Submission to the Inquiry into Competition within the Australian Banking Sector 3. Funding Mix and Cost ^[6]

Australian banks source their funding from deposits as well as domestic and global capital markets. As a result, their funding costs are affected by a range of financial market factors.

For the decade or so until mid 2007, relatively stable financial market conditions meant that spreads on the banks' various sources of funding changed little (Graph 9). As a result, movements in banks' overall cost of funds tended to follow those in the cash rate.

From the middle of 2007, banks' funding costs rose relative to the cash rate, mainly due to large increases in the cost of deposits and long-term wholesale debt as a result of the global financial crisis. The effect of these changes on banks' overall funding costs has been accentuated by a shift in banks' funding mix towards these more expensive types of funding.

3.1. Composition of Banks' Funding

Banks operating in Australia have diverse funding bases, with most funding sourced from deposits, short-term and long-term wholesale debt. The funding mix differs somewhat across banks, however, with the major banks having slightly larger shares of deposit funding and long-term wholesale debt, but make little use of securitisation, compared with the banking system as a whole.  The regional banks generally have a slightly smaller share of deposits than the major banks, but make greater use of securitisation and less use of offshore funding. Foreign-owned banks have fewer deposits and correspondingly source more funding from domestic and offshore capital markets (Table 2).

The funding mix of banks in Australia was fairly stable during the few years leading up to the onset of the global financial crisis in mid 2007. As a result of a reassessment of risk, together with regulatory and market pressures, banks in Australia have increased their use of deposits (particularly term deposits) and long-term debt, as these funding sources are perceived to be relatively stable. On the other hand, they have reduced their use of short-term debt and securitisation (Graph 10). Moreover, as the larger banks have replaced the market share of lenders that relied more on securitisation, this has seen the funding of the banking sector as a whole more closely resemble the funding structure of the larger institutions.

The regional banks have experienced the largest increase in the deposit funding share, while the major banks have also increased their use of deposit funding. In contrast, the foreign-owned banks have experienced little change in the proportion of funding coming from domestic deposits.

The share of funding sourced from long-term wholesale debt (domestic and foreign) for the overall banking system has increased by 7 percentage points since mid 2007 to almost 25 per cent, with all of the main groups of banks increasing their use of this funding source. At the peak of the crisis, during late 2008 and the first half of 2009, the banks mainly issued government-guaranteed bonds, but as market conditions improved throughout 2009, the major banks increasingly issued unguaranteed bonds.^[7]

The increase in the share of funding sourced from deposits and long-term debt has facilitated a decline in the share of funding sourced from short-term wholesale debt (domestic and foreign). The share of securitisation has also fallen since the onset of the financial crisis, as the amortisation of the outstanding stock of RMBS generally continues to exceed new issuance.

The major and regional banks have also bolstered their balance sheets by raising equity, through a combination of retained earnings and share placements, mainly in late 2008 and during 2009. For the banking system, the share of equity in total funding liabilities has increased by about 1 percentage point since mid 2007 to about 7 per cent.

3.2. Cost of Funding

The cash rate remains a major influence on banks' funding costs, providing the anchor point for the yield curve. However the global financial crisis and its ongoing effects have caused the costs of banks' main sources of funding to rise relative to the cash rate. The increases have been particularly large for deposits and long-term wholesale debt.

3.2.1. Deposits

Competition for deposits in Australia has intensified since around mid 2008, resulting in a significant increase in deposit rates relative to market benchmark rates. Overall, the average cost of the major banks' new deposits has risen noticeably relative to the cash rate; it is estimated to be currently only slightly below the cash rate, whereas prior to the onset of the financial crisis, deposit costs were about 150 basis points below the cash rate (Graph 11).

Within the deposit market, competition has been strongest for term deposits. The average rate on banks' term deposit specials – the most relevant rate for term deposit pricing – is currently more than 70 basis points above market rates for debt of equivalent terms. In the few years prior to the global financial crisis the average rate was generally about 60 basis points below. For the major banks, the rates on their longer maturity term deposits have generally been higher than the yields on their unguaranteed bonds of equivalent maturity over the past year (Graph 12). The regional banks are likely to have seen a slightly larger increase in their average deposit costs than the major banks, reflecting their greater use of term deposits.

