NZ bank margins in focus

Having realised that official interest rate cuts are no longer effective in bringing down lending rates, the Reserve Bank of New Zealand has turned to banks' rising interest rate margins which now need to narrow if lending rates are to trend lower.

The ineffectiveness of official cash rate as a monetary policy tool became evident as early as March when the six-month deposit rate rose and the floating rate on home loans stopped sliding even as OCR fell to record lows.
 
This was the first indication that deposit rates could no longer keep pace with falling OCR, and therefore lending rates have no scope to fall further. Indeed, the business base lending rate of banks also dropped a mere three basis points from March to May.
 
New Zealand was one of the first countries to officially slip in to a recession when its GDP contracted in the first and second quarter of 2008. However, the seeds of recession were sown way back in 2006 with the collapse of finance companies that had lured investors with high returns and invested them into risky assets.
 
While New Zealand wasn't directly exposed to the stress in structured finance products that caused turmoil in other parts of the world, reduction in liquidity, the impact of finance companies' failure and a falling property market steered the economy towards recession sooner than other countries.
 
In hindsight, it seemed the Reserve Bank was a little too late in reacting to the slowdown as its inflation targeting policy meant rates could not move lower when inflation rate was high. But when it was evident that the global and its own economy is faced with the worst economic recession since the 1930s, the pace of rate cuts came faster - a huge 575 basis points in a span of 10 months.
 
The Reserve Bank expected cheaper overnight rates to translate to lower rates for businesses and households as that would ultimately help to bring about an economic recovery. But that was not to be.
 
Data suggests that as the OCR got lower, banks' domestic interest rate margins got wider indicating the benefits of lower rates were not getting fully passed on. As much as 71.5 per cent of banks' total funding now comes from domestic sources, so a rise in margin here would indicate their overall margin have been steadily on the increase.
 
At the end of April, banks' interest rate margin on their domestic borrowings rose to 293 basis points, the highest since December 2004.
 
To put this in to perspective, from 170 basis points in July 2008 the spread has been widening each month with each increase in spread coinciding with the cut in the OCR.

Whilst banks' margins were overlooked in the past, it has now become an area of concern for the Reserve Bank because it dilutes the impact of its rate cut moves.

With deposit rates now sticky, the only way lending rates could trend lower is if banks' squeeze their margins and therefore it is little surprise that the focus of the Reserve Bank and the government has turned to banks' interest rate and profit margins.
 
Earlier this month the Finance and Expenditure Committee of Parliament expressed surprise that despite severe impact of the current recession, bank profits declined only marginally in the past year. The committee urged banks to pass on OCR cuts to their interest rate to the maximum extent possible.
 
"We encourage the banking sector to consider carefully their corporate citizenship, especially when taxpayers are effectively providing the financial sector with large amounts of liquidity," the report noted.
 
"Overall, we share the Reserve Bank's concern about the role of the banking sector in responding to the current recession," the report concluded.
 
But banks insist that it is the increase in their funding costs which has forced them to increase some rates, rather than lowering their lending rates any further.
 
Since May, domestic swap rates have moved up which means banks' wholesale funding costs have gone up. The spread between the two-year and 10-year swap rate widened to 236 basis points on May 27 from 197 basis points at the start of the month, indicating pressure on longer term rates. Five-year swap rate rose to 5.35% earlier this week which is the highest rate since late-November.
 
During this period, banks also raised their domestic deposits as each scrambled to increase their share of domestic deposits. Earlier this month, ASB lifted its one-year deposit rate to 4.55% from 4.50%.
 
Banks have also been advertising "specials" on deposit rates by introducing varying deposit periods at slightly higher rates to attract investors.
 
In the international market, the fund flow has improved but they are now available at a higher cost.
 
On the lending side, all the major banks kept their floating mortgage rate unchanged while cutting their short-term fixed mortgage rates. Some of them hiked their long-term mortgage rates. ANZ and National Bank raised three-year mortgage rate to 6.85% from 6.75% and five-year to 7.80%, up 35 basis points.
 
Base lending rate of businesses has moved down only 242 basis points from July 2008 to May 2009 in comparison to the 575 basis points OCR cuts.
 
A combination of all the above indicates that banks' interest rate margin could have come under pressure recently, but it is hard to imagine it would have narrowed sharply. Even a sharp rise in overseas funding costs shouldn't squeeze margins too much because it only accounts for about 30% of the banks' total funding.
 
Given the depth of the current recession, the Reserve Bank is probably expecting that domestic margins should revert to at least the lows seen in recent years - maybe 163 basis points.