Banks' funding costs and lending rates are animportant part of the transmission of monetarypolicy to economic activity and ultimately inflation(see Explainer: The Transmission of MonetaryPolicy). The interest rates that banks chargeborrowers and pay to savers influence the decisionsof businesses and households about how muchthey want to borrow or save. To fully understandthe transmission of monetary policy, it is importantto understand what banks' funding costs andlending rates are, and what influences them.[1]
What are Banks' FundingCosts and Lending Rates?
Banks collect savings from households andbusinesses (savers) and use these funds to makeloans to those who want to borrow (borrowers).Banks must pay interest on the funds that theycollect from savers, which is one of their mainfunding costs. On the other hand, banks receiveinterest from loans that they make to borrowersand this is a large part of their revenue. From theperspective of a bank:
- funding costs are the interest rates paid tosavers
- lending rates are the interest rates paid byborrowers.
How do Banks FundThemselves?
Banks collect funds from savers in variousways. Deposits from Australian households and businesses account for around two-thirdsof Australian banks' total funding. Banks can also collect fundsfrom savers by issuing bonds and other debtsecurities in financial markets, which account foraround a third of Australian banks' funding. Othersources of funding like equity – for example, banks'shares listed on the share market – represent theremainder of banks' funding. (For updated data onthe composition of funding for banks in Australia,see the Reserve Bank's monthly Chart Pack.)
What Influences Banks'Funding Costs?
The cash rate
The cash rate has an important role in determiningthe interest rates on banks' funding sources.However, the interest rates banks pay for differentsources of funding don't necessarily move by thesame amount or at the same speed as a change inthe cash rate.
Market reference rates
Changes in the cash rate are typically transmittedquickly to an important group of interest ratescalled ‘market reference rates’. Market referencerates are based on transactions betweenparticipants in a financial market that happen oftenenough to reliably measure these rates. Becausemarket reference rates are reliably measured, theyare often used as a benchmark for pricing bondsand other debt securities, including those issuedby banks. An example of an important marketreference rate for bank funding costs is the bankbill swap rate (BBSW).
Deposit rates
Deposit rates are less directly influenced by thecash rate and changes to the cash rate also tendto take some time to be transmitted to depositrates. This is because banks have discretion insetting deposit rates and also because depositrates are influenced by other factors. For example,banks may raise deposit rates, independently of achange in the cash rate, to attract more deposits.Banks might wish to hold more deposits becausethey are considered more stable than some othersources of funding.
Other monetary policy tools
Other monetary policy tools can also haveimplications for banks' funding costs (see Explainer:Unconventional Monetary Policy).
Extended liquidity operations: termfunding schemes
Term funding schemes allow banks to borrowfunding from the central bank at a low cost foran extended period. These schemes aim to lowerbanks' funding costs and provide funding that isstable, particularly in times of economic distresswhere the cash rate may have also reached itslowest practical level. For instance, in Australiathe Term Funding Facility (TFF) was announced inMarch 2020 during the COVID-19 pandemic (seeBox below on ‘The Term Funding Facility’).
Policies that influence the slope of therisk free yield curve: asset purchases andforward guidance
The risk free yield curve influences marketreference rates for some sources of bank funding.Consequently, policies that influence its slope, suchas asset purchases and forward guidance, mayflow through to bank funding costs (see Explainer:Bonds and the Yield Curve).
Other factors that influencefunding costs
A variety of other factors can also influence bankfunding costs without any change in the stance ofmonetary policy in Australia. These include:
- demand for or supply of different types offunding, for instance more competition amongbanks to attract deposit funding typicallyresults in higher deposit rates
- the compensation required by savers to investin bank debt.
What influences banks'lending rates?
Banks set their lending rates to maximise theprofitability of lending, subject to an appropriateexposure to the risk that some borrowers will failto repay their loans. Banks measure the profitabilityof lending as the difference between the revenuethe bank expects to receive from making the loansand the cost of funding loans. Factors that affectthe profitability of lending will in turn influencewhere a bank decides to set its lending rates.
Banks' funding costs
Funding costs will influence where a bank setslending rates. When funding costs change, theresponse of lending rates will depend on theexpected impact on a bank's profits. If fundingcosts increase, then a bank may wish to increaselending rates to maintain its profits. However,borrowers may seek to borrow less if lending ratesare higher. If this were to occur, then the bankwould see less demand for loans and this couldreduce its profits. A bank must balance theseconsiderations in deciding how to set lending rates.
Competition for borrowers
If borrowers are seeking to borrow less fundsthan banks want to lend, then banks will haveto compete to attract borrowers and maintaintheir profits. All else equal, a higher degree ofcompetition among banks to attract borrowerstypically results in lower lending rates.
The risk that borrowers do notrepay their loans
For each loan that it makes, a bank will assess therisk that a borrower does not repay their loan (thatis, the credit risk). This will influence the revenuethe bank expects to receive from a loan and, as aresult, the lending rate it charges the borrower. If abank considers that it is more likely to lose moneyfrom a credit card loan than from a home loan,then the interest rate on a credit card loan will behigher than for a home loan. A bank's perceptionof these risks can change over time and influencetheir appetite for certain types of lending and,therefore, the interest rates they charge on them.
Box: The Term Funding Facility
The Reserve Bank announced the Term Funding Facility (TFF) in March 2020 alongwith several othermonetary policy measures designed to help lower funding costs in the Australianbanking system.
The TFF made a large amount of funding available to banks at a very low interestrate for three years. Funding from the TFF was much cheaper for banks than otherfunding sources available at the time it was announced.(See announcement of TermFundingFacility andthe Governor's speech Responding to the Economic and Financial Impact ofCOVID-19.)
The TFF was designed to lower banks' funding costs and in turn to reduce lendingrates for borrowers. The TFF also created an incentive for banks to lend tobusinesses (particularly small and medium-sized businesses). This was becausebanks could borrow extra funding under the TFF if they increased their lendingto businesses: for every dollar of extra lending to small- or medium-sizedbusiness, banks could access five dollars of extra funding under the TFF (forlarge businesses, the amount was one dollar of extra funding).[2]
Endnotes
Learn more in the annual Bulletin article on Developments inBanks' Funding Costs and Lending Rates (2023). [1]
See the Bulletin article on ‘The Term Funding Facility’ for more information. [2]
