RBNZ says fixed mortgage rates OK, but floating rates should be lower (Update 3)

The Reserve Bank said a large part of the recent cuts in the Official Cash Rate had been passed on to household and business borrowing rates, but 100-150 basis points of higher marginal funding costs had offset some of the 575 basis points of OCR cuts. Floating mortgage rates have dropped to an average 6.34% now from 10.64% just before the OCR cuts from 8.25% to 2.5% started in July last year. That means the OCR has dropped 575 basis points, while the floating mortgage rate has fallen 430 basis points. That 145 basis point gap is at the upper end of the Reserve Bank's 100-150 basis point estimate of the increase in funding costs. The Reserve Bank made the point repeatedly in its analysis that banks focused on marginal funding costs in their interest rates decisions, rather than the average funding costs relied on in the Westpac analysis.

Marginal funding costs have increased to around 100-150 basis points over the OCR from around 20-30 basis points over the OCR prior to the onset of the global financial crisis (see chart below). That means upwards of about 100-150 basis points of the 575 basis point reductions in the OCR have been offset by increased funding spreads.

It was critical of Westpac's analysis.

There is useful information in the Westpac analysis of bank funding costs, but we take issue with the use of average funding costs as an appropriate basis for marginal pricing decisions. The interest rate on a bank's latest loan will more likely reflect current marginal funding costs than historical average costs.

The Reserve Bank analysis included a chart below showing indicative marginal funding costs marginal to the Official Cash Rate. This highlighted the extra costs of term deposits in recent months, but the declining margins on foreign wholesale funding. The Reserve Bank highlighted three funding channels where costs had increased for banks. Firstly, deposit rates had risen in recent months despite the falling OCR as banks competed for local funds against various bond issues

Six-month deposit rates were generally priced at around 40 basis points below six-month bank bill rates prior to 2008, but have recently risen to more than 100 basis points over bank bills.

Secondly, short term wholesale funding had become very expensive in the immediate aftermath of the Lehman Brothers collapse, but had eased back in recent months as central banks pumped liquidity into global credit markets. Finally, long term wholesale funding costs had also risen since the Global Financial Crisis, although they had fallen from post-crisis highs as well.

The Reserve Bank then showed a chart comparing marginal funding costs with floating mortgage rates. The grey bars are a measure of the net interest 'profit' margin on this lending.

Over the past several months the floating mortgage rate has lagged the fall in the marginal funding cost indicator, with the spread between the two widening. However, it is difficult to draw conclusions about this spread going forward "“ particularly given uncertainties around the exact composition of marginal funding costs at any particular time.

The Reserve Bank then published a chart showing what was happening to the marginal funding costs compared to fixed mortgage rates. Again, the grey bars show the profit margin on this lending. The Reserve Bank again took issue with the Westpac analysis around the issue of marginal funding costs.

There is undoubtedly some smoothing of pricing on new loans relative to the short-term movements in marginal funding costs. Notably, banks did not raise rates in response to the implicit increase in marginal funding costs associated with the sharp widening in wholesale funding spreads during late 2008 "“ although the banks actually raised little, if any, wholesale funding during that period. However, the cost of funding existing loans is not the appropriate reference point for pricing new loans, particularly when the underlying wholesale interest rates are falling rapidly due to cuts in the OCR.

The Reserve Bank pointed out that its new Prudential Liquidity policy had pushed some banks to lengthen their funding and raise more domestically, which had increased their funding costs.

The shift the banks have made themselves over the past six months or so to more stable "˜core' funding sources has increased their marginal cost of funds, particularly through higher deposit margins. The new liquidity policy is consistent with this trend and will reinforce it over the long term. Some banks are already meeting the required core funding ratio and the others will have a two-year transition period. Accordingly, we do not expect the new liquidity policy to have a significant further impact on the banks' cost of funds. The policy is only likely to really bite in a cyclical upturn, when the banks might be tempted to revert to inappropriately heavy reliance on the short-term offshore markets to fund a rapid credit expansion.

And here's the Reserve Bank conclusion.

