Monday, December 10, 2012

The hidden truth about interest rates

The prize for journalistic innovation of 2012 must surely go to whoever thought of a way to turn a cut in the official interest rate from good news to (the much more valuable) bad news: abandon the media's eternal assumption that everyone's a borrower and let the grey-power lobby bang on about the evils of lower deposit rates.

It's such an improvement on the standard good-into-bad transformation: bleating about the greedy banks not passing on all the rate cut to people with mortgages.

If we keep down this track we can turn all rate stories into bad news: as Reserve Bank board meetings approach you hold the mike up to all the professional urgers predicting death to the economy if rates aren't cut. Then, when the Reserve obliges, you pass the mike to whingeing oldies.

I suppose it's a good thing for the media to discover at long last that interest rates are a two-way street; that though borrowers gain from lower rates, savers lose. And that there are actually a lot more savers than borrowers.

There's just one problem with the newly fashionable bleeding for retired depositors: it doesn't necessarily follow that a cut in the banks' interest rates for people with home loans leads to similar cuts in rates paid to depositors - a point the grey-power lobby didn't bother making clear to a newly sympathetic media.

There are probably few more underreported topics than what's happening to deposit rates. The banks don't mention them in their press releases announcing cuts for borrowers, and the media rarely press the banks to be more forthcoming.

But even if some of the big four banks shave their deposit rates, I doubt they all will. And those that do are not likely to cut them by as much as the 20 basis points they're lopping off mortgage rates.

Why not? Well, if the media had been reporting the whole affair conscientiously, rather than turning it into a comic-book contest between good guys and bad guys, ripoff merchants and impoverished victims, you'd already know why.

The reason the banks haven't been cutting deposit rates the way they've been cutting mortgage rates goes to the heart of their reason for not passing on official rate cuts in full. Since the onset of the global financial crisis in 2008, the banks have been locked in a battle to attract deposits from ordinary Australian savers.

This battle has forced up the rates being paid to depositors. Whereas before the crisis the rates on at-call savings accounts were about 100 basis points below the official interest rate, today they're on par with it. And whereas term-deposit "specials" were below the equivalent rates paid in the wholesale market (bank bills), today they're about 150 basis points above them.

So, savers ought to be the last people complaining about the way events have transpired since the financial crisis changed the rules of the game. They're laughing all the way to the bank.

Indeed, the higher rates being paid to depositors (relative to where the official rate happens to be), are by far the greatest reason the banks have been imposing "unofficial" rate rises on home (and business) borrowers and now are passing on only about 80 per cent of the official rate cuts. The lesser reason is the higher rates they have to pay on their foreign "wholesale" borrowings.

In other words, it's not the banks that are supposedly ripping off poor home buyers, it's the whingeing retirees. The banks' cost of borrowing has increased, and all they've done is pass the higher cost on by cutting mortgage rates by less than the fall in the official rate.

But that doesn't give people with mortgages a licence to feel hard done by. Why not? Because, as the Reserve's deputy governor, Dr Philip Lowe, reminded us yet again last week, the Reserve has cut the official rate by more than it would have, just to ensure home buyers get the desired degree of rate relief. They haven't been short-changed.

On the face of it, the banks have done nothing wrong. They've merely passed on their higher cost of borrowing, leaving their "net interest margin" (the gap between the average rate they charge and the average rate they pay for funds) at about 230 basis points, virtually unchanged from what it was immediately before the crisis.

But it's not that simple. The question we need to ask is the one the media rarely do: why has the banks' cost of borrowing risen so much since the crisis? And why has a deposit-seeking war broken out among them?

Short answer: because the crisis revealed them to be dangerously dependent on foreign wholesale borrowing for their funds. So, the sharemarket and the credit rating agencies have forced them to lift their reliance on "stickier" retail deposits to about 54 per cent of their total funding.

But this means running a bank is now less risky than it was before the crisis. This, in turn, means their risk-adjusted rate of return on capital no longer needs to be as high as it was.

So, the degree of competition among the banks is sufficient to force them to give depositors a much better deal, and sufficient to have them wanting to preserve their profitability (and their chief executives' remuneration packages) relative to the others, but insufficient to force down their rates of return the way the textbook says should happen.

In all the millions of angry words the media have spilt on the topic this year, the hidden truth is that home borrowers have little to complain about and depositors even less - save for the small truth that our banks remain far more profitable than they need to be.