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Milford's Paul Morris investigates why interest rates have been drifting higher even as the OCR has stayed low. Borrowers may find the availability of credit to be 'more selective'

Milford's Paul Morris investigates why interest rates have been drifting higher even as the OCR has stayed low. Borrowers may find the availability of credit to be 'more selective'

By Paul Morris*

Traditionally a lower Reserve Bank of New Zealand (RBNZ) Official Cash Rate (OCR) precipitates lower New Zealand bank interest rates.

But not recently.

Figure 1 below illustrates that 6-month deposit rates and new customer floating mortgage rates have actually been drifting higher since mid-2016 despite a lowering OCR.

This is nominally bad for borrowers but good for bonds, income assets and depositors, subject to some important caveats discussed below.

Figure 1; Core funding and retail deposit funding; Source Reserve Bank of New Zealand

The cause is primarily bank regulation and a change in the structure of bank funding

To a large extent this divergence can be attributed to changes in bank regulation in reaction to the Global Financial Crisis (GFC).

The GFC illustrated that then prevailing global bank regulation was insufficient to ensure the resilience of the banking sector to economic shocks. The reaction was higher international minimum regulatory standards which in large part have been adopted by the RBNZ as requirements for New Zealand bank registration. The result is arguably a safer banking sector, designed to avoid a repeat of GFC bank bail-outs, with enhanced supervision, larger layers of capital to absorb losses, and better access to liquidity/ funding.

The RBNZ’s prudential standards on bank liquidity have however had a material impact on the cost of a bank’s funding, by placing restrictions on its sources. To a large degree this explains what appears to be a structural increase in bank interest rates above the OCR, illustrated by Figure 1.

Banks must now meet minimum liquidity standards, including a Core Fund Ratio (CFR). The CFR requires a bank to fund at least 75% of its loan portfolio from stable sources. These sources are essentially retail and commercial (non-financial company) customer deposits, long term wholesale funding (longer than 1yr) and the bank’s own capital. That differs from pre-GFC when over half of local bank funding was from short dated wholesale money markets.

The difficulty is attracting stable funding

Household deposits, the most stable source of bank funding, account for roughly 40% of overall bank funding. Figure 2 illustrates that increasingly; deposit growth has been falling behind bank lending growth. This means banks are having to work ever harder to attract deposits or long dated wholesale market funding.

Attracting deposits in a low interest rate environment is difficult, as depositors look to higher yielding assets. It is even more challenging when consumers are confident and spending, contributing to a fall in what was never an impressive New Zealand household savings rate. This has forced banks to pay higher interest rates, even as the OCR has fallen. That may allow a bank to increase its market share of household deposits but RBNZ analysis noted that the overall deposit pool is less sensitive to a higher rate.

A bank’s shortfall in deposit funding needs to be filled from long term wholesale sources, e.g. through bond issuance. Changes in global bank regulation, recent credit rating downgrades and restrictions on funding from the local Australasian owned banks’ parent banks, all limit the quantum of wholesale funding available, at least at economic prices. Moreover, the RBNZ noted recently that independent of future lending growth, local banks have already NZ Dollar 45 billion of stable funding to replace from wholesale sources over the next 3 years.

This has all contributed to higher bank interest rates and a diminished relationship between the OCR and bank rates.

What are the ramifications?

Bad for borrowers

This situation is not great for borrowers, as banks increase lending rates in line with funding rates, to protect their net interest margin and profit. It also produces a constraint on the pace at which banks can grow lending. Combined with RBNZ macro prudential tools (e.g. LVR mortgage limits) the availability of credit to the economy may become more selective, and ultimately slow.

Good for bonds and income assets

To protect financial stability and reduce the risk of excessive credit growth the RBNZ is unlikely to be frowning on these tighter financial conditions. It may also mean its next OCR hike is postponed, and the extent of any hiking cycle diminished.

That may protect the value of income generating assets. Including large parts of the New Zealand share market, corporate bonds and property.

Good for depositors but note the caveat

Whereas pre-GFC deposit rates were close to the OCR they now offer a considerable extra return, for what are arguably less risky banks, thanks to regulation. It is however important to remember some caveats:

  • New Zealand bank deposits differ from many jurisdictions, including Australia, as there is now no official deposit guarantee scheme.

  • Some banks have been charging increasing deposit break fees, reiterating the illiquidity of deposits.

  • Finally, in theory at least, in the post GFC world banks are now less likely to receive a tax-payer bail-out or guarantee. Unlike Australia, New Zealand has a framework to resolve a failed bank. This is called Open Bank Resolution (OBR) and outlines to whom a failed bank’s losses should be assigned. Shareholders are the first to bear losses, followed by subordinated debt holders. If there are any remaining losses, these are allocated to the bank’s unsecured creditors, including its depositors. See here.

Figure 2; Annual increase in credit and deposit funding; Source; Statistics New Zealand, RBNZ.


Paul Morris is Portfolio Manager at Milford Asset Management. This article is a re-post of one that first appeared on their website. It is here with permission.

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19 Comments

Household deposits, the most stable source of bank funding, account for roughly 40% of overall bank funding. Figure 2 illustrates that increasingly; deposit growth has been falling behind bank lending growth. This means banks are having to work ever harder to attract deposits or long dated wholesale market funding.