In contrast to many other countries during the global financial crisis, a large part of the OCR cuts have been passed on to household and business borrowing rates, reflecting the soundness of New Zealand banks. Marginal funding costs for banks have increased relative to the OCR, reflecting increased spreads for deposit and wholesale funding. We estimate that these increased spreads have offset 100-150 basis points of the reductions in the OCR. The factors influencing the banks' pricing decisions are complex and involve a range of trade-offs. On the one hand, banks must ensure that they earn an adequate rate of return on lending to reflect the underlying credit risks. On the other hand, if margins on loans are expanded unduly, this is likely to carry costs for the macro-economy and can hinder the efforts of monetary policy to stimulate economic activity. On balance, we believe the pricing of the banks' fixed-rate lending products is reasonable given the underlying cost of funds and taking into account the margins typically earned on these products over time. However, the pricing of floating-rate mortgages appears unusually high over recent months and we believe there is some scope for further reductions in these rates without compromising the viability of this lending.

Here's a link to a similar study of bank margins in Australia by the Reserve Bank of Australia. My view The core of the Reserve Bank's argument is embodied in the fifth chart showing the difference between "indicative marginal funding costs" and floating mortgage rates. The grey bars are the key measure for the Reserve Bank when it argues the banks have kept floating rates too high. I have asked the Reserve Bank for the spreadsheet underpinning this measure of the "indicative marginal funding cost" to see what it's made up of. The second chart gives an indication and includes some assumptions, including that 55% was 'extra deposit' costs, 15% was long term wholesale costs and 30% was short term wholesale funding costs. Also the Reserve Bank put the following note on the chart:

Weights assume banks are raising funds in proportion to the existing structure of their liabilities. In reality, banks have raised relatively little long-term wholesale debt in recent months.

The implication from this note is that the banks are funding from cheaper short term wholesale markets and from cheaper term deposits rather than expensive long term funding. The Reserve Bank doesn't know what the mix of the marginal funding costs is, particularly for April, May and June because the banks have not reported them yet. It is trying to find out. The activity in the market suggests the banks are taking notice of the Reserve Bank's direction to raise more of their funds from domestic retail savers through term deposits rather than hot short term money on foreign wholesale markets. That means the banks are competing hard for term deposits and this is pushing up their funding costs. Kiwibank announced today it was lifting its 4 month and 1 year rates to 4.6%. The average bank 1 year term deposit rate was 3.96% in February when the OCR was 3.5%. Since then the OCR has been cut to 2.5%, meaning this 'spread' has widened to 210 points from around 50 points. So what does this all mean? The Reserve Bank has made some assumptions and from that is saying that short term lending rates are higher than they should be. It doesn't say how much higher. Its problem is that its own analysis says that marginal funding costs have risen around 100 to 150 basis points relative to the OCR. When you look at the floating mortgage rate it is 145 basis points above where it should be if there had been no financial crisis. So where is the profiteering? The fifth chart appears to show the 'spread' rising around 75 basis basis points from its 'natural' level in the last three to four months. This is the key point. The Reserve Bank is suggesting that the banks are 'overcharging' around 22% of home owners (those with NZ$36.8 billion of mortgages on floating rates) by around 75 basis points or around NZ$275 million a year. This sounds like a big number, but a few tweaks in the Reserve Bank's assumptions or differences with reality could wipe that out. It is not the mass profiteering that politicians have implicated. It's also not the smoking gun that some might have hoped for. There's also an argument to say it's a price worth paying for the banks still growing lending at a time when banks elsewhere around the world are contracting lending and foreclosing on homeowners willy nilly. Your views and insights? We welcome comments and any further insights on this article and its source documents in the comments field below. Or if you want to remain under the radar please email bernard.hickey@interest.co.nz and we'll be in touch. We practice a form of collaborative journalism that aims to include the insights and expertise of our readers to improve our articles. That includes clearly identifying any errors and correcting them. We also update articles with relevant new information and commentary and will label our articles Update 2 etc. We know we don't know everything and we know we're not always right. We appreciate your help in constantly improving and deepening the knowledge and debate on interest.co.nz.