Tuesday, 30 June 2009
by Bill Rosenberg from CTU Monthly Economic Bulletin June 2009 There has been much public debate as to whether the banks have dropped their interest rates enough in response to the Reserve Bank’s reductions in its Official Cash Rate (OCR). In May, Statistics New Zealand in its latest Producers Price Index, reported that in the March quarter “the margins that financial intermediaries [mainly banks] make on their borrowing and lending operations… increased due to the rates for borrowing falling more than the rates for lending.” This followed increases in the previous six months, and both the quarterly and annual increase were the largest since records began in 1994. Parliament’s Finance and Expenditure Committee was told by Deputy Reserve Bank Governor Grant Spencer that “It is disappointing that banks have not dropped mortgage rates further as more people face loan defaults in the coming year”. The Committee reported that “We are concerned that New Zealand businesses find it increasingly difficult to access credit from the major Australian-owned banks, where lending decisions are reportedly now being made by offshore bank parties rather than onshore relationship managers.” There were calls (as yet unheeded) for an inquiry into the banking system. In its June Monetary Policy Statement, the Reserve Bank again complained that “it appears as though the most recent reductions in the OCR have not been passed on to borrowers to the extent that we would have expected. While there has been some increase in funding costs from higher retail deposit rates and longer-term interest rates offshore, this does not appear to fully explain the relative lack of movement of interest rates at shorter terms.” The following graph from Reserve Bank data illustrates the widening bank margins. Since about March, interest rates have levelled out or risen despite continuing cuts in the OCR. In defence, the banks say they have to borrow at higher interest rates domestically because of competition for bank deposits, and rates have risen overseas where they still source almost 40% of their funds, because of the state of those financial markets. In addition, they need to tighten up their lending conditions and raise interest rates because business risks have increased due to the recession. Clearly though, the Reserve Bank is not convinced. There are at least two explanations for what is happening, both of which may apply. The first is that the big four Australian banks are taking advantage of their dominant position and pushing out their margins between their borrowing and lending costs to protect or expand their profits. Statistics New Zealand and the Reserve Bank provide some evidence for that. However it is difficult to believe that is the full story. The small New Zealand banks – Kiwibank and TSB included – have increased interest rates almost as fast. Given their competitor status, they would be more likely to have taken advantage of the increasing margins to undercut the Big Four. A second explanation is that because we have virtually unregulated movement of funds between New Zealand and the rest of the world – open international capital markets – we to a large degree import the monetary conditions of the rest of the world (interest rates and availability of finance). To simplify, if interest rates offered to savers here are lower than the rest of the world, fund managers can take their money to where interest rates are higher, forcing banks here to raise the rates they offer. If our domestic rates go higher than international rates, the banks can (and will) borrow more cheaply overseas in order to lend for mortgages and business loans. There are complicating factors such as margins for risks in our economy and changes in the exchange rate, but it means that the Reserve Bank has much weakened ability to influence monetary conditions within New Zealand. It has some influence on short term interest rates, because the OCR is for short term lending. But longer term rates are much more connected to international conditions because they can be funded profitably from overseas. We saw an opposite symptom of the same cause when the economy was at its height – the Reserve Bank had to set the OCR punitively high to have any effect. Now, no matter how low it cuts the OCR, it seems that longer term rates won’t respond sufficiently. The result undermines the needed stimulus to a depressed economy, and contributes to a persistently overvalued exchange rate, penalising exporters. A revealing scenario is being played out at the same time. The Reserve Bank wants to wean the major banks off their risky habit of borrowing at short terms (like 90 days, often overseas) and lending for mortgages longer term, and in general to lengthen the terms of their borrowing. It is likely to be worried that another freeze in world financial markets would force it to repeat what it did last year: arrange overseas funding lines to be used to prevent New Zealand’s financial system from freezing up too. The new regulations it is putting in place have been delayed, presumably under pressure from the big four Australian banks which are the main perpetrators, and Westpac came out recently saying that being forced to borrow longer term would further increase costs, which they would pass on to borrowers in higher interest rates. We said these regulations are important, and the banks have a responsibility to keep interest rates down by absorbing some of the costs – if they exist – into their profit margins. It is interesting that, according to an article in the Reserve Bank of Australia’s June Bulletin, the same four banks when operating in Australia borrow overseas for longer terms (they borrow relatively little short term overseas). Yet a Sunday Star-Times survey of international interest rates reported on 14 June indicated that while interest rates on deposits are lower here, mortgage interest rates are already higher than Australia. The OCR is currently higher in Australia too (3.0 percent compared to 2.5 percent here). The banks have some credibility issues.