Why Banks Want Higher Interest Rates (And It’s Not What You Think)

So when the RBA raised interest rates by a quarter of a percentage point on Tuesday, the cost of borrowing money, in the overnight market from other banks, also increased by 0 .25%.

This overnight rate is the anchor for all other short-term loan rates in the market, such as the rate for one-month, three-month loans, etc. This is because if a bank can earn a certain rate of interest for lending money overnight, it will charge a higher rate for prolonging the money for a longer term.

In fact, the three-month banknote swap rate (BBSW) is the commonly used benchmark rate on which most lending rates in the economy are calculated.

So when overnight interest rates are raised by the RBA, base interest rates across the economy rise.

To compensate for this increase in base interest rates, banks simply increase the rate they charge borrowers, such as variable rate mortgage customers.

All other things being equal, banks are simply increasing mortgage rates to offset this increase in the cost of money. This is the intention.

How do banks increase their profit margins?

A higher home loan rate is basically the whole point of the RBA’s interest rate hike. By increasing borrowing costs in the economy, consumption is expected to slow, which reduces demand and therefore upward pressure on prices.

The RBA might be annoyed if it cut rates and the banks never passed it on, but it’s unlikely to have problems with banks raising rates in full.

But there are a few moving parts within the banking system that mean rising rates are good for banks, not just because the absolute rate they charge borrowers goes up.

The first is that most loans taken out by Australian banks are funded by deposits. Some of these deposits, such as term deposits, pay relatively high interest rates while some deposits, such as a savings or transaction account, pay nothing at all.

When interest rates are high in absolute terms, loans financed by these zero-cost deposits are very profitable. But as rates fall and banks lower mortgage rates, the profit margin on these cheap deposits shrinks. When this process is reversed, banks benefit.

Another reason why banks prefer higher interest rates is that they have quite a large pool of liquidity that is effectively idle and cannot be lent out. This includes money he keeps on hand as capital that acts as a buffer for distressed loans.

Banks invest these funds in ultra-safe assets, mainly three- and five-year bonds. But until recently, three- and five-year interest rates have fallen, which has reduced the interest income of this portfolio.

This trend is reversing and banks are reinvesting maturing bonds at a now higher rate, which inflates their margins.

So the banks are indeed earning at higher interest rates, but not just because the absolute rate of your mortgage has gone up.

What happened when the RBA last raised the cash rate?

When the Reserve Bank last raised interest rates in 2010, banks were in a bind. They had grown their loan portfolios so rapidly that they had to look beyond household deposits to wholesale bond markets to fund lending activity. But those markets turned hostile as they faced a scrap for the deposit pool at home.

This meant that their funding costs were rising faster than the RBA was raising rates, so they made the unpopular decision to raise rates more than the central bank – something Australians weren’t used to.

Wholesale funding and deposit costs are less of a problem now, as home loan growth has moderated while households are plentiful with liquidity from banks.

It is therefore unlikely that we will see banks moving away from the RBA. On the contrary, there is more competition now for home loans.

When do banks raise interest rates on deposits?

Where controversy may lie in 2022 is in deposit rates – and whether banks are slow to pay fair deposit rates as a way to protect their margins.

This is where there has been a considerable change in behavior. Before interest rates fell to near zero, banks had to compete for deposits (which they needed to fund and grow their lending business) by offering attractive term deposit rates.

But in a low-rate world, most customers switched to a savings account because there wasn’t enough reward to not have your money at all.

As rates rise, banks are likely to find themselves competing for deposits by offering higher rates, which will increase their costs and reduce their profits.

We have already seen forced action on deposit rates by the big four banks.

After the RBA announcement, the CBA raised its interest rate on 18-month term deposits (for those willing to put $5,000 to $2 million in an account) by 1.95 basis points. percentage.

Meanwhile, ANZ Bank, Westpac and National Australia Bank have raised their rates for various savings accounts by the same 25 basis points as the official cash rate hike.

How much will banks gain from this rate hike?

Analysts have different views on what banks will gain from the rate hike given all the variables involved.

Morgan Stanley estimates that for every quarter-point increase in interest rates, the bank’s net interest margins will increase by 3 basis points. This helps bank profits.

Macquarie estimates that over the next three years, higher rates will boost profits by about $1.6 billion, or about 3-5%.

But other analysts like Citi think most of the gains will be eaten away as cheap pandemic financing fades and overall deposit interest costs rise.

Another twist is that as interest rates rise (meaning investors derive higher income from a safe investment such as a bond or deposit), investors may view banks as relatively less attractive investments, even if their profits are on the rise. Thus, bank stocks may not rise or fall.

How do banks profit from fixed rates versus variable rates on home loans?

Over the last couple of years there has been a huge growth spurt in fixed rate home loans because they were so much lower than variable loans.

There is a reason for this. It was amid the pandemic gloom and with central bank policies designed specifically to reassure borrowers that rates would not rise, three-year borrowing rates were rock bottom.

This meant that banks could borrow money or hedge their interest rate risk for three years and lock in a profit margin, while offering their customers an attractive three-year lending rate.

Now that interest rates have risen, three-year bond rates have jumped. In fact, the RBA was forced to abandon its policy of fixing the three-year bond rate at 0.1%.

The consequence is that anyone who wants to get a fixed rate home loan now has to pay a significantly higher rate, which is now higher than a variable rate loan.

The expected path of interest rates

In theory however, fixed rates reflect the expected path of interest rates plotted by the market, which means that if traders are right, variable rates rise to a level comparable to high fixed rates.

So what does this mean for bank profits?

Well, overall it’s good because banks make slightly bigger spreads on variable home loans compared to fixed home loans. Thus, a shift in the mix towards variable mortgages improves their overall margins.

This concerns a final point on the mea culpa of the Reserve Bank. Lowe said rates won’t go up for three years, and yet they are. If you took out a home loan, should you feel cheated? Maybe not.

His (eventually broken) promise mattered in that it fixed borrowing costs for three years when he made it, which, in turn, made home loans three years fixed. extremely inexpensive.

Many Australians have taken advantage of this, but when these terms expire they may be in shock when it comes time to renegotiate.

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