Attracting deposits in a low interest rate environment is difficult, as depositors look to higher yielding assets. It is even more challenging when consumers are confident and spending, contributing to a fall in what was never an impressive New Zealand household savings rate. This has forced banks to pay higher interest rates, ... Read more

Household deposits, the most stable source of bank funding, account for roughly 40% of overall bank funding. Figure 2 illustrates that increasingly; deposit growth has been falling behind bank lending growth. This means banks are having to work ever harder to attract deposits or long dated wholesale market funding.

Attracting deposits in a low interest rate environment is difficult, as depositors look to higher yielding assets. It is even more challenging when consumers are confident and spending, contributing to a fall in what was never an impressive New Zealand household savings rate. This has forced banks to pay higher interest rates, even as the OCR has fallen. That may allow a bank to increase its market share of household deposits but RBNZ analysis noted that the overall deposit pool is less sensitive to a higher rate.

Hmmmm...

View ANZ interest rate offers

The ANZ call rate is 10bps and yet residual maturity O/N call money in the NZ banking system amounts to $146.919 billion, ~33% of total funding reported at $404.435 billion. View RBNZ data

Let's face it, banks are responding to captured depositors who cannot take their money out and place it elsewhere, given bank vaults store a measly ~$782 million cash backstop.

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Hi Stephen, can you please elaborate on why banks would increase depo rates in response to "captured depositors"? I would have thought stickiness of depo's would decrease rates for existing customers.

O/N money would not be counted in same way as depo's for core funding. Is that your point? 33% of pot isn't actually TDs?

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"To a large extent, this divergence (between OCR & bank interest rates) can be attributed to changes in bank regulation in reaction to the Global Financial Crisis (GFC)"
The GFC occurred in 2007-2008 the divergence in rates is happening in 2016 (as per your own chart)

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From RBNZ,
"Core funding ratio

New Zealand-incorporated registered banks are also subject to a minimum core funding ratio (CFR). The basic notion underlying the CFR is a comparison between an estimate of the funding of the bank that is stable and can be assumed to stay in place for at least one year (‘core funding'), and the core lending business of the bank that needs to be funded on a continuing basis.

The Reserve Bank initially set the minimum CFR at 65 percent from April 2010, and increased the minimum to 70 percent from 1 July 2011. A final increase raised the minimum ... Read more

From RBNZ,
"Core funding ratio

New Zealand-incorporated registered banks are also subject to a minimum core funding ratio (CFR). The basic notion underlying the CFR is a comparison between an estimate of the funding of the bank that is stable and can be assumed to stay in place for at least one year (‘core funding'), and the core lending business of the bank that needs to be funded on a continuing basis.

The Reserve Bank initially set the minimum CFR at 65 percent from April 2010, and increased the minimum to 70 percent from 1 July 2011. A final increase raised the minimum to 75 percent from 1 January 2013.

Requiring banks to maintain a minimum CFR reduces the vulnerability of the banking sector in a period of general market disruption."

So that can explain some lag.
Note for parent banks in Oz Basel III being phased
http://www.rbnz.govt.nz/research-and-publications/speeches/2014/speech2…

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"Attracting deposits in a low interest rate environment is difficult, as depositors look to higher yielding assets"

And what would these "higher yielding assets" be that are taking away money from bank deposits ???

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Figure 2 shows a credit growth over deposit growth from 2001 to 2009 far, far greater than over the last 2 years.

So I don't buy the justification of this article for higher interest rates

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Maybe back then the RBNZ didn't care where banks got their funding from.

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The first fatality to be caused by a driverless car will see the mother of all law suits against the maker.
Car makers will be to scared to produce them.

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There are probably already people planning to execute this scam. Take grandpa out for a walk, shove him into the path of a driverless car, claim he stumbled, PROFIT.

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... but ... I'm very fond of my dear old Gummy Gramps ...

What we need , is a Trade Me section which lists unwanted grandparents ..

... you could bid on someone else's cantankerous old grand pa or ma , and if you win , have yourself adopted to them by deed poll ... then shove them in front of the nearest driverless car ...

Win / win !

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Train gramps to do stunts and it's repeatable.

Be right back, registering website for Kakapo's Stunt Grandpa For Hire Agency Inc.

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>"What we need , is a Trade Me section which lists unwanted grandparents .."

We have a ready bunch of sellers just waiting for such a market, too!

Source 1

Source 2

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The Unwanted

When they leave they should take their elderly with them

"when their offspring leave for fresh opportunities overseas, we don’t demand they take their parents with them, even though the argument most commonly used for admitting them in the first place is that it is harsh and culturally inappropriate to separate parents and children"
http://www.noted.co.nz/currently/politics/how-bizarre-absurdistan-revis…

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ngakoni,

And I bet that somebody said the same thing about the first automobile,the first aeroplane,perhaps the first train.

What about the first fatality from electrical current? No doubt there will be lawsuits-there are plenty of 'ambulance-chasing' lawyers,but that won't stop progress.

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HEY! BAD!
Why aren't you talking about the Official Cash Rate story?

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Quite simply, NZ's risk premium has gone up.

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The actual question is why aren't rates higher, not lower? Banks are actually reducing, not raising interest rates at the moment for savers. This is despite NZs risk going up and credit ratings dropping.

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So that's who is bidding up the NZ stock market; former bank depositors.

May not end well.

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Also becoming Landlords Mike. Remember the Govt complaining that not enough people are saving?
No - just rack up credit!

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