The sources and costs of bank funds post-GFC
In recent years, the rising cost of funds has often been cited by the
major banks as to why they have not always strictly followed changes to the
official cash rate made by the RBA. As these decisions impact the large number
of Australians with variable rate mortgages, this explanation has been
controversial and not generally well‑understood in the community. This
chapter explores the changes to Australian banks' funding mix and costs since
the global financial crisis. It also discusses the relationship between the
cash rate and funding costs, and examines various options put forward to help
address funding cost issues.
The main sources of funds for Australian banks are deposits, with other
major funding sources being long-term and short-term wholesale debt. Equity and
securitisation provide other sources of funding. Figure 4.1 shows how
Australian banks' reliance on each funding source has changed since the global
financial crisis, with a significant shift towards deposits and long-term debt,
and away from short-term debt and securitisation.
Figure 4.1: Funding composition of banks in Australia (as a percentage
** Includes deposits and
intragroup funding from non-residents.
Source: RBA; based on data
from APRA, RBA and Standard & Poor's. Data are adjusted for movements in
foreign exchange rates.
The change can largely be explained by banks reassessing the risks
associated with some funding sources during the global financial crisis and the
repricing by investors of the risk of banks generally. The tightening of
international funding markets during the midst of the crisis meant that banks
encountered difficulties in rolling over their short‑term debt.
Consequently, Australian banks have increased their utilisation of more stable
funding sources such as domestic deposits and long‑term wholesale funding
(in place of short-term debt). This development is likely to be sustained as
banks prepare for the Basel III stable funding requirements that will be
imposed in 2018. However, these more stable funding sources have proved more
expensive for Australian banks with competition for domestic deposits becoming
more intense and the cost of long‑term wholesale funding steadily
increasing since the global financial crisis (relative to the official cash
rate set by the RBA).
Relationship between funding costs
and the official cash rate
It follows that a bank's overall funding costs depend on the balance of
funding sources it utilises, and the cost associated with each source. Before
examining the changes to the funding sources, and given the continued public
debate on this issue, it is helpful to discuss how movements in the official
cash rate set by the RBA impact the cost associated with each funding source.
The prevalence of variable-rate residential mortgages in Australia means
that movements in the cash rate can be expected to have a more direct impact on
new and existing lending than in other countries.
From the mid-1990s until the onset of the global financial crisis, bank lending
rates closely adhered to changes in the RBA's official cash rate (Figure 4.2).
Figure 4.2: Spread to the cash rate—standard
variable housing loans
Source: Based on RBA data
The close relationship over many years between movements in the cash
rate and lending rates, particularly variable mortgage rates, has created a
public expectation that changes to banks' standard variable mortgage interest
rates should only be influenced by the RBA's decisions on the cash rate. In
recent years, however, while banks have followed the direction of the RBA's
decisions on the cash rate, they have not always altered their interest rates
by the same percentage point change in the cash rate.
The RBA provided the following explanation about the role of the cash
rate and how it interacts with banks' funding costs:
The level of the cash rate set by the Reserve Bank is a
primary determinant of the level of intermediaries' funding costs and hence the
level of lending rates. It is the short-term interest rate benchmark that
anchors the broader interest rate structure for the domestic financial system.
However, there are other significant influences on intermediaries' funding
costs, such as risk premia and competitive pressures, which are not affected by
the cash rate. At various points in time, changes in these factors can result
in changes in funding costs that are not the result of movements in the cash
RBA Assistant Governor Dr Guy Debelle expanded on the impact of risk
The longer you borrow at, the more people want a bit of
compensation for that. As you move beyond overnight and further out in time,
you get a premium to compensate you for that. On top of that, if you are a
bank, you are a more risky proposition than we [the RBA] are, and so people
want to be compensated for that as well. So the cash rate still plays a very
important role in the cost of the banks' borrowing, but there are other risk premia
and term premia, reflecting how long they are borrowing at, which move around
with market conditions—and they have certainly moved around a lot over the past
The RBA also noted that since the onset of the global financial crisis
in 2007 'there has been a lift in the whole structure of interest rates in the
economy relative to the cash rate' due to increased competition for deposits
and higher wholesale credit spreads.
Dr Debelle observed that during the 2000s up to the onset of the crisis, 'risk
premia were incredibly low and did not move'.
This allowed for changes to variable interest rates to follow movements in the
official cash rate during that period.
