Executive Summary
The purpose of this report was to examine interest rate disparity between Reserve Bank of Australia (RBA) and major Australian banks. The report presents RBA monetary policy decisions since December, 2012 and how major banks have responded to them. Focus was placed on the RBA’s April, 2012 interest rate decision. The report also presents recent monetary policies from China, India and Europe for comparison purposes.
Research for the report involved current literature review of articles covering recent monetary policies and major banks responses. Main findings indicate that there exist interest rate disparities between central banks’ monetary policy and commercial banks.
In all the cases reviewed interest cuts had no effect on banks’ lending rates. While it is clear that major banks interest rates will never match RBA’s interest cuts, this report recommends that RBA continues with interest cuts, but find other means to pressure major banks into matching their interest rates with RBA interest cuts to gain public confidence.
Introduction
The RBA lowered cash rates by 25 basis points in December, 2012 to 4.25 and has kept it on hold for now four months in a row. In its April, 2012 decision, the RBA left the cash rate unchanged to the surprise of many. Despite the interest cuts, major Australian banks are hesitant on matching their interest rates with RBA interest cuts.
The purpose of this report was to examine the interest rate disparity between RBA and major Australian Banks. The information gathered was to guide an understanding into monetary policies and the disparities that exist between cash rate cuts and banks’ lending interest rates.
It was assumed that cash rate cuts by central/reserve banks should instantly ease the financial markets. This should compel major banks into lowering their interest rates.
The current financial situation in Australia and world over was considered with a view to understanding the effect of cash rate cuts on banks’ lending interest rates. Information was gathered by way of online review of current literature. Although immense literature existed on the internet on this topic, most of the articles could not meet the required academic threshold for inclusion in this report.
The report is presented in three major parts. The first part is introductory part, which presents the executive summary and introduction to the report. The second part covers a review of literature, which also presents the major findings and discussions. The final part presents summary/conclusion and recommendations of the report.
Literature Review
Banks are sometimes forced to borrow money from other banks on a short-term basis to cover liquidity shortfalls resulting from customer withdrawals. Interbank interest rates thus denote interest banks charge on such short-term loans. Most often, interest rates follow the law of demand and supply and to some extent inflation and activities in the financial market.
However, the government, through central bank, has a say on the prevailing interbank interest rates especially as a means to containing inflation or easing credit crunch. Since December 2011, the RBA has kept interbank interest rates on hold at 4.25%. This decision, especially as made in April 2012, came to the surprise of many who thought the RBA would lower the rates further to 4.0%. But what reasons did RBA give for the hold?
Reasons for leaving the cash rate unchanged
According to the minutes of RBA board meeting on 3rd April 2012, the decision not to ease interest rates further was guided by the prevailing international and national economic conditions. It was noted during the meeting that the world was expected to experience a below-trend pace economic growth rate in 2012, with Europe weakening while China and Asia easing in growth pace (RBA, 2012).
However, the board noted that the US, Australia’s main trading partner, was in its recovery and growth for the year 2012 is expected to be about average. The board also noted improved sentiments in the financial market following impressive progress in resolving sustainability of the fiscal and debt positions in many European countries (RBA, 2012).
At the domestic level, the board noted a decline in demand compared to the year 2011 as well as easing conditions in the housing sector. Labour market conditions in Australia also showed an increase in unemployment rates. Inflation was, however, reported to be within the target, but the board noted the lack of data on inflation.
The board’s decision was also guided by the fact that Australia’s financial conditions remained unchanged in March, with interest rates on loans remaining close to medium-term averages, while exchange rates remained high and credit growth modest (RBA, 2012).
Reasons for banks not matching RBA interest cuts
Even as the RBA maintained the cash rates on hold for four months in a row, only small to medium size banks have lowered their interest rates to match RBA cuts. Major banks are still yet to match their interest rates with RBA interest rate cuts. Some banks have even raised their interest rates.
But what reasons to they give for such responses? It is worth noting that RBA’s monthly interbank interest rate is not the only influence on banks’ lending rates. Most banks in Australia acquire loan from international banks hence their interest rates is greatly influenced by activities in the global financial markets (ANZ, 2012).
Most often, banks blame high funding costs associated with the weakening of the European economy for failure to lower interest rates. Most Australian banks depend on international borrowing especially from European countries to make up for their liquidity shortfalls.
The financial crisis in Europe, which began in late 2011, has meant that Australian banks acquire credit at a high interest rate hence lowering their lending rates to match RBA interest cuts seem unrealistic. For instance, ANZ has been raising its interest rates since February 2012, despite RBA’s decision to keep cash rates on hold (ANZ, 2012).
The bank has blamed funding costs resulting from weakening activity in the global financial market as sufficient reason for raising its interest rates, despite RBA’s interest cuts. At the domestic level, banks have cited reduced borrowing rates and increased competition for deposits as their reasons for not matching with RBA interest cuts (Australian Bankers Association, 2012).
