Brian Gaynor: Cost of funding lets Australian banks off hook

The banks' reluctance to reduce their interest rates in response to the latest cut in the official Reserve Bank rate has created great controversy.

It raises two important questions:

Are the Australian-owned banks gouging their New Zealand customers?

Do they offer better terms to their Australian borrowers?

Interest rates and bank lending policies are complex issues and the best place to start is with the official cash rate, the rate set by central banks under their monetary policy mandates.

The official cash rate is the rate charged on overnight loans between financial intermediaries. It has a powerful influence on other interest rates and is the basis of a country's interest rate structure.

However, there may be other factors that affect long-term rates and, if this occurs, short-term and long-term rates may move in opposite directions.

New Zealand and Australia's official cash rates have dropped dramatically over the past 14 months. The Reserve Bank of Australia has reduced its cash rate from 7.25 per cent to 3.00 per cent since March 2008, while our Reserve Bank has cut its official rate from 8.25 per cent to 2.50 per cent over the same period.

The Reserve Bank of Australia's decision to move more slowly this year means we now have a slightly lower cash rate than Australia.

As far as the banks are concerned, one of the important differences between the two countries is that New Zealand banks source 39 per cent of their total funds from offshore while Australian-based banks obtain only 27 per cent of their funding from this source (see Table 1).

Domestic funding is more reliable and secure and banks with a high level of offshore funding can come under pressure when credit conditions tighten.

Another important factor is a country's credit rating, which is currently AAA for Australia and a slightly lower AA+ for New Zealand. Credit rates are important as far as bank offshore funding costs are concerned because both the Australian and New Zealand Governments guarantee bank borrowings.

Thus total bank funding costs are higher in New Zealand, even though the official cash rate is lower, because of the country's lower credit rating, higher cost of offshore funding and the large proportion of total funding sourced from this area.

In recent months banks in both countries have experienced a share decline in offshore funding as illustrated by the following figures:

The New Zealand-based banks' offshore funding plunged from $142.0 billion at the end of February to $128.8 billion at the end of March. This is a worrying development as the banks haven't been able to attract sufficient domestic funding to replace these foreign-sourced funds.

Offshore funding by the Australian-based banks fell from A$701.6 billion in January to A$686.7 billion in February, the latest available figure.

Another big difference is that 75 per cent of residential mortgages across the Tasman are on floating interest rates compared with only 23 per cent in this country.

As a result, Australian borrowers obtain more immediate benefits from a reduction in the official cash rate because monetary policy decisions have more influence on short-term rates than long-term rates. New Zealanders' preference for fixed-rate mortgages also means break fees become a major issue in this country when interest rates are falling.

The other factors we need to look at are the banks' domestic short-term and long-term borrowing costs compared with their lending rates.

Short-term funding costs - through bank bill markets - are slightly higher in Australia, 3.14 per cent compared with 2.83 per cent in New Zealand. This is consistent with the official cash rates. However short-term mortgage interest rates are lower across the Tasman and this gives the Australian-based banks a margin in the vicinity of 2.60 per cent compared with 3.57 per cent in this country.

This indicates that our banks have higher profit margins on variable-rate mortgages, although each bank has slightly different lending rates and bank bill rates fluctuate daily.

In addition, variable-rate mortgages are less important in New Zealand because most borrowers are on fixed-term contracts in this country.

The situation regarding fixed-rate mortgages is quite different. Interest rates on two-year mortgages are higher in New Zealand, 6.25 per cent compared with 5.45 per cent across the Tasman, but our banks pay much more for two-year deposits.

As a result, the indicative profit margin on two-year mortgages is just 1.00 per cent in New Zealand compared with 1.95 per cent in Australia. Once again, these figures are indicative only as each bank has its own rate and the numbers are different for terms of less than and more than two years.

But the key issue is that short-term and long-term interest rates have de-coupled in New Zealand because our banks source 39 per cent of their funds from the more expensive offshore markets, which are independent of our official cash rate. When our banks try to shift this funding from offshore to domestic depositors they have to offer high interest rates because of the shortage of domestic funds due to our low savings rate.

Thus New Zealand has a sharply rising interest rate yield curve, meaning long-term interest rates are much higher than short-term rates. This new development reduces the effectiveness of the Reserve Bank's overnight cash rate reductions.

The only way this dilemma can be resolved is if foreign markets free up again, which enables the banks to refinance their maturing offshore funding on more attractive terms.

The other option is that we save more and our banks obtain a higher percentage of their funding from domestic depositors.

These two developments are unlikely, at least in the short term.

Thus the answers to the two opening questions are as follows:

The New Zealand-based banks are not gouging their customers, even though our mortgage rates are higher. These rates are higher because borrowing costs on bank long-term funding, particularly from offshore, is more expensive than it is in Australia.

Australian borrowers have lower mortgage costs because banks across the Tasman are able to obtain cheaper long-term money from domestic savers and depositors.

Another issue over the next few months will be the Government's soaring Budget deficit and its additional borrowing requirements.

Table 2 shows the total amount of New Zealand's overseas debt sourced by banks, Government and others, mainly companies.

Although the Crown's offshore borrowings have remained static, the country as a whole is probably at or near its offshore borrowing capacity.

If the Government sources its escalating borrowing requirements from offshore then it will crowd out other New Zealand borrowers on these markets, particularly the banks.

If the Crown borrows onshore then the competition for domestic savings will increase and long-term interest rates may rise further as a result.

Thus it has become increasingly clear that short-term and long-term interest have de-coupled and the Reserve Bank's official overnight cash rate has less and less influence on the country's interest rate structure, particularly fixed-term mortgage rates.

Disclosure of interest: Brian Gaynor is an executive director of Milford Asset Management.