To enable an analysis of how the cost of individual funding sources for
banks has changed, Dr Debelle was asked whether changes to the official cash
rate are more relevant to either retail deposits or wholesale funding. Dr
Debelle considers the effect to be 'roughly the same':
Dr Debelle: ... As I said, those other influences I talked
about earlier have moved around a bit differently for some of those other types
of funding—deposits versus wholesale funding. In particular, actually in the
deposit market, there has been a lot of competition over the last couple of
years, which has driven up the costs of deposits relative to other sources of
funding, including wholesale funds. But, beyond movements in those different
premia, the cash rate has roughly the same influence on all, regardless of the
source of funding.
CHAIR: It feeds into the cost of deposits as well as the cost
of wholesale funding to a roughly equivalent level.
Dr Debelle: Yes. As I said, those other things move around
and they move around at different times, but, once that has all settled down,
What impact have the decisions by banks not to adjust their lending
rates by the same degree as revisions to the cash rate had? Dr Debelle has
stated that it has not significantly impacted the ability of the RBA to conduct
its monetary policy functions:
... the Reserve Bank Board takes these developments into
account in its setting of the cash rate to ensure that the structure of
interest rates in the economy is consistent with the desired stance of monetary
And as this committee observed in 2011:
... if the banks increase their loan rates by more than
the Reserve Bank's adjustment to its cash rate, it does not mean that borrowers
are paying higher rates on their loans (in any other than a very short-term
sense). The average loan rate is essentially where the Reserve Bank believes it
should be in order to meet its medium-term inflation target. If the banks
expand their margin over the cash rate, then the Reserve Bank will set a lower
cash rate than they would otherwise have set.
The issue is more one of public perception and widespread scepticism of
the banks' arguments, not helped by some of the banks' actions.
During the Competition Inquiry, the CEO of the National Australia Bank
reflected that, although the RBA's cash rate decisions influence the market by
setting the trend for the direction of rates, they are not the main factor
taken into account by banks when deciding their interest rates. Accordingly, in
his view, the banks 'have made a problem for themselves here by continually
moving in line with the Reserve Bank':
When spreads were very narrow, you must bear in mind that pre
the global financial crisis we were borrowing in the spread range of perhaps 15
to 20 basis points over a benchmark. When that blew out to 250 basis
points in the crisis, it was clearly even a broader disconnect, if you like,
between our funding costs and the RBA. I have got a lot of empathy for the
public who say, 'Hang on a second. For 15 years you have moved your rates in
line with the RBA up and down. Suddenly there's a disconnect there. In some way
you're taking a profit because you're not borrowing at that point in time.' The
reality is that that is not the driver of our funding but we have, for many,
many years, created that perception in the public's mind, so we have got to
face the fact that this is something we have created through our own poor
communication on the issue. I am hoping that, as we start to have these sorts
of discussions going forward, people will start to see there is a different
driver of funding. But I certainly do not blame the public at the moment
for being upset about moves they see as not in line with the RBA.
Since the Competition Inquiry, banks have started to change how they
review and announce their pricing decisions. On 8 December 2011, ANZ
differentiated itself from the other major banks by declaring that any changes
to its retail and small business variable interest rates would be announced on
the second Friday of each month.
Overall funding costs
It is recognised that assessing the funding costs that banks face, even
at a sector-wide level, is difficult:
[O]verall funding is a mix of various bank liabilities across
differing maturities. Funding costs reflect two components, the general level
of interest rates and credit spreads over and above the risk free rate (government
rates) ... Moreover, particular funding costs, such as deposit rates
may vary relative to the cash rate and government risk free rates, depending
upon the degree of competition and movements in the relative cost of other
forms of funding. The cost of those other forms, such as wholesale debt market
funding, will depend upon the credit spreads which banks must pay for such
funds and which can vary markedly over time in response to changes in general
market confidence as well as assessments of individual bank risk. How bank
funding costs vary over short periods of time is difficult to assess, because
banks may be changing their mix of funding and rolling over maturing sources of
longer term funding where movements in both the general level of rates and
credit spreads since that debt was initially issued need to be taken into
Figure 4.3 illustrates the RBA's estimate of how the major banks' overall
funding costs have changed since mid‑2007.
4.3: Major banks' funding
Note: CDs refers to
certificates of deposit, which are negotiable bearer debt securities with a
fixed interest rate and maturity date issued at a discount to their face value.
