Latest NewsTougher Times for Borrowers Are Here to StayWednesday, 21 December 2016

The global financial crisis may seem to have left Australia's banks unscathed, but it's changed how they raise their funds, in ways that disadvantage borrowers and the wider economy while greatly advantaging savers.

Have you ever given any thought to where the banks get the money they lend to home buyers and businesses? It's explained in an article in this quarter's Reserve Bank Bulletin.

Banks act as "financial intermediaries" between savers on the one hand and investors on the other. They borrow money from savers and then lend it to businesses or home buyers or people who need personal loans.

The interest the banks pay to savers is their "cost of borrowing". The interest they charge their borrower customers has to cover that cost of borrowing as well as covering the banks' operating expenses and leaving them with a profit.

The gap between the interest the banks pay and the interest they charge is their "net interest margin" and it also represents the "cost of intermediation" - the price the community pays for the service the banks provide in bringing savers and investors, lenders and borrowers, together.

According to the latest figures, just under half the funds borrowed by the big four banks (including St George) is supplied by retail depositors.

A quarter of the funds comes from "long-term wholesale debt", which means three- or five-year corporate bonds issued by the banks to pension funds and others with money to invest. Roughly two-thirds of these are bought by foreign investors and one-third by local institutions.

A bit less than 20 per cent of the major banks' borrowed funds comes from "short-term wholesale debt", which means 90- or 180-day bank bills and "commercial paper" issued to big outfits with money they want to park, including pension funds, other investment funds and even other banks.

About half this money comes from foreigners and half from locals. That leaves 8 per cent of the banks' funds coming from their own equity capital - supplied by their shareholders - and only about 1 per cent coming from "securitisation" - the issue of residential mortgage-backed securities to investors, including pension funds.

So that's where the banks get the money they lend to their borrowers. But here's the point: these latest proportions of the various sources have changed a lot as a result of the global crisis.

We know that the securitisation market - where banks bundle up mortgages and turn them into bonds that they sell to institutional investors - was among the first to be hit in the crisis, so the banks are getting a lot less of their funds from this source (even though the local securitisation market seems to be getting back on its feet).

But the bigger change has been the move away from short-term wholesale funding. Our banks - but also banks in the United States and Europe - had become quite heavily reliant on this source, but when the crisis hit it suddenly dried up, creating considerable liquidity problems for the banks. They needed to be able to "roll over" (renew) their bank bills and commercial paper, but they couldn't.

So the banks have wanted to reduce their reliance on short-term debt and they're under pressure to do so from the sharemarket and the ratings agencies. What's more, they know the revised international standards for bank capital adequacy and liquidity will be pushing them in the same direction.

To make banks safer they need longer-term sources of funds - say, five-year bonds rather 90-day bank bills. And where the maturity isn't longer, the funds they gather need to be "stickier" - more likely to stick around than be moved elsewhere.

Guess which funding source is sticky? Retail deposits from you and me.

That's true of term deposits - which are generally for three or six months, but can go out to five years - because they're highly likely to be rolled over when they reach maturity.

But it's also true of ordinary bank deposits, which are "at call" - they can be withdrawn without notice.

Great idea - make banks safer. One small problem: long-term funding costs more. Savers have to be paid a higher interest rate to induce them to agree to tie their money up for longer.

And to induce you and me to put more money into bank deposits the banks have had to offer us interest rates very much higher than the paltry amounts they offered in the good old days before the crisis. How much more?

On average, according to the Reserve's calculations, about 1.6 percentage points more. As you probably know, you can get some amazing deals these days, including one of the big banks offering 5.85 per cent on at-call deposits in an online account.

There was a time when the main competition between the banks was to sign people up for home loans. These days the big fight is for deposits. Great news for savers.

As you well know, the banks have been raising the interest rates they charge by more than the increase in the official interest rate, saying their cost of borrowing has been rising faster than the official rate.

It's true. At first it was because rates before the crisis had gone too low and failed to adequately reflect the risks involved. Then it was because everyone was so scared they were demanding exorbitant risk margins - assuming they'd lend to you in the first place.

But now the crisis has receded and people have calmed down, it's clear we're left with a lasting increase in the level of interest rates (which is quite independent of where the central bank happens to be in its interest-rate cycle, whether it's holding rates below normal to encourage borrowing or above normal to discourage borrowing).

The level of rates is now higher for two reasons. First, because the banks are having to pay savers higher rates to obtain the longer-term, stickier funding needed to make the banking system safer.

And, second, because safer banking, with higher ratios of bank capital to bank loans, is more expensive, and the banks need to increase their margins to cover the extra expense. That is, because greater safety has raised the cost of intermediation.

Trouble is, a higher cost of intermediation inevitably means fewer business investment proposals will be sufficiently profitable to get the go-ahead, making it a dampener on economic activity.

This won't be a great problem for our economy, but it does demonstrate one reason the US and European economies will take a long time to get back to healthy growth.