Wednesday, 11 January 2012

Bank Funding Costs And Margins

There is a growing amount of misinformation or misunderstanding permeating the discussion of bank funding costs.  The problem comes when funding costs are blurred or even confused with bank net interest margins. 

Net interest margins, by definition, are the amount above the cost of funding that covers variable costs and profits.  As is therefore obvious, the cost of funds for a bank has little to do with margins.

Funding costs can go up or down with zero impact on margins.   Bank funding costs have increased in the last few years, certainly relative to the official cash rate set by the RBA. 

In a speech last month, RBA Deputy Governor Ric Battellino stated plainly:
  • The main effect of the European crisis on Australian banks is through the increased cost of funds in global markets … debt has become more expensive.”

RBA Governor, Glenn Stevens has no doubt about funding costs either.  In 2010 he said:
  • Since the middle of 2007 there clearly has been an increase in their overall costs of funds relative to the cash rate.”

The RBA should know this better than just about anyone and especially so given their access to otherwise confidential data from the banks.  That said, the interest rate paid by the banks on deposits has risen sharply in recent years.  Before the Crisis, deposit rates were frequently 100 to 150 basis points below the cash rate, now they are 100 to 150 basis points above the cash rate.  Note that at the moment, around 90% of bank funding comes from deposits and wholesale funding.

The fact that banks have not and will not be matching RBA interest rate moves says little or nothing about margins.  What it does suggests is that the RBA cash rate is diminishing in its importance or influence as a factor driving the cost of being a bank.  This point is well understood by the RBA even if it is not understood by others, especially those working in areas competing with the banks with a vested interest to pursue.

In terms of net interest margins for the banks, it is worth highlighting the findings of the RBA.  In its Quarterly Statement on Monetary Policy last month, the RBA noted:
  • “in aggregate, the net interest margin of the major banks has fluctuated in a narrow range since 2004, of between 2.25 and 2.50 percentage points.”

So the RBA research shows that over roughly 8 years net interest margins have been little changed, even though over that period, the gap between the RBA cash rate and the standard variable mortgage interest rate (for example) has widened from around 180 basis points in 2004 to around 305 basis points now.  That “blow out” in the spread was concentrated during 2007/08 when the GFC started to bite and access to funding and indeed wholesale funding costs rose substantially.  Recall Mr Stevens comment quoted above.
To reiterate:  net interest margins are little changed even though the gap between the cash rate and mortgage rate has blown out by around 125 basis points.
This simple point goes to the heart of the issue. 
Another cross check on this matter is bank share prices.  If margins were widening and the banks were exploiting their oligopoly power and government assistance in some way, you’d reckon bank share prices would be doing well.
Right now, CBA is trading around $50.  In 2007, it was trading above $60.  NAB is trading around $24 – it was above $40 in 2007.  Westpac is trading at $20 and in 2007 is traded above $30.  For ANZ, it is currently around $21 and in 2007 it was above $30.
These prices show that in the very years where the gap between cash and retail lending rates have risen quite massively, banks share prices have slumped.  Bank share price falls must be for other reasons, critical among them is that there has been no net change in margins.
Mark Bayley, Aquasia’s strategist and one of the sharpest minds in the space finds that bank funding costs are rising.  His evidence is the price the banks are paying for their new wholesale funding in the global market place.

He notes a couple of recent trades by the Big 4 banks suggesting, tongue in cheek, that a recent deal was not well publicised because the bank in question may well be “embarrassed by the margin they had to pay.”

This extra cost of funding is magnified when the deals are swapped back into Australian dollars.  Bayley concludes that:
  • “The recent euro pricing illustrates that the market has deteriorated since the first offshore US$ issuance and that once again the cost of bank funding is only heading in one direction and it isn't down. As such it further increases the probability that the banks will not completely pass on any RBA interest rate cuts.”

The bottom line of all this is that bank funding costs have increased.  Simple.  It’s also clear that net interest margins haven’t changed in almost a decade.  

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