Source: Cameron Deans and
Chris Stewart, 'Banks' Funding Costs and Lending Rates', RBA Bulletin, 2012,
no. 1 (March), p. 41; Bloomberg, RBA and UBS AG (Australia Branch) data.
As Figure 4.3 indicates, it is estimated that the major banks' funding
costs have risen significantly since mid-2007. Overall, the RBA estimates that
the major banks' funding costs have increased by about 140–150 basis points,
relative to the cash rate, since mid-2007.
The RBA also considers that, for regional banks overall, the rise in the cost
of funds has been even greater:
The available evidence suggests that, in aggregate, the
increase in the regional banks' funding costs since the onset of the financial
crisis has been larger than that experienced by the major banks. This reflects
the fact that smaller banks have experienced a larger increase in funding costs
and have made a larger shift in their funding mix towards deposits.
From the perspective of individual major banks, ANZ and the CBA provided
the following charts of how their funding costs have changed and how much
of this increase has been recovered. NAB advised:
Our costs of funds has risen, let us say, 140 basis points
over that period. We have recovered 125. So there has been some compression in
that. Then various business products are repriced similarly but not in the same
way. So the net is that there has been some degradation, certainly for us, over
Figure 4.4: Change in ANZ's funding
costs relative to the cash rate
Note: The chart depicts the
average change in cost of funding relative to the cash rate over the 12 month
period ending September 2007.
Source: ANZ, Submission 78,
Figure 4.5: Change
in CBA's retail bank funding costs relative to the cash rate
Source: Commonwealth Bank of
Australia, Submission 81, p. 23.
The following paragraphs examine the changes in the utilisation and cost
of each funding source, and the factors influencing these changes.
The turmoil of the global financial crisis has had a sustained impact on
saving behaviour. As illustrated by Figure 4.6, the level of household saving
increased significantly with the onset of the crisis. Households also began to
adjust their investment patterns, moving towards lower risk methods of
increasing their savings such as term deposits, at the expense of investments
associated with higher risk such as shares.
This is shown in Figure 4.7.
Figure 4.6: Household saving ratio
Australian Bureau of Statistics, cat. 5206.0.
Figure 4.7: Annual net asset purchases
Freestone et al., 'The rise in household saving and its implications for the
Australian economy', Treasury Economic Roundup, issue 2, 2011, p. 64.
It is apparent that competition for term deposits has become more intense
following the global financial crisis. The ABA provided the following account
of how the crisis has affected the demand for deposits:
As revealed around the world, a high level of reliance on
foreign funding exposes a country to greater shocks. Investors that extend
money do so because they are confident in getting it repaid, and in situations
of uncertainty, there is a bias to investment in their home countries. In order
to reduce this risk, the Australian banks have competed ferociously for household
and business domestic deposits in order to fund growth in credit. This has been
a bonanza for savers who are enjoying very good deposit deals. Further,
foreshadowed regulatory changes for liquidity are giving banks incentives to
further focus deposit competition onto term deposits.
Businesses have also contributed to deposits:
... strong business profits
and business caution have resulted in larger corporate cash holdings, which
have been increasingly invested in deposits rather than other financial instruments,
particularly short-term bank paper.
Figure 4.8 compares the interest rates for term deposits compared to
retail online savings accounts and government bond yields, and it is clear that
there has been a significant change to the returns associated with these
products. The RBA notes that while deposit rates and yields on bank debt
generally declined between mid‑2011 and early 2012, these declines have
not matched the reduction in the cash rate during this period.
Term deposits now represent a greater share of overall deposits than prior to
the global financial crisis.
Comparison of retail deposit rates with government bonds
Note: Online savings account
and term deposit rates based on balances of $10,000. Term deposits rates based
on three year deposits.
Source: Based on RBA data (F2
Westpac explained that competition among banks was particularly intense
for term deposits, compared to online on-call deposits, as term deposits are
regarded by regulators as a more stable source of funding, and banks want to
have a greater proportion of their funding mix in a stable funding base.
