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BFCSA: Bank funding costs hit 'record lows': Reserve Bank

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Bank funding costs hit 'record lows': Reserve Bank

Australian Financial Review May 12, 2019 4.25pm

Jonathan Shapiro


The troubling spike in short-term bank funding costs has now completely reversed while the decline in Australian interest rates means long-term bank borrowing costs are now at "record low" levels, according to the Reserve Bank.

The significant improvement in funding costs, which had prompted the banks to increase standard variable mortgage rates last year, should provide a boost to the bank margins, but also intensify calls for them to pass on the savings to customers.

In its quarterly statement of monetary policy, the central bank noted that the spread between the three-month bank bill swap rate and the overnight cash rate had contracted from around 60 basis points at the start of the year, to about 20 basis points, its lowest level since 2017.

That has provided a reprieve for the banks whose net interest margins are adversely affected by a widening of the bank bill rate relative to the cash rate.

Fully unwound

“The increase in banks' wholesale funding costs in 2018 has been fully unwound given the decline in interest rates in short-term funding markets over the course of this year," the Reserve Bank said in its quarterly statement published on Friday.

The Reserve Bank also noted that “interest rates at which banks raise long-term debt funding have declined to record lows” as a result of a fall in base interest rates as financial markets begin to price in a fall in the cash rate to 1 per cent within two years.

Australian five-year bank funding costs, estimated by the sum of the five-year swap rate and credit default swap spreads, have declined from 3 per cent at the start of the year to 2.1 per cent at present,  having fallen well below the previous low of 2.5 per cent in August 2016.

Investors that bought major bank debt five years ago at a rate of 4 per cent will get about half the rate if they reinvest the proceeds in the same bonds.

Australia's banks are more exposed to movements in credit risk spreads as opposed to absolute funding levels but the Reserve Bank noted that spreads on three-year bonds had improved by 20 basis points since the start of the year.

Attractive conditions

This week, Australia's big four banks took advantage of attractive funding conditions as National Australia Bank and Westpac raised a combined $4.5 billion of debt in the local bond market.

Westpac's $3.5 billion bond issue included a tranche maturing in 5.25 years that  just offered a yield 2.42 per cent, while the three-year floating rate notes paid  62 basis points above the bank bill rate, or about 2.3 per cent.

National Australia Bank, meanwhile, raised $1 billion of subordinated debt at a margin of 215 basis points above the bank bill rate, or 3.80 per cent.

In total, Australia's banks have issued around $40 billion of bonds this year, which the Reserve Bank said was a "similar pace" to previous years.

While wholesale funding costs influence bank profits, deposits are the primary source of financing for the sector with household deposits accounting for a third of total non-equity financing.

“On average, retail deposit rates are at a low level, consistent with the low level of market interest rates,” the Reserve Bank said.

One analyst said it was not clear how the banks would respond to a
"significant" improvement in funding costs, as they could either reap the benefit of the improvement in margins, or compete for volume by offering attractive rates to prospective borrowers in an environment of low credit growth.

Broadly equivalent

While an improvement in funding costs is helping the banks,  some of the benefit is negated by the "flat yield curve" in which short-term interest rates and long-term rates are broadly equivalent.

Banks tend to suffer a flat yield curve environment because they borrow in the short term and lend in the longer term.

The funding cost improvement comes amid a broadly challenging environment for the banks as recent results showed arrears are rising, credit growth is slowing and operational costs are becoming more of a focus.

Some analysts also expect that the major banks are also likely to be impacted by an expected reduction in the overnight cash rate as the benefit banks receive from deposits that attract no or low interest reduces when prevailing interest rates fall.

Just under half of major bank deposits pay a rate equivalent or below the cash rate, while 10 per cent of deposits pay no interest.

The experience in the United States and Europe has been that bank profitability suffers in an ultra-low interest rate environment.



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