Demystifying Interest Rates

By Patrick Tuttle
Posted in Pepper News on Friday, May 18, 2012
Demystifying Interest Rates

With the Reserve Bank of Australia’s recent reduction in the cash rate, it’s interesting to note the comments made by RBA governor, Glenn Stevens, around the increasing separation between the RBA’s cash rate and the mortgage interest rates set by the market, including major banks, regional banks and other non-bank lenders. In my opinion, this acknowledgement is well overdue.

Prior to the global financial crisis, the major banks almost always aligned themselves with the RBA’s cash rate decisions, causing the central bank to become a hero or scapegoat in the eyes of the media and public, depending on whether the cash rate was rising or falling. This was convenient for the banks as they were operating in a market where their cost of funding was relatively cheap.

However, now that the Reserve Bank has made such a bold step in its attempt to stimulate and encourage consumer spending, and thereby kick start our two-speed economy, the banks themselves are now being demonised by politicians on all sides for not passing on in full the RBA’s reductions to their standard variable interest rates.

For the politicians, the banks are a convenient whipping post. They rightly know that home loan interest rates are personal for all Australians. Almost everyone has a mortgage, so any increase or decrease in interest rates hits our hip pockets, big time.

What this simplistic focus avoids, is the fact that Australia has largely weathered the global financial crisis which has decimated the United States and Europe due to a very strong domestic banking system, a government that had the courage to inject large economic stimulus when it was needed, and a decisive central bank prepared to adjust interest rates when prevailing economic conditions demand it to do so.

Australia has also weathered the storm because, as a society, we have recognised that money is no longer cheap. That’s why household savings rates are at an all-time high, why Aussies aren’t splashing their hard-earned cash on plasmas, or are choosing to renovate their homes rather than buy new ones. Australians get it, we’re not stupid.

The funding costs of the major Australian banks and other mortgage lenders have forever changed as a result of the global financial crisis. The cost of money is now significantly higher, whether it’s the cost of borrowing between banks, the cost of retail deposits which banks raise from their customers, or the cost of money raised through the process of securitisation - which in simple terms is the cost of raising money by lenders from investors in the debt capital markets.

The misconception…

There is a general misconception that changes to the RBA cash rate have an immediate and direct knock-on effect on the variable interest rates underpinning our home loans. In reality, the RBA cash rate merely represents a trend line, one of many inputs which ultimately influence home loan interest rates.

Among the other factors which influence the setting of home loan interest rates, are:

  • Increasing funding costs for borrowing money from overseas markets;
  • Competition for retail deposits among banks;
  • Increased regulation for banks to hold sufficient capital to secure their loan books and therefore protect the interests of deposit holders and shareholders; and continuing volatility and uncertainty of macroeconomic conditions, particularly in the Eurozone.

Australia currently lacks the ability to fund its lending activities (including home loans, commercial property loans, and loans to small business) entirely through domestic sources such as retail bank deposits, so our financial institutions are at the mercy of overseas markets. The interest rates our mortgage lenders pay for raising money offshore don’t change just because the RBA makes an announcement. About 40% of the major banks’ funding is sourced from offshore, hence the RBA cash rate is not the sole determinant of their cost of funding, it is simply one of many inputs.

What needs to change…?

So where does this leave us? Yes, it’s encouraging to see Glenn Stevens acknowledge that he doesn’t expect home loan interest rates to come down by the same number of percentage points as the RBA cash rate, but surely this just reinforces the misconception that the expectation should be there in the first place?

More emphasis needs to be placed on the complete range of factors which influence home loan interest rates in Australia, rather than with the false obsession that the RBA cash rate is all that matters.

Australians deserve better than that. Politicians please take note. Stop focusing on the lowest common denominator. Give us all some credit, we’re smarter than that.

Patrick Tuttle

About Patrick Tuttle

Patrick Tuttle was a respected leader in the Australian residential mortgage and consumer lending market, and within the broader financial services and securitisation industries. As Co-Group CEO, Patrick was responsible for all aspects of the Pepper Group's Australian, European and Asian consumer lending and loan servicing activities, including the development of the Group’s short and long term strategic direction in collaboration with his Co-Group CEO (Mike Culhane), creating and implementing the Group’s business plan and achieving targeted profitability.<\/p>