The ANZ was asked how its expansion into several Asian countries, which
generally have higher saving rates than Australia, is affecting the bank's
overall funding needs. The ANZ acknowledged that its proportion of loans to
deposits in Asia was 60 per cent, whereas it is 134 per cent for the ANZ Group
overall, and that on occasion it had remitted surplus funds from Asia to fund
its Australian operations. However the ANZ's Deputy CEO advised that 'our
strategy is not to fund our domestic bank, if you like, from our Asian
business; it is really to fund our Asian expansion through the deposits in
Given that smaller ADIs traditionally have been more reliant on deposits
as a funding source than the major banks, Abacus was asked how the increased
competition for deposits among all ADIs was affecting mutual ADIs. Abacus
advised that, under present market conditions, their members are able to secure
a sufficient level of deposits. However, they raised some concerns about the
long-term implications for mutuals:
Part of that is because lending demand is probably a little
bit subdued at present ... should economic conditions or confidence
increase and people take on more risk, you have that money leaving the deposit
market. You also have increased demand for loans, so you have increased demand
for funds. I think that is pretty interesting. So at the moment our liquidity
is very high. It has always been very high and remains so. This is about the
price point. The only distinction I would make between us and the banks, and
why the deposit cost is so critical for us, is that we do not have the same
diversity of funding that the major banks have, for instance, and therefore we
do not get to spread that cost—it is all largely in one bucket.
The ANZ, however, does not consider competition for deposits will ease
any time soon:
While we continue to see volatility in the global markets, in
the interests of maintaining stability and certainty of our funding we expect
the banks to continue to work very hard to raise domestic deposits. We would
see those being at least at current level or, if we can achieve it, slightly
higher levels as a proportion of our total funding than where they are today. I
do not see that intensity for competition in the domestic deposit market easing
off in the near term at all. I think, therefore, the likelihood that you are
going to see an easing in those costs is small.
While deposits have always formed a large component of the major banks' funding
mix, the overall shortfall in domestic funding sources means that banks have to
participate in domestic and global debt markets. Smaller banks make less use of
offshore borrowing than the major banks and instead rely more on other funding
sources. The global financial crisis caused significant disruption and
volatility in international financial markets. Following its feature role in
the crisis in the United States the securitisation market collapsed, including
in Australia even though we suffered no failures here. Increased risk and
risk-aversion has led to higher risk premiums for wholesale debt. Accordingly,
following the global financial crisis both the cost of wholesale funds and the
ways that these funds are utilised have changed.
Unsecured long-term and short-term
As noted earlier, the proportion of wholesale funding in the overall
funding mix has decreased, with deposits being increasingly utilised (see Figure
4.1). Within the wholesale debt category, there has been an important
development. Although the cost of long-term wholesale funding has increased
significantly more than the cost of short‑term funding, banks are increasingly
utilising their proportion of long-term funding instead of short-term debt.
In doing this, banks are seeking to secure more stable funding sources and
reduce the risk associated with replacing maturing wholesale debt. A Westpac
executive told the committee that, from a risk‑management perspective,
the unstable nature of the markets has proved to be more challenging than the
As you know, about 30 per cent of the money we raise comes
from offshore markets. We are a price taker in those markets and the price of
credit in those markets not only has stayed high but is extremely volatile. In
fact, if there were an issue that really underpins the riskiness of it, it is
more the volatility of the price rather than the absolute level of it.
As shown above in Figure 4.3, while the costs associated with short-term
wholesale debt (relative to the cash rate) increased during the height of the global
financial crisis and briefly at the start of 2012, for much of the period since
the crisis there appears to have been a relatively small increase in the cost
of short-term wholesale debt (relative to the cash rate) compared to the price
banks faced prior to the crisis. However, the difference between the price of
long-term wholesale debt and the cash rate has steadily grown compared to June
2007. Treasury's assessment is as follows:
In terms of the actual dollar figure, we can say aggregate
funding costs in recent times have probably gone down. Relative to benchmarks,
relative to the cash rate, they are still elevated.
The duration of long-term wholesale funding and the timing of its
maturity affects the exposure of a bank to changing funding costs. Long-term
funding is, by definition, obtained for some years. Higher costs at present for
long‑term funds impacts the cost of new funds, whereas the banks' average
long-term wholesale funding costs are influenced by the maturity date of their
existing funds and the need to source new funds:
While the relative cost of new long-term wholesale funds is
currently higher than that of maturing funds, this has had only a moderate
effect on the major banks' average bond funding costs relative to the cash rate
to date ... This reflects the fact that it takes at least 3 to 4 years
for the major banks' existing bond funding to be rolled over. Since spreads
began to rise sharply in August 2011, the major banks' issuance of new bonds
amounts to about 12 per cent of their outstanding bonds. As a result, the cost
of the major banks outstanding long-term wholesale debt is likely to have risen
by about 25 basis points relative to the cash rate over the past year.
