since the banks have moved their rates lock-in-step with the Reserve Bank of Australia’s (RBA) cash rate decisions. And you may have noticed by ANZ’s choice to go it alone, that the cash rate is not the be all and end all for banks when they set their lending rates. Apparently there’s a lot more to it.
Money’s important, so we all know interest rates should be too, right? But how do you cut through the, ahem, industry jargon to get to the good stuff underneath. Let’s walk through why lending rates don’t end at the RBA cash rate decisions.
You have probably noticed that when the topic of lending rates comes up, the first thing out of the bank’s mouths is the phrase, ‘increased cost of funding.’ But what does this actually mean? Don’t the banks get their money from the RBA and shouldn’t we be paying the interest rate set by the central bank?
Unfortunately, because the banks source their money from all over the world, the RBA cash rate does not represent the true cost of money. Although it’s important for setting the rate at which banks borrow from each other, the role of the RBA is only part of the picture when looking at banks sources of funding. In a post Global Financial Crisis (GFC) world, the places where banks are getting their money from are changing and the prices they charge to you, the consumer are changing too.
So, when looking at how banks set their lending rates, we have to look at where the banks source their money to understand how they arrive at the figure they charge to their customers.
SOURCES OF FUNDING
Currently on average, banks source about 60% of their money from Australians who deposit money and 40% comes from wholesale sources of funding; that is, money that’s sourced from other Australian banks, overseas institutions and investors.
WHOLESALE FUNDING:
The easiest way to think about this is if you are a shop owner. You sell to your customers at a retail price, the goods that are sold to you and any other business is done at a wholesale price. It’s the same for banks.
SHORT TERM DOMESTIC WHOLESALE FUNDING:
When looking at short term wholesale funding, this is mainly sourced from other banks and financial intermediaries for a period of 1 to 3 months.
The interest paid on funds that comes from the money market is determined by the RBA. The head bank affects supply and demand of the availability of cash in banks exchange settlement accounts through the implementation of monetary policy.
The interest paid on this portion of banks’ funding (20%) depends on the length of the deposit taken from the money market and on average is closely related to the cash rate target set by the RBA.
For example, if a bank takes a 30 day deposit on the day of the RBA cash rate target decision, the interest charged on this deposit will be closely aligned with the cash rate as the security will mature at about the time of the next decision on rate movements.
LONG TERM WHOLESALE FUNDING:
When talking about the other 20% of wholesale funding, this is debt banks will get to fund their business, which they then have to pay back in a period longer than a year at a fixed rate of interest.
The cost of this form of debt for banks is increasing, because cheap long term debt that was sourced prior to the GFC is now maturing. To cover the gap in their finances, banks must source new forms of long-term wholesale funding that is more expensive to obtain due to global pressures.
This is what the banks refer to when they say the cost of overseas money is getting more expensive.
CUSTOMER DEPOSITS:
Since the GFC, customer deposits have become a much larger share of the bank’s bread money.
Because money has become more expensive, and access to it is less certain, due to the GFC and Sovereign Debt Crisis, there is greater competition in Australia for deposits.
Within banks deposit funding there has been a switch to short-term deposits, which pay higher interest rates than other form of deposits.
This is so because:
- Banks have offered attractive rates to customers for their deposits.
- Strong business profits have resulted in businesses increasing their corporate cash holdings invested in deposits rather than other forms of investment.
- Households have increased their term deposits placed with banks, superannuation funds have also done this too.
What this all means is that, due to competition in the market for deposits, banks have left their rates high. While in the past couple of years the average rate on deposits has fallen 25 basis points, the cash rate has fallen by 50 basis points; meaning deposits have become more expensive relative to the cash rate.
PROFIT AND RISK.
Banking is a business and, like any business, bankers need to make a profit. Steven Muchenberg, head of the Australian Bankers Association, says that our banks need to remain profitable to show the world that our system is healthy and worth investing in.
His argument is that in order to keep sourcing money from overseas institutions (about 20%), Australian banks need to remain a good investment for them. If their profitability starts to weaken, overseas investors will charge more for the money they lend to our banks, leading to even higher funding costs and higher lending rates to customers.
Risk is another important factor for banks when they set their lending rates. Whether this be risk on a large scale like the small margins they apply to borrowing and lending on the exchange settlement account level or the risk they apply to a customer with a bad credit history who is looking for a loan, it factors into every decision the bank makes when they lend out money.
END.
Mortgages matter, and the amount you pay on your mortgage matters most of all. Whether or not banks are justified in moving independently of the cash rate, Australian banks are some of the most profitable in the world. If you’re unhappy with the way your bank is acting, compare your options and vote with your feet.
Related posts:
- Biggest Gap In Decades For Mortgage And Cash Rates
- How Will The Recent Interest Rates Rise Affect You And Your Home?
- Guide to Interest Rates
- Bank of Melbourne to cut rates for home loan customers
- Home Loan Interest Rates
- St.George Home Loan rates to rise by the RBA 25 points
- Bank of Melbourne to cut rates for home loan customers
- Don’t Get Caught Out With Interest Rates Increases
- What are Home Loan Comparison Rates & How to use them
- Pride or Profit. How Much Will You Pay For Home Loan Satisfaction
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