Deposits constitute 60% of banks liquid capital (Australian Bankers Association, 2012). Competition for deposits means that banks may be faced with liquidity shortfalls as banks fight for the few deposits.
Besides, most banks depended on house owners as the main borrowers, but reduced activity in the housing sector has seen many customers avoid bank loans and rather opt to repay previous loans. This only means that the demand for loans has drastically reduced hence banks are only left with the option of keeping interest rates high to be able to make profits.
Nevertheless, the RBA treasurer, Wayne Swan, believes that banks should pass interest cuts to the public. According to him, it is true that banks are operating under difficult global financial environment, but they should also be concerned about their local borrowers and pass on interest cuts to the public (Financial Review, 2011b).
He warns that if banks fail to lower their interest rates to match with RBA interest cuts, then they should be ready to face the wrath of customers who definitely will be angered by such defiance.
Similar pressure on banks to match their interest rates with RBA interest cuts has also been expressed by federal Finance Minister, Penny Wong, who noted that bank’s failure to pass on interest rate cuts to the public could deny households with mortgage worth $300, 000 a monthly saving of up to $49 (Financial Review, 2011a).
As a business analyst, I support the Treasurer’s call for banks to match their interest rates with RBA interest cuts. While banks repeatedly mention the high cost of wholesale credit from international financial market as sufficient reason for them not to match their interest rates with RBA interest cuts, it should be noted that international borrowing only accounts for 20% of the banks’ sources of funding (Colebath, 2012).
The balance is generated domestically from customer deposits (accounting 60%) and short-term bonds (accounting 20%) (Colebath, 2012). While the international cost of funding may have risen, domestic costs have not risen hence it would only be fair for banks to pass on interest cuts to the customers who form a substantial source of their funding.
International comparisons
Similar monetary policies on cash rate cuts have been witnessed across Europe, China and India. The European Central Bank raised benchmark rate by 25 basis points in April 2012, but kept interbank interest rates on hold at 1% (Song, 2012). Just like Australian banks, European banks are still yet to match their interest rates.
In China, the People’s Bank of China lowered banks’ reserve requirement ratio (RRR) by 0.5% in December, 2011 in a bid to ease short-term credit crunch (Xin and Yao, 2011).
While this monetary policy, which came into force in February 2012, has eased credit crunch by releasing between 350 billion Yuan to 400 billion Yuan into the banking system, banks in china are still hesitant on lowering interest rates given the high inflation rates in the country (Xin and Yao, 2011).
Indonesia also lowered its interbank interest rates by 25 basis points to ease inflation in a decision that surprised many financial players, but major banks failed to lower their interest rates to match interest cuts. However, inflation in Indonesia has since eased following interest rate cuts.
Conclusion/Summary
Cash rates have become important monetary policy through which central/reserve banks ease credit crunch and contain inflation. The push for interest rate cuts came as a means to ease financial markets from inflation and credit crunch that has been witnessed since late 2011 with economic growth in Europe weakening while China and Asia eases in pace.
Most economic analysts argue that cash rate cuts are an automatic recipe for low interest rates. However, it is evident from this report that banks have other factors to consider for lowering their interest rates and cash rate cuts may have minimal effect on major banks. For major banks, activities in the global financial market have greater influence than domestic interbank interest rates.
While RBA’s cash rate cuts should automatically lead to interest rate reductions as has been witnessed in small to medium size Australian banks, the difficult global financial environment in which major Australian banks operate cannot be ignored when understanding the interest rate disparity. Examples from Europe, China and Indonesia have also revealed a disparity between central bank’s monetary policies and banks’ interest rates.
Recommendations
Based on the findings, this report recommends that the Reserve Bank of Australia:
- Revisits its monetary policy and address the disparity that exists in interest rates between major banks and RBA interest rate cuts before lowering the rates any further as anticipated in May,2012
- Establish mechanisms for ensuring that its cash rate cuts are automatically transferred to the public
- Encourage banks to capitalize on domestic sources of funding as global financial market is likely to get tougher as European economy weakens.
References
ANZ 2012, Why ANZ is changing the way it sets interest rates. Web.
Australian Bankers Association 2012, Bank funding-an explanation, media release. Web.
Colebath, T 2012, Big banks marginal case. Web.
Financial Review 2011a, Wong urges banks to pass on rate cut, media release. Web.
Financial Review 2011b, Big four silent as Swan presses for rate cuts, media release. Web.
RBA 2012, Minutes of the monetary policy meeting of the reserve bank board-3 April 2012. Web.
Song, D. 2012, EUR/USD: Trading the European Central Bank interest rate decision, news report. Web.
Xin, Z. and Yao, K. 2011, China’s central bank cut reserve requirements for commercial lenders on Wednesday for the first time in three years, a policy shift to ease credit strains and shore up an economy running at its weakest pace since 2009. Web.