The timing and volume of this rollover is clearly important. Australian
banks have been replacing cheaper, pre-crisis, debt with new debt at higher
prices. The RBA recently observed:
While spreads on new wholesale debt have declined so far this
year, banks' funding costs are about 50 basis points higher than they were in
mid 2011 relative to the cash rate. In part, this reflects banks gradually
rolling over their maturing long-term funding at higher spreads.
Other influences on the cost of wholesale funding are the strategies
employed by Australian banks for obtaining and utilising long‑term
wholesale funding. Some banks are increasing the duration of their long-term
funding; ANZ has increased their average duration from four to five years.
While this provides greater stability to the funding mix, it generally comes at
a higher cost.
The management of interest rate and exchange rate risk also impacts funding
costs. The banks enter into interest rate and cross‑currency swaps,
effectively hedging almost all of their bonds which were issued in foreign
currencies back into Australian dollars. The banks also:
... tend to issue in markets where it is cheapest to
borrow Australian dollar equivalent funds at that time. In this way, they take
advantage of pricing differentials between alternative funding markets, using
derivatives to manage the associated exchange rate risks.
Accordingly, while the relative cost of new long-term wholesale funds is
currently higher than that of maturing funds, the effect of this is moderated
'if fixed‑rate wholesale debt is assumed to be swapped back into
variable-rate obligations. The extent of the rise in relative costs for
individual banks varies according to each bank's use of interest rate
For the example given in paragraph 4.31, the rise in funding costs relative to
the cash rate may only be around ten basis points in the year to March 2012
rather than 25 points if it is assumed that fixed-rate wholesale debt is
swapped into variable‑rate.
A recent development in wholesale funding was the 2011 amendments to the
Banking Act 1959 which allowed ADIs to issue covered bonds.
A covered bond is an instrument issued by an ADI where, in the event that the
issuing ADI defaults on its payment to the bondholder, the bondholder may
recoup their investment either from the issuing ADI or through a preferential
claim on a specified pool of high quality assets. Treasury submitted that since
the relevant legislation was passed in October 2011, banks have raised around
$30 billion through covered bonds.
Research by the RBA suggests that the issuance of covered bonds has not
impacted the overall funding mix, although it has enabled funding of a longer
duration—covered bonds issued so far have been for terms of five to ten years,
rather than the three to five years applying to unsecured bank bonds.
The legislative amendments included provisions for smaller ADIs to pool
their assets together to issue covered bonds and therefore take advantage of
the higher credit ratings generally associated with these bonds.
ING Direct were asked how attractive this option was to smaller banks, but advised
that they consider it to be something 'extremely difficult to do':
Mr Hellemans: ... considering the complexity that you
have about combining a pool of mortgages—to be able to determine the standards
of those mortgages and everything else, and the consequences. So it is actually
extremely difficult. I think that a lot of people are just daunted by the
complexities and the compliance issues that would be related to that kind of
CHAIR: So the suggestion that was raised at the time that
covered bonds really would only assist the majors and effectively, again,
provide them with yet another advantage in the competitive environment is
Mr Baker: Yes.
Securitisation involves bundling illiquid assets and converting them
into a package of securities that can be issued into the capital markets. The
resulting bonds are known as asset backed securities, a common type being
residential mortgage‑backed securities (RMBS) where various residential
mortgages are the illiquid assets. As canvassed during the Competition Inquiry,
the securitisation market has in the past been important for competition in the
Australian banking sector. In particular, non‑bank lenders relied on
securitisation to compete with the major banks, as it allowed them to expand
quickly without having to establish a large network of branches and compete for
One of the clear effects of the global financial crisis was the collapse
in the securitisation market, as illustrated in Figure 4.9 below. APRA
officials have commented that up until around 2004, securitisation 'generated
clear benefits for competitiveness, efficiency, contestability, and neutrality'
... for safety and systemic stability, in its earlier and
simpler incarnation, securitisation was not a problem. The ADIs participating
in this market generally maintained good lending discipline, abetted by the
lenders mortgage insurance companies supporting the market. In Australia at
least, unregulated lenders generally exercised some common sense in their
lending and loan management.
We saw in America and Europe, however, that securitisation in
the 2000s increasingly became a vehicle which supported over-complexity,
reckless and too often fraudulent lending, and gross conflict of interest. The
2007–08 phase of the global financial crisis was not caused by securitisation,
but securitisation structures and re-securitisation structures featured
prominently in the capital losses and illiquidity associated with that crisis.
