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Savers to foot the bill for making banks safer

David Bassanese
Wednesday, October 21, 2015

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When push comes to shove, someone will need to pay for the added capital 'saddlebags' banks will be required to carry when making home loans. 

Shareholders have endured some pain, but to the extent bank seeks to retain their returns on equity, this should prove fleeting. And lenders will only endure some pain if the Reserve Bank of Australia (RBA) tolerates some lift in interest rates.  

Given the still fragile state of the economy, however, the last thing we need right now are higher lending rates. One way or another the RBA will see to it that this does not take place.

Accordingly, it seems likely that those most in the firing line to pay for higher capital costs will be long-suffering savers. This effective cost transfer will take place should the RBA lower official interest rates in a bid to offset any upward pressure on home lending rates caused by banks attempting to retain profit margins in the face of higher capital costs.   

All this is the price authorities feel we need to pay to make our banks unquestionably strong by global standards. I’m doubtful we really needed to go this far, but what is clear is that making banks hold more capital as a buffer against potential losses on loans does not come without a cost – which someone needs to pay.

Let’s not forget our banks operate relative simple (and arguably lower risk) business models than some of the bigger banks in the US and Europe – through reduced proprietary financial market trading and greater focus on home loans. Our banks did not go down the path of investing in risky US sub-prime mortgages that caused woe in many other parts of the world. 

Yet the Murray Inquiry found they do retain other risks associated with high local market concentration and reliance on offshore funding. The implied Government guarantee covering the major banks also imposed added risk to taxpayers and may could encourage banks to engage in overly risky lending. 

As a result, the Murray Inquiry decided that bank capital ratios should be beyond reproach – and set at least around the 75th percentile among that of global peers.

Based on APRA’s latest calculations, that would require a rise in bank capital ratios of at least around 2 percentage points. The Murray Inquiry in turn, estimates could be funded by an increase in the average interest rate on a loan by less than 20 basis points.

Arguably, therefore, this is why Westpac came up with its 0.2% increase in loan rates – though based on the estimates above this does seem at the top of the range of likely cost. In turn, that’s likely why Treasurer Scott Morrison argues Westpac's move was in excess of what seemed required to preserve bank profitability.

In Westpac’s defence, however, the capital picture is being clouded by two separate factors. For starters, APRA is increasing the risk weighting applied to home loans – which effectively lowers bank capital ratios all else constant. At the same time, APRA wants overall capital ratios to be increased. Westpac is arguably trying to respond to both pressures.

What’s more, to the extent capital levels across the global banking sector are also being lifted, there could be further pressure on local banks to raise capital levels further down the track. Indeed, there is a risk of ever rising capital requirements (a bit like CEO’s pay), if regulators across the world all decide they want their banks to have above-average capital ratio. 

So far at least, other banks have not followed Westpac’s lead. But as all banks face similar capital pressures it means that can only hold part if they are prepared to sacrifice profit margins. While this may impart some momentary public relations benefit, and could lift market share, the cost to the bottom line are likely to prove too great over the long-run. They will likely follow in due course.

If the major banks did follow, and the RBA judged the across the board lift in mortgage rates was unhelpful, the RBA could respond by lowering the official cash rates – which would effectively allow banks to lower their lending rates again to the reduced cost of local deposit funding.  

So far so good, but notice what this implies: to keep lending rates steady in the face of higher capital costs – and the Big Four banks unflinching desire and ability to preserve returns on equity – the required widening in bank interest margins will need to come from lower deposit rates, rather than higher lending rates. All else constant, the impact of high capital costs will be to lower the 'neutral' official cash rate – and hence deposit rates – going forward.

So we end up with savers having to foot the bill for making banks safer. As the saying goes, there’s no such thing as a free lunch. 

Published: Wednesday, October 21, 2015

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