Developments in Banks' Funding Costs and Lending Rates | Bulletin – March 2023 (2024)

Introduction

Banks fund themselves via a range of sources, including deposits, wholesale debt and equity. The cost ofbanks’ funding is a key determinant of the rates they offer on loans to households and businesses(RBA 2023a).^[1] The Reserve Bank’s monetary policy affectsbanks’ funding costs – and, in turn, lending rates – primarily through its influence ona range of interest rates in the economy. Indeed, this is an important channel through which monetarypolicy is transmitted (RBA 2023c; Brassil, Cheshire and Muscatello 2018). This article updates previousanalysis,^[2] focusing on developments in the major banks’funding costs and lending rates over 2022.

Funding costs and lending rates increased substantially over 2022

During 2022, the Reserve Bank withdrew some of the extraordinary monetary policy support put in placeduring the COVID-19 pandemic (RBA 2023b). The Bank raised the cash ratetarget by 300basis points, to 3.1percent by the end of the year – one of thelargest and most rapid increases in the cash rate on record. The cash rate is a key determinant ofbanks’ funding costs through its influence on the broader interest rate structure in the Australianfinancial system. Much of banks’ wholesale debt and deposit funding is linked to bank bill swap(BBSW) rates either directly or via banks’ hedging practices.^[3] These rates are heavily influencedby the cash rate (and expectations about the path of the cash rate) and so rose substantially over 2022(Graph1).

Tighter monetary policy drove up costs across banks’ funding base over 2022, though the overallincrease in major banks’ non-equity funding costs was smaller than the increase in the cash rate bythe end of the year (Graph2) (discussed further below). Lending rates also increased considerablyfor the first time in over a decade, as banks passed on higher funding costs to borrowers. The increasein outstanding lending rates was limited over 2022 by the large share of fixed-rate housing credit thatwas taken out around historically low interest rates during the pandemic, and ongoing price competitionto attract and retain housing borrowers.

Composition of bank funding

Banks obtain funding from retail deposits, wholesale deposits, wholesale debt (including securitisation)and equity. In recent years, banks also sourced low-cost funding from the Reserve Bank’s TermFunding Facility (TFF), which was introduced at the outset of the pandemic as part of a monetary policypackage to support the Australian economy at that time (Black, Jackman and Schwartz 2021). Thecomposition of the major banks’ funding in terms of these broad categories was little changed over2022 (Graph3).^[4]

Deposits are the largest source of bank funding

In aggregate, deposits account for around two-thirds of major banks’ non-equity funding. This sharehas been relatively stable over the past two years, following a large increase in both the stock andshare of deposit funding after the onset of the pandemic in 2020. The increase in deposits during thepandemic reflected a number of factors, including the effect of increased lending by the banking sector,government bond purchases by the Reserve Bank and the decline in the stock of banks’ outstandingwholesale debt (RBA 2020). More lending creates deposits as the funds made available to a borrower findtheir way into a deposit somewhere in the banking system, either as a deposit in the borrower’saccount or in another account when the borrower uses those funds to make a purchase (Kent 2018). Netredemptions of bank debt and purchases of government bonds by the Reserve Bank may increase depositgrowth when asset holdings of non-bank investors are replaced with deposits, but these factors were notmaterial drivers of deposit growth over 2022.

The stock of major banks’ deposits increased further over 2022, with the stock of term deposits heldby households and businesses rising notably (Graph4). At-call balances ended the year littlechanged, with an early increase later unwound as some depositors switched from at-call deposits to termdeposits as the spread between interest rates on these products widened (discussed further below).Nonetheless, term deposits remain a slightly smaller share of major banks’ deposit base comparedwith the period shortly before the pandemic. The composition of aggregate deposits by depositor type waslittle changed.

Major banks’ wholesale debt issuance picked up

Major banks’ issuance of wholesale debt increased considerably over 2022, but the total share offunding sourced from wholesale debt markets was little changed. In the case of long-term debt, the valueof issuance was the highest since 2017 (Graph5), with increased activity both onshore and offshore.In an environment of higher yields and increased volatility over 2022, banks shifted more of theirissuance to shorter tenors compared with 2021 (e.g. three year and five year, instead of seven year) andissued more secured debt such as covered bonds, which have a lower risk profile. After accounting formaturing debt, the stock of outstanding long-term debt grew at a similar pace to other funding sources.This compares with subdued bank bond issuance and an overall decline in wholesale debt funding during thepandemic, when the major banks were able to access alternative term funding via the TFF at very low rates(Johnson 2022).

