Analysis: The case for banks pocketing the lot

With the Reserve Bank of Australia cutting the cash rate by 25 basis points, to 3.25 per cent, on Tuesday, the usual pressure is on (from customers, politicians and the media) for the major banks to show their hand on home loan rates.

The main argument being put forward for the cut in the cash rate to be passed on in full to borrowers is that wholesale funding costs have fallen from a peak earlier this year.

However, there is more to be considered than just the recent decline in wholesale funding costs for the major banks.

In fact, broader consideration of the banks' overall cost of debt funding, the extent to which earlier rate cuts have been passed on and the overall trend in their profitability, would allow an argument to be mounted for not passing on the most recent cut at all. (Although Bank of Queensland has already said it will reduce variable rates by 20 bps.)

When the wholesale cost of debt for the major banks peaked in February this year, the cost of three- and five-year funds stood at 145 bps and 185 bps, respectively, over benchmark rates.

In December 2008 - when funding costs peaked during the global financial crisis - the respective margins for the banks were 160 bps and 190 bps (including the cost of the Commonwealth government guarantee).

Thus, the surge in the cost of wholesale debt for banks (since mid-2011) is near enough equivalent to the highest seen during the GFC. The recent decline in the wholesale cost of debt has allowed these spreads to contract to 80 bps and 117 bps, respectively.

This is in line with where spreads were early last year, but also equates to the average cost of debt through 2009. In other words, the cost of wholesale debt funding for the major banks hasn't really changed in three years.

But let's take a broader view of what has happened to the net interest margin of the four major banks and their return on equity. It is well known that the banks have expanded their net interest margin since the GFC. But what has happened more recently as the RBA has embarked on it latest cycle of cutting the official cash rate?

According to Australian Prudential Regulation Authority data, the average net interest margin of the four major banks was 2.17 per cent at the end of March 2011. This is the average return the banks made on lending after deducting the cost of funds lent from the interest earned.

By the end of March 2012 (unfortunately, this is the extent of APRA's data at the moment), the net interest margin had fallen to 2.10 per cent, as the official rate cuts at that time had been passed on (to varying degrees). A seven bps fall may not seem like much, but it should be viewed in the context of what has happened with return on equity over the same period.

ROE has fallen to 14.3 per cent, from 15.6 per cent, on an annualised basis.

But, that's OK, as the cost of wholesale debt funding has fallen in the intervening period. However, while this is true, data from the RBA shows that the average cost of all deposits, relative to the cash rate, increased by 65 bps between March 2011 and August this year. This a move from 40 bps under the cash rate to 25 bps over it.

Moreover, most of this increase has occurred since December last year, when wholesale debt margins were again moving higher. The move by the banks to source more deposit funding has had a significant impact on its cost.

How all this works out in terms of the banks' net interest margin and return on equity to the end of September 2012 won't be known for some time yet (the June quarter disclosure by most banks was slight).

In the meantime, anecdotal evidence says the banks have a case, this time around, for restoring their net interest margin and profitability.

A commentary by Standard & Poor's released yesterday that focussed on mutual deposit-taking entities highlighted this theme, noting that many mutuals are anticipating a lower margin in 2013.

S&P also highlighted the fact that major banks have, over the cycle of easier monetary policy, worked "to protect interest margins to meet return-on-equity targets."

There is a need for healthy banks to adjust interest rate pricing levers to meet profit targets (and thus meet the demands of debt and equity investors).

The banks also have regulatory decisions on which to frame a case for limiting cuts in the rates charged to borrowers.

The declining ROE trend will only be exacerbated when the Basel III-mandated capital increases come into effect, from January 1.