Figure 4.9: Australian RMBS issuance (A$
Statement on Monetary Policy, February 2012, p. 52
The Australian government supported the securitisation market during and
after the global financial crisis by instructing the Australian Office of
Financial Management (AOFM) to temporarily invest in AAA-rated Australian RMBS.
In total, the AOFM has been instructed to invest up to $20 billion. As of
12 September 2012, it has participated in just under $15.5 billion worth
The future strength of the securitisation market is still an open
question. The CEO of the AOFM noted that while the infrastructure for
securitisation has been persevered, demand for RMBS transactions has 'ebbed and
flowed'. He observed:
There is no getting away from the fact that RMBS is a credit
product. If credit globally is struggling as an asset class then so will RMBS,
and no amount of buying by the Australian government is going to change that.
While a Treasury officer noted that securitisation 'has lost its bad
odour from previously', he mused:
To some extent, it is still disappointing that the
securitisation market has not got going again as strongly as we would like. It
was always going to be around five per cent of funding in the whole system, but
it is important because it does help some of the smaller lenders. But I will
just finish on that point. I think internationally people are now seeing that
they need to have a securitisation market, so I am hopeful that it will pick up
Are debt markets recognising the
fundamental strength of Australian banks?
An interesting topic examined by the committee was the risk premiums for
wholesale debt paid by Australian banks compared to banks in other
jurisdictions. The Australian banking system is well-regulated, the major banks
are the most profitable in the developed world and are among the most highly
rated, and the broader economy is performing strongly compared to other
developed countries; however, are these factors being adequately recognised by
the wholesale markets?
At one of the public hearings, an argument was put forward that foreign
government agencies have recognised the strength of the Australian economy and
financial system, and are eager to buy Australian government bonds because they
are low-risk and have a positive return, yet Australian banks were not being
received with similar enthusiasm by wholesale markets. The head of Treasury's
Markets Group suggested that, in his view, the soundness of Australia's
financial system was not being fully reflected through lower funding costs.
However, he added:
I think sometimes the way international markets look upon it
is, 'A bank's a bank.' It is an Australian bank, and it is competing with
Canadian banks and with Europeans, but it is a bank. And I think what you will
find in markets now is that there is a greater risk in investing in a bank than
there was pre‑GFC. It does not matter what bank it is.
Treasury also pointed out that international lenders seek to diversify
their risk, and accordingly would have a limit on the amount of money that they
would be willing to invest in bonds that are linked to the Australian economy.
Perhaps explaining the apparent disconnect, the ANZ identified that Australian
government debt would be more attractive as it is AAA rated whereas bank debt
is AA rated.
RBA Assistant Governor Dr Guy Debelle indicated that there was a
decreased willingness generally among bond holders to hold private debt
compared to well-rated government debt—noting that the borrowing costs for the
Australian government recently were the lowest since Federation—however, Dr
Debelle pointed out that Australian banks are still benefiting in terms of
funding costs due to their reputation relative to other banks, particularly
Westpac's evidence supported this contention, noting that they pay a premium of
around 150 basis points, while an A-rated bank in London or New York, in its
view, would likely be paying around 200 basis points. Westpac's evidence
also highlighted how differences in base rates can conceal the advantage from
debt markets that Australian banks receive compared to many of their
If I was the treasurer of RBS, NatWest or some other bank at
the moment I would probably be paying well over 200 over the base
rate ... Their base rate, Libor, is half of one per cent. I am paying
3½ on my base rate—that is, my 90-day bill rate—and I add 150 to that, so that
is five per cent. If I were at RBS, London or Citibank, New York—that is, an
A-rated bank—I would probably be paying 200 over, but my base rate, Libor, is
only half of one per cent, so I am only paying 2½ per cent in absolute terms.
But the spread over my base rate, because I am borrowing in US dollars, is
Future direction of funding costs
It appears that funding costs will remain elevated for some time, on
both the wholesale debt and deposit fronts. On the wholesale debt side, it has
been observed that although the cost of issuing new unsecured wholesale debt
fell during early 2011, relative to other benchmarks,
the cost has again increased since mid-2011 as investors demand more
compensation for taking on bank credit risk globally.
A senior Treasury officer reflected on the short-lived decline in costs, noting
that 'everyone looks for light at the end of the tunnel'. In his view, however:
It will never go back to the lowest levels it was pre-GFC,
which is probably a good thing. People thought things had settled down but this
is a market and the market factors in risk.