Stronger issuance over 2022 partly reflected the fact that the TFF closed to new drawdowns in June 2021.Banks also started preparing for TFF repayments coming due over 2023 and 2024 (Graph6). Inaddition, the Committed Liquidity Facility allowances were reduced to zero over 2022 and some debtissuance was to fund the purchase of government securities to continue satisfying High Quality LiquidAsset (HQLA) requirements (APRA 2023). The Reserve Bank’s assessment is that the funding taskrelated to the refinancing of the TFF is sizeable but manageable; public statements made by some bankshave supported this assessment (Black, Jackman and Schwartz 2021; NAB 2021; ANZ 2022). Banks’decisions about how to repay TFF drawings will depend on a number of factors, such as their asset growthand the price and availability of the full range of funding sources, including deposits.

The major banks’ equity share of total funding was little changed

The amount of banks’ equity funding (or ‘equity capital’) rose over 2022 in line with anexpansion in banks’ balance sheets, leaving the equity share of funding little changed. The majorbanks maintained capital buffers well above their regulatory requirements over the year, despite severalof the banks returning some capital to shareholders through share buybacks and dividends. Overall, bankswere well positioned to meet APRA’s ‘unquestionably strong’ capital framework that cameinto effect in January 2023 (RBA 2022).

Major banks’ cost of funding

As noted above, the major banks’ funding costs rose sharply over 2022, driven by a tightening inmonetary policy (Graph1; Graph2). The overall rise in their outstanding non-equity fundingcosts was smaller than the increase in the cash rate (Graph7). The factors contributing to this gapincluded limited pass-through of increases in interest rates in other markets to some of the rates paidon the banks’ deposit base (particularly household and at-call products) and lags in the effect ofhigher BBSW rates on wholesale funding costs. Most of the impact of a change in BBSW rates flows throughto wholesale funding costs in three to six months, with the time frame varying according to the maturityprofiles of banks’ short-term debt, wholesale deposits and interest rate hedging instruments.

The estimated level of major bank funding costs also includes adjustments to account for how banks mayhedge their interest rate risk. The estimates presented here assume that to the extent fixed-rate fundingliabilities are not naturally hedged by offsetting fixed-rate assets, interest rate swaps are used totransform fixed-rate payments into floating-rate payments (Berkelmans and Duong 2014). It is possiblethat major banks have hedged differently to the simple adjustment made in these estimates. This may havecaused funding costs to increase by more than presented here due to the rise in floating rates over 2022.For example, banks may have chosen to swap fixed-rate funding drawn from the TFF (rather than relying ona fixed-rate asset, such as lending, as a natural hedge). In this instance, the effective cost of TFFfunding will have increased alongside the increase in floating rates, rather than remaining at the lowrate on TFF drawings.^[5] Similarly, major banks’ effective earnings fromtheir fixed-rate loan book may have increased with the rise in floating interest rates if fixed-ratelending was hedged using interest rate swaps.

In aggregate, deposit rates rose but by less than the cash rate

The divergence between overall deposit costs and the cash rate was underpinned by limited pass-through totransaction and at-call savings accounts (Graph8). At-call deposits accounted for around80percent of major banks’ deposit base on average in 2022. Average rates on new termdeposits increased by more than the cash rate, in line with the larger movements in BBSW and longer termswap rates, which are the key benchmarks used to price these products. Compared with earlier periods ofmonetary policy tightening, total deposits comprised a larger share of major banks’ funding in 2022,amplifying the effect of changes in deposit rates on major banks’ total funding costs.

By depositor type, banks have increased rates on wholesale deposits by more than on household deposits(Graph9). This different treatment is likely, in part, to reflect wholesale depositors having awider range of market-based alternatives in which to place cash. For households, increases in at-calldeposit rates have been larger for savings products that require depositors to adhere to certainconditions to earn interest (e.g. the balance must increase in the month) than for online savingsproducts without conditions. Some of the largest increases in advertised deposit rates have been offeredby non-major banks.

