Submission to the Inquiry into Competition within the Australian Banking Sector 4. Lending Rates

Banks' interest rates on all of their loan products have risen relative to the cash rate since mid 2007 (Graph 17). The sizes of the increases have varied considerably across the different loan types, reflecting factors such as changes in the banks' perceptions of the riskiness of the borrower as well as the speed and magnitude by which loans can be repriced. In particular, there has been a marked increase in the risk assigned by banks to lending to particular segments, at least partially arising from the increase in non-performing assets in some sectors.

4.1. Housing Lending Rates and Spreads

As mentioned in Section 2, the competitive pressures in the Australian mortgage market over the past two decades or so have seen interest spreads on mortgages decline. Between 1993 and 1998 the spread between the major banks' housing loan indicator rates and the cash rate fell from about 430 basis points to less than 180 basis points (Graph 18). This spread was steady from 1998 to 2007, as banks' overall funding costs followed the cash rate reasonably closely. Nevertheless, continued competitive pressures meant that it become commonplace for lenders to offer most borrowers a discount, which gradually increased to around 60 to 70 basis points on the indicator rate. The discounts were used by the banks to compete for new business while minimising the forgone interest of lower effective interest rates on their existing housing loan portfolios. As a result of discounting, the spread between the average variable interest rate paid by borrowers and the cash rate fell from 150 basis points in 2000 to 125 basis points in 2007. Since 2007, reflecting the rise in funding costs, the average full-doc housing indicator rate at the major banks has increased by about 120 basis points relative to the cash rate.

The range of interest rates that lenders charge on variable housing rates varies considerably. While the advertised packaged rate on variable rate loans for the major banks averages 7.1 per cent, the range between the highest and lowest advertised rates is 35 basis points. Likewise, the advertised interest rates charged by a wider range of institutions varies between 6.9 per cent to 7.5 per cent. As well as interest charges, most institutions levy fees on these loans, including setup, servicing and exit fees. On a $250,000 mortgage held for up to three years, for instance, these fees are estimated to add, on average, about 30 basis points a year. By individual lender, however, the fees range from a few to over 50 basis points, making comparisons of effective interest rates difficult (Graph 19).

International comparisons of interest margins on housing loans are difficult, as the nature of the standard mortgage product differs substantially across countries and there is often discounting of posted rates which are difficult to track. In some countries, including Australia and the United Kingdom, variable-rate loans predominate, whereas in New Zealand and Canada, fixed-rate loans of between two and five years are more common; in the United States and some European countries long-term fixed-rate mortgages predominate. The features offered on housing loans also differ significantly across countries; for example, loans with redraw facilities and flexible repayment structures are relatively uncommon in many continental European countries.

Notwithstanding the difficulties in making comparisons, the available evidence suggests that spreads to policy rates on variable full-doc housing loans in Australia are around the middle of the range of those in most other advanced countries (Graph 20). These spreads are particularly high in the United States at present, although variable-rate loans make up a small share of the US mortgage market. Likewise, there has been a sizeable increase in housing loan spreads in the United Kingdom, where bank funding pressures have been particularly severe. Spreads on fixed-rate mortgages in Australia are also broadly in line with those in other advanced countries.

In some countries, products are available where interest rates are, at least initially, benchmarked to market or policy rates. The mortgage rate generally tracks the benchmark subject to certain clauses, such as a floor on the mortgage rate if the benchmark falls below a certain level. While ‘tracker’ or benchmarked products can provide informational benefits for borrowers and potentially provide lenders with a smoother margin on their mortgage book, these products are not without limitations. In the United Kingdom, for example, the spread between new tracker rates and the policy rate has increased sharply, rising by more than the UK standard variable rate (Graph 21).

The Australian housing loan market is characterised by relatively limited use of fixed-rate loans by international standards. Historically, more than three-quarters of housing loans have been written with a variable interest rate, and most of the remaining share have rates that are fixed for less than five years. While Australian households will, as a result of this behaviour, generally bear more interest rate risk on their mortgage debt compared to households in other countries, this is partly offset by providing households with greater flexibility. In particular, when interest rates fall to low levels, many households tend to take the opportunity to make additional principal repayments. In contrast to variable-rate loans, fixed rate loans almost always have restrictions on prepayments. The greater prevalence of variable-rate loans in Australia is, in part, likely to be influenced by the fact that these loans provide borrowers with greater flexibility in making prepayments, with Australian borrowers valuing this feature, given that owner-occupier interest payments are not tax deductible as they are in a number of other countries.

Also, the greater prevalence of variable rate loans increases the effectiveness of monetary policy, as the bulk of households is affected quickly by changes in interest rates. This means that, other things equal, the Reserve Bank needs to move the cash rate less than might otherwise be the case.

4.2. Business Lending Rates and Spreads

Similar to the behaviour of banks' housing indicator rates, banks' small business indicator rates roughly tracked movements in the cash rate between 1998 and 2007 (Graph 22). However, the spread between the actual rate paid by small businesses and the cash rate narrowed over this time. Partly this was because small businesses increasingly obtained credit by borrowing secured against residential property, rather than obtaining an unsecured loan, thereby paying a lower interest rate. It also partly resulted from a decrease in risk margins charged by lenders.

Since the onset of the global financial crisis, banks' business lending rates have risen relative to the cash rate, reflecting a combination of higher funding costs and a reassessment of risk margins. The sizes of the increases have varied considerably across the different loan types, however, reflecting factors such as changes in the banks' perceptions of the riskiness of the borrower, the speed at which loans can be repriced, and the sensitivity of the borrower to changes in lending rates. Furthermore, even for similar products, there has been a marked increase in the range of interest rates offered by banks. In November 2010, the range between the highest and lowest rate offered by the major banks on a residentially secured small business loan was around 120 basis points, compared to 35 basis points in June 2007 (Graph 23).

The major banks' variable indicator rates on small business lending have risen by around 220 basis points relative to the cash rate since mid 2007, and some individual borrowers may also have faced additional increases in risk margins. The higher indicator rates have flowed through immediately to new and existing variable-rate loans. For fixed-rate loans to small businesses, which account for about one-third of outstanding lending, spreads over swap rates on new loans have generally risen by 140–155 basis points. Overall, interest rates on outstanding (fixed- and variable-rate) small business loans have increased by about 170 basis points relative to the cash rate since mid 2007.

There can be considerable variation in interest rates across large businesses, as banks base their pricing on the characteristics of the individual borrower. Banks increased their spreads (over bank bill rates) on new loans from mid-2007, due to their higher funding costs and a pick-up in arrears and losses on business lending. The available evidence suggests that the average spreads on new term loans to large businesses increased by about 200 basis points, from around 50–100 basis points in mid 2007 to a peak of around 250–300 basis points in mid 2009. Since then, spreads on new loans have declined a little, although the average margin on outstanding loans has continued to rise slowly as margins on new loans are still above those on existing loans (Graph 24). For bill facilities, which have a shorter average maturity of around one to two years, the recent reduction in margins on new loans is already flowing through to lower average margins. Overall, the average interest rate on outstanding (fixed- and variable-rate) large business loans is estimated to have risen by about 100 basis points relative to the cash rate since mid 2007.

4.3. Summary

The above changes have resulted in an increase in the spread between lending rates and the cash rate. All else equal, this means that a given level of the cash rate is more restrictive than has been the case over the previous decade. While the cash rate is well below its average since end 1996, rates for both small and large businesses are a little above their averages (Graph 25). The Reserve Bank Board has taken this into account in its monetary policy decisions.