RDP 9504: The Link Between the Cash Rate and Market Interest Rates 5. Conclusion

For changes in the cash rate to have an effect on economic activity and inflation, the changes must be passed through to market interest rates. For some interest rates, the pass-through is complete and often instantaneous, while for others, the pass-through is slow and less than complete. In markets where competition is weak and where customers' decisions are not very interest-rate sensitive, changes in the cash rate have relatively little effect on interest rates. There is also sometimes only a small effect on interest rates and yields on long-term deposits and securities. For these rates, the pass-through depends very much on how movements in the cash rate affect the outlook for future changes in the cash rate and inflation.

Given the importance of banks in the financial intermediation process, the reaction of bank lending rates to movements in the cash rate is particularly important. In the early 1990s, as the cash rate was reduced, lending rates did not fall one-for-one, and as a result, the spread between lending rates and the cash rate widened. In late 1994, this spread narrowed again, but at the end of 1994 it remained above the average level of the late 1980s.

Determining the relative importance of the various factors driving changes in bank lending margins is a difficult task, for the various factors are not independent of one another. Bank profitability was significantly reduced in the early 1990s, reflecting high bad debts expenses, but also an adverse change in the structure of the bank's liabilities. To some extent, the effects of these developments were not fully reflected in bank profitability due to the increased spreads between lending rates and short-term money-market interest rates.

In the early 1990s, the relatively large spreads between loan rates and short-term money-market rates meant that, at the margin, bank lending (in particular, housing lending) was highly profitable. In response, banks competed aggressively for new loans, but attempted to maintain the profitability of existing loans by offering lower margins only to new borrowers. This saw a number of new providers of finance enter the market and offer the same discounted interest rate to all customers. While it took some time for these new entrants to become established, they have now gained a small market share and provide potentially important discipline on the rate-setting behaviour of the existing institutions. The willingness of customers to switch to these new providers and to switch banks to take advantage of discounts for new customers has also placed downward pressure on lending spreads.

These new providers of finance have less of a competitive advantage as market interest rates move up. Banks have access to retail deposits whose interest rates are relatively insensitive to changes in the cash rate. When market interest rates are low, the benefit of the retail deposit base is small and, as a result, spreads at the margin tend to be higher. As market rates rise, the benefit gained from the retail deposits increases. This allows banks to reduce the spread between loan rates and money-market rates and, in doing so, put more competitive pressure on the new entrants who rely much more heavily on funds that attract money-market rates.

Nevertheless, in the medium term, if new entrants have lower operating costs than the traditional providers of housing finance, lending margins should continue to narrow over time, as the new lower-cost firms attract an increasing market share. The challenge for the traditional institutions is to reduce their operating costs, so that their return on equity can be maintained despite the narrowing of margins. Ways to do this include removing cross-subsidies between lending and payments functions and implementing more efficient fee structures. In the medium-term, the entry of new institutions that directly link their loan rates to money-market interest rates, can also make it more difficult for intermediaries to provide loans whose variable-rate interest rates do not move closely with money-market rates. This suggests that over time, variable rate lending rates will come to move more in line with changes in the cash rate.