RBA officials have noted that, for short-term debt, while the cost can
increase for major banks during times of global uncertainty, it should stabilise
when conditions improve:
Short-term issuance is somewhat of a buffer for the major
banks. When global markets are dislocated, they tend to issue more onshore
short-term debt. This tends to drive up the cost, which may also be rising at
the same time because of the tensions which are causing the dislocation
globally. Conversely, when conditions improve and term wholesale issuance picks
up, short-term issuance declines, reducing the spread with further downward
pressure from the improved market sentiment.
There are two key elements to future wholesale funding costs—the amount
of pre-crisis debt that is due to mature and be replaced at a higher
post-crisis cost, and the direction of wholesale debt prices generally. The ANZ
and NAB advised that they still had longer‑dated (7–10 year) debt issued
pre-crisis that is due to mature and which will need to be replaced.
Regarding the likely direction of wholesale funding costs, there was a
general consensus that it would depend on global economic sentiment:
... is Europe going to collapse; is the US era over? Those
sorts of things keep it high and those spreads move out very quickly when
people get scared and then they just come in very slowly.
Westpac considers that the risk premium of around 150 basis points for a
AA rated bank, compared to pre-crisis premiums of around 25 basis points,
could conceivably 'be the new normal':
The question of whether 150 turns itself back into a quarter
of a per cent is driven by investor preference, if they love us and are happy
with the level of return.
Westpac also pointed out that with the international regulatory changes
and continued de-leveraging, based on previous experiences of market downturns
investors could be five years away from becoming comfortable with a lower risk
You would like to think that there would be some longer-term
reward for being well run. There should be a differential between a AA bank and
a single-A bank. You would think that under normal, ongoing, quite predictable
growth arrangements, that spread would come in. But we are not at that point.
We are a good five years away from being at that point ... bear in
mind that we have a lot of regulatory stuff that is going to flow through. It
will not really flow through until 2015. There are other forms of regulation
that will not come on until 2017–18. Until those regulatory impacts flow
through and people are comfortable with them, I think people are always going
to hold a bit in reserve in terms of price. That is why I say it will be five
years—not because there is no macroeconomic improvement. It is just that these
other discontinuities in the market are going to take some time to really feed
through and settle down. We have not been in this situation for a long time. I
reckon there will always be a degree of premium in the price until people feel
100 per cent confident in the new regime.
The Deputy CEO of the ANZ speculated that 'there is a prospect that we
could see the premium come in a little', but it would depend on a number of
It has obviously come in from where it was in the worst parts
of the crisis. If you are an international bond investor, in your mind is: 'I'm
looking at return for risk.' They have really moved the pendulum to be lower
risk but still reasonable return. I think they see the Australian market as
being a lower risk market but not without risk. The sorts of concerns that you
hear about from the bond investors include: the housing market here—whether it
is sustainable, and we have heard for a number of years international concerns
about whether we are going to see a sharp decline in the value of mortgages; we
do not think that is the case and we tell them that—and Australia's dependence
on China and the growth of China, so if China were to suddenly slow, what might
that mean for Australia? There are those sorts of issues. There are some
questions around the commercial property market here, particularly in some
states where it has been particularly soft.
Turning to deposits, it is clear that competition for term deposits
among the banks has intensified for some time, leading to higher costs for
banks (although obvious benefits for depositors). Abacus argues that, while
this is being managed by mutual ADIs at present, it raises some questions about
the long-term funding stability of that household deposit market:
... one of our concerns is not so much about us competing
with much larger institutions right now but about what would happen should, for
instance, economic situations change and people have more risk appetite and want
to take their money out of banks and put them into, for the sake of argument,
equity. If we are continuing to fight ferociously over a shrinking pool of
deposits that is a far different scenario than the one we are facing right now.
Other issues which may impact the
cost of funds
As the previous chapter noted, the implementation of Basel III and other
regulatory changes may have an impact on funding costs, particularly the stable
funding requirements. However, in addition to global market developments and
regulatory change, certain characteristics of the Australian financial system
and the broader economy may also have an impact.
