Since the removal of the regulatory ceiling on the mortgage rate in 1986, movements in the mortgage rate have largely tracked movements in the banks’ funding costs, except for a period of 4-5 years during the mid-1990s when competition among the major banks (initiated by the CBA) and from new entrants to the mortgage market led to a significant narrowing in banks’ margins on mortgage loans (although this was partly offset by the introduction of new fees and increases in existing fees).

From 1990 onwards, when the Reserve Bank began announcing changes in its cash rate, the cash rate was taken as a rough proxy for banks’ cost of funds; and except when markets were pricing significant rises or falls in the cash rate, this proxy was reasonable. Overt and covert political pressure (especially from Peter Costello when he was Treasurer) used to ensure that the timing of changes in mortgage rates was closely linked to the timing of changes in the cash rate.

When rates were coming down in the early years of this decade, Costello’s office made a point of ringing round the major banks after the RBA had announced a cut in the cash rate, demanding to know when each bank was going to be announcing a cut in its mortgage rate and occasionally suggesting that if such an announcement wasn’t forthcoming before Question Time (or some other deadline) the bank in question would be the subject of adverse commentary from the Treasurer.  In late 1999, when John McFarlane mused aloud on a couple of occasions about whether ANZ might raise its mortgage rate ahead of expected increases in the cash rate (because as the market ‘priced in’ those expected increases, ANZ’s cost of funds rose), Costello on each occasion said “if ANZ puts up its mortgage rate people should change their bank”. (As an aside, after the second time that Costello responded in that manner to John McFarlane’s musings, I sent John an email suggesting that on the next occasion, John should say – since this was in the lead-up to the introduction of the GST – “does that mean if the Government puts up people’s taxes, people should change their government” – but not surprisingly John McFarlane didn’t follow up on that suggestion). One of the consequences of the global ‘credit crunch’ triggered by the sub-prime mortgage meltdown in the United States has been that the RBA’s cash rate is no longer a proxy for the banks’ cost of funds. The premium which Australian banks pay for raising wholesale market funds for periods such as 30, 60 or 90 days – which used to be of the order of 5-10 basis points (0.05-0.10 pc point) above the cash rate until roughly this time last year – has since ‘blown out’ to around 40-50 basis points (0.40-0.50 pc point); and it is this increase in the cost of funds which has been passed on to customers in the form of higher mortgage and other lending rates (in much the same way that airlines, for example, have passed on increases in jet fuel prices to customers in the form of surcharges).  Whether a future reduction in the Reserve Bank’s cash rate would be fully reflected in a reduction in mortgage and other lending rates would therefore depend on the extent to which it resulted in a reduction in banks’ overall cost of funds. (In the UK, reductions in official rates since late last year have not been reflected in lower mortgage and other lending rates, for exactly the same reason that Australian banks have raised lending rates by more than the increases in official rates). Competitive pressures and tensions would also play some role in the decisions which banks would make in those circumstances. And although it is undeniable that competition from non-bank lenders has declined over the past year (because the non-bank lenders were, in general, much more dependent on wholesale funding than the banks, building societies and credit unions), competition among the banks themselves (for market share) remains very strong. 

Peter Fray

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