The cost of new wholesale funding rose alongside benchmark rates

The cost of issuing short-term and long-term wholesale debt rose over 2022, following the increase inbenchmark market rates. Domestic yields on major banks’ three-year bonds ended the year around5percent – the highest level since 2012 (Graph10). Bank bond yields alsoincreased by more than the increase in comparable swap rates (which are reference rates for the pricingof fixed-income securities). This difference reflected stronger demand for bank funding and a broaderincrease in risk premia. The spread to the swap rate ended the year a little above its three-year averageover the period preceding the pandemic. A wider spread suggests it became more costly for banks to swapfixed-rate liabilities into floating-rate liabilities. The cost of swapping foreign currency debt backinto Australian dollars also rose from the historical lows seen during the pandemic. If yields andspreads remain around these levels, then as maturing debt is rolled over, the cost of banks’outstanding debt will also increase a little further, putting upwards pressure on funding costs.

See Also

How Banks Make Money And Why It's Shifting In 2021 | Nucoro

Lending rates

Major banks responded to higher funding costs and increases to the cash rate by increasing lending rates.From April to December, compared with a rise in the cash rate target of 300basis points, theaverage outstanding housing lending rate increased by around 190basis points and the averageoutstanding business rate increased by just over 260basis points. The average new lending rates forhousing and business purposes rose by a little more than the average rates charged to existing borrowers,but by less than the cash rate. The average rate charged on outstanding personal debt also increasedslightly.

Housing lending rates

The increase in the average rate charged to existing housing borrowers was mainly driven by increases invariable rates. Over 2022, the average outstanding variable rate returned to levels not seen since 2013,the last time the cash rate was above 3percent (Graph11).

Although lenders passed on cash rate increases in full to variable reference rates, very few borrowers payrates as high as these. Instead, borrowers are offered, or negotiate, a discount relative to thesereference rates (RBA 2019). During 2022, banks competed strongly for new and externally refinancingborrowers, particularly those of higher credit quality, in addition to adjusting discounts to retainexisting borrowers. Liaison suggests that around 30percent of variable-rate borrowers haverenegotiated a lower rate on their housing loan with their existing lender since May. Many borrowers havealso refinanced with a new lender, with major banks extending cashback offers to customers of around twoto four thousand dollars.

The large share of fixed-rate lending taken out during the pandemic also weighed on pass-through to theaverage rate charged to all housing borrowers (Graph12). While around one-quarter of fixed-rateloans outstanding in early 2022 rolled to a new (and in most cases higher) interest rate over the year,the remainder were unaffected by the rise in lending rates. As these borrowers’ fixed-rate periodsexpire in the period ahead, the total average outstanding housing rate is likely to increase further(Lovicu et al 2023).

Business lending rates

Interest rates on variable-rate loans to businesses of all sizes have increased alongside the cash rateand three-month BBSW (which is the benchmark for most loans to medium- and large-sized businesses)(Graph13).^[6] Loans to medium and large businesses account for justunder 90percent of total business credit and the majority are on a variable rate.^[7]Reflecting the dominance of variable-rate lending, the average outstanding rate on business loans hasmoved considerably more than the average outstanding housing rate.

Implied lending spread

A bank’s implied lending spread is the difference between the average lending rate it charges toborrowers and its overall funding cost. We estimate that the implied lending spread for the major banksnarrowed further over 2022 (Graph14). Underpinning this, the aggregate lending rate increased byaround 30basis points less than funding costs. Key factors weighing on the aggregate lending rateincluded the high share of fixed-rate housing loans that did not reprice, and the effect of ongoingcompetition in housing lending on interest rates for new and outstanding variable-rate loans.

The lending spread shown above differs from reported measures of bank profitability like net interestmargin (NIM). Reported NIMs for the major banks generally started to increase during 2022. Among thedifferences between these measures, the lending spread excludes the effects of non-loan interest-earningassets, such as cash and other HQLA, which are captured in banks’ NIMs. Yields on some of theseassets have risen – for instance, the rate paid on Exchange Settlement balances held at the ReserveBank increased from zero to 3percent over 2022. The lending spread estimate also likely onlypartially accounts for hedging practices, whereas reported NIMs will fully reflect hedging cash flows.

Conclusion

The effects of tighter monetary policy over 2022 have driven a substantial increase in banks’ fundingcosts. In turn, banks have started charging higher interest rates on loans to households and businessesover this period. As such, the cost of borrowing for many households and businesses has increasedconsiderably for the first time in over a decade, leading to a significant tightening in financialconditions for these borrowers.