Perceptions of risk
A paper prepared by KPMG and the Australian Centre for Financial Studies
identifies three key characteristics of the Australian banking system that
could be perceived to be areas of risk. They are:
- the relatively heavy reliance on foreign wholesale funding
compared to other banking systems, which could leave the system vulnerable to
upward pressures on funding costs resulting from international developments;
- that investors may consider there is a greater risk of contagion
or systemic shocks as a result of the dominance of the big four banks and their
similar funding patterns; and
- the large emphasis on residential property lending compared to
other banking systems could be perceived to be a risk (the paper argues the
low-risk nature of this is 'not fully appreciated in international circles').
Professor Milind Sathye also noted the reliance on residential loans,
submitting that the proportion of housing loans within gross loans has risen
from approximately 51 per cent in 2004 to 59 per cent in 2011. Professor Sathye
argued that this exposure of the Australian banks to the mortgage market may
pose some risks:
A sharp decline in house prices could be disastrous for our
[systemically important financial institutions] as well as for the Australian
economy. Are house prices in Australia inflated? While a study by The
Economist London, [a] couple of years back stated that Australian houses
are overvalued by more than 60 per cent, econometric analysis by IMF Economists
in December 2010 found that the overvaluation was between 5–10 per cent.
Estimates may differ but the fact remains that there is a bubble in the market.
In a 2010 report, the IMF also noted that the major Australian banks
were significantly exposed to other economies, particularly New Zealand:
Home-host relations between Australia and New Zealand are
particularly important, as approximately 90 percent of New Zealand's banking
system assets are controlled by the four major Australian banks. Conversely,
all four of the major Australian banks are materially exposed to New Zealand
Further, the ANZ's Deputy CEO observed that bond investors would
consider the reliance of Australia's economy on China, and implications for
Australia if China suffered an economic shock, although he added that 'most
bond investors worry a lot and they are always finding new things to worry
about, but, in the range of worries they have, Australia is a relatively small
Funding advantages from being a
There are other aspects of the Australian financial system which could
be more positive for the major banks in securing their offshore funding. The Australian
Centre for Financial Studies submitted that the major Australian banks could be
receiving a competitive advantage compared to other banks as 'they are widely
perceived as having implicit government support and will not be allowed to
In most cases of troubled financial institutions which are
prudentially regulated, APRA is able to arrange a "smooth exit" by
way of an arranged merger. The Financial System Stability Special Account
established following legislation in 2008, provides a budget appropriation
available to facilitate the potential costs involved. However, this is unlikely
to be feasible in the case of the "big four" banks due to the sheer
size and complexity of their balance sheets and operations. They are "too
big to swallow" by other financial institutions in a situation of
financial distress when the risks involved are likely to be substantial and
hard to assess.
This would have domestic competition implications. IMF researchers have
estimated the value of these perceptions for large international banks to be a
funding advantage of, on average, around 20 basis points.
Credit rating agencies
While the reputations of credit rating agencies were clearly damaged by
the global financial crisis, the ratings they issue are still closely observed.
The major rating agencies (Standard & Poor's, Moody's and Fitch) currently
give the Australian major banks a AA- rating. The ANZ's 2011 annual report includes
a useful discussion of how credit ratings affect its funding costs and
operations more generally:
ANZ's credit ratings have a significant impact on both its
access to, and cost of, capital and wholesale funding ... A downgrade
or potential downgrade of ANZ's credit rating may reduce access to capital and
wholesale debt markets, potentially leading to an increase in funding costs, as
well as affecting the willingness of counterparties to transact with it. In
addition, the ratings of individual securities (including, but not limited to,
Tier 1 Capital and Tier 2 Capital securities) issued by ANZ (and banks
globally) could be impacted from time to time by changes in the ratings
methodologies used by rating agencies. Ratings agencies may revise their
methodologies in response to legal or regulatory changes or other market
The importance of a high credit rating for obtaining lower cost funding was
made by a major bank. It used this to argue why increased funding costs had to
be passed on:
Mr Joiner: You could ask: why don't you eat more margin and
why do you feel the need to pass those things on? We always have a cautious
weather eye to the general health of the banking system, at least as perceived
by the ratings agencies. We are one of seven or eight AA banks left in the
world and we are barely in that category.
CHAIR: Four of them are the Australian big ones.
Mr Joiner: Yes. We are AA-. We have been marked down to the
bottom category in AA. I think the rating agencies take a good deal of comfort
in the profitability of the banks as well as in the regulatory regime, the
state of the sovereign and so on. I think that, if you allow the profitability
of the industry to drift away, you will quite quickly find that you do not have
a AA banking system. And, if you do not have a AA banking system, it typically
puts pressure on the sovereign rating.
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