By Milind Sathye
THE chairman of Westpac in a recent interview signalled that lending rates would continue to rise in the next five years - no matter what happens to the official cash rate. He said there was a permanent shift in the driver of interest rates on loans and deposits to international wholesale money markets.
Nothing could be further from the truth.
International wholesale funding constitutes only about 26 per cent of total bank funding. The cost of this funding has in fact declined below pre-crisis levels.
Analysts measure banks' reluctance to lend by comparing the London interbank offer rate (LIBOR), which is based on the rate banks charge other banks to borrow money without security, to the overnight indexed swap (OIS) rate, which is derived from the central-bank-defined overnight rate.
Over the five years preceding the financial crisis, the LIBOR-OIS spread averaged 0.11 percentage points. Last week it stood at 0.08 percentage points, that is, below pre-crisis levels. The story of the cost of other sources of funding is no different. Deposits constitute more than 52 per cent of bank funding, and the cost has declined, except for special-rate deposits (see table).
Another test to debunk the rising deposit cost argument is the actual interest expenses on deposits. Interest paid by banks on deposits declined from $74 billion (June 2008) to $70 billion (June 2009), according to the latest data from the Australian Prudential Regulation Authority.
Interestingly, the outstanding bank deposits rose from $1.4 trillion (June 2008) to $1.6 trillion (June 2009), a rise of $203 billion. Consequently, the cost of deposits to average deposits fell from 5.75 per cent to 4.59 per cent over the period. Importantly, transaction accounts that constitute 9 per cent are free of that cost. Yet banks continue to harp that their deposit costs after the crisis are higher than before the crisis, and to justify higher lending rates on this basis.
Domestic debt constitutes the remaining 22 per cent of bank funding for which another spread, comparing the bank bill swap rate to the OIS, is often used as a gauge. That spread was about 0.1 of a percentage point before the crisis, blew out to about 1.5 percentage points during the crisis and is now down to 0.27 of a percentage point. For long-term domestic borrowing, the pre-crisis spread was 0.15 of a percentage point, which rose to 2.61 percentage points but is now down to 0.86 of a percentage point.
But the best indicator of overall cost of funding is what banks actually pay for wholesale borrowing. The overall cost of funding measured by the proportion of total interest expenses to total liabilities fell from 5.29 per cent to 4.30 per cent, using statistics published by APRA. And the Reserve Bank study on bank funding costs, published in its June 2009 bulletin, has a graph of major banks' average funding costs that shows a clear decline in overall funding cost.
Interestingly, banks tell only one side of the story - the funding cost story - and never the combined story of cost, revenue and profits at one place. For example, the Australian Bankers Association fact sheet in February made a case that funding costs are rising. Curiously, the association forgot the cost of borrowing from international markets altogether; there was no mention of this cost.
But there is one set of numbers that has certainly gone up - that of bank profits. The operating profit of banks rose by $6 billion in the year ending June 2009, compared with the year ending June 2008, and it was not because banks became more efficient. The ratio of operating expenses to total assets (an indicator of efficiency) of the majors remained unchanged at 1.4 per cent in the two years, according to APRA.
The Treasury secretary recently admitted the major banks consolidated their market power due to the crisis. The government policy in the crisis actually helped the big banks consolidate market power.
The fee structure for the bank guarantee put in place by the government helped banks make record profits at the cost of the taxpayer. It also discriminated against community institutions such as credit unions. The fee was risk-based (0.7 of a percentage point for the majors and up to 1.5 percentage points for others) instead of market-based as in Denmark or debt maturity-based as in the US or Britain.
Banks raised about $106 billion by June 2009. As the KPMG Financial Institutions Performance Survey 2009 shows, in the six months ending June 2009, banks' spread (the difference between average borrowing cost and average lending rates) increased by 0.21 of a percentage point. Accordingly, over a three-year period, the profit made by banks works out to $1.34 billion out of the wholesale funding guarantee alone - leaving aside the deposit guarantee.
Putting it another way, $1.34 billion is a taxpayer-funded subsidy for banks - mainly the majors, the main issuers of the debt.
The government now wants small financial institutions to pose competition to major banks after having done everything they could to benefit the majors. The major banks need to be made accountable. The solution lies in making the information on bank funding costs, lending rates, margins as well as fees and the international comparisons publicly available.
Milind Sathye is a professor of banking and finance at the University of Canberra and a deputy general manager of the Reserve Bank of India.