Rates on at-call savings deposits – including bonus saver, cash management and online savings accounts – have also risen relative to the cash rate (from which these deposits are priced). The average rate on the major banks' at-call deposits, which account for a little under half of their total deposits, is currently estimated to be around 40 basis points below the cash rate, compared with around 100 basis points below in mid 2007.

3.2.2. Wholesale debt

For several years up to mid 2007, the major banks were typically able to issue 3-year bonds in Australia and offshore at an overall spread (including the hedging costs on foreign currency debt) of around 50 basis points over government bond yields (Graph 13). Since then, spreads on banks' bonds have risen significantly, as has the cost of hedging foreign currency debt back into Australian dollars.^[8] The overall cost to the major banks of issuing new 3 year bonds peaked in late 2008 at about 220 basis points over government yields for debt issued in Australia and at about 280 basis points for debt issued offshore. The improvement in capital market conditions over the past year has seen the cost of issuing new onshore 3-year debt fall to around 120 basis points above government bond yields in recent months. However, banks have continued to lengthen the maturity of their bond funding by issuing at longer tenors. The average maturity of issuance over this period has been around 4½ years, at an average spread of about 170 basis points including hedging costs.

Since mid 2007, the average cost of the major banks' outstanding long-term debt is estimated to have risen by about 100 basis points relative to the market's expectation for the cash rate. But these higher spreads have only affected banks' new bond issuance, not their outstanding stock of debt that was issued prior to the onset of the financial crisis (about 20 per cent of the current stock outstanding). If bond spreads and hedging costs remain around their current levels, then as maturing bonds are rolled over, the average spread on banks' outstanding long-term debt is estimated to increase by a further 15–20 basis points over the next year. Given that long-term debt is around 25 per cent of banks' overall funding, this translates into an increase in total funding costs from this source of around 5 basis points over the next year.

The regional banks, which are smaller and have lower credit ratings than the major banks, have experienced an even larger increase in the cost of long-term wholesale debt, though it is a smaller share of their total funding. Prior to the onset of the financial crisis, regional banks were able to issue 3-year bonds at an estimated overall spread of about 40–50 basis points over bank bill or swap rates, compared to current indicative spreads of about 150–200 basis points.

Short-term wholesale debt accounts for about one-fifth of banks' funding, and is priced mainly off 1 month and 3 month bank bill rates. Prior to mid 2007, bank bill rates closely tracked the market's expectation for the cash rate (the overnight indexed swap or OIS rate) with the spread between 3 month bank bills and 3 month OIS remaining stable at around 10 basis points (Graph 14). While the onset of the global financial crisis saw bank bill rates rise well above OIS rates, the sizeable risk premium has now largely dissipated. Hence, major banks' short-term capital market debt is currently only about 10–15 basis points more costly relative to the expected cash rate than it was in mid 2007.

RMBS account for a negligible share of the major banks' funding, but are reasonably important for the smaller financial institutions. The cost of new securitisation funding has risen significantly since the onset of the global financial crisis (Graph 15). Spreads on RMBS are similar for the different types of banks (and also for non-banks). This means that securitisation is relatively more cost effective for the smaller banks, given that spreads on their on-balance sheet wholesale debt (particularly long-term debt) are much higher than for the major banks.

The major and regional banks also issued a significant amount of new equity and hybrid securities during late 2008 and 2009 to further strengthen their balance sheets and support lending growth. This additional capital was expensive for the banks, as their share prices were relatively low through much of this period, and spreads on hybrid securities have increased markedly since mid 2007. While this has had only a modest impact on overall funding costs given their small shares in total funding, it has contributed to the recent decline in their return on equity.

3.3. Overall Funding Costs

Taking into account the costs of individual funding sources noted above, and weighting them by their share of total bank funding, allows an estimate of the overall change in banks' funding costs. Since mid 2007, the higher cost of deposits has made the largest contribution to the overall increase in funding costs, reflecting their large weight in total funding and the 125 basis point rise in deposit rates relative to the cash rate. Long-term wholesale debt has also made a substantial contribution to the increase in the major banks' overall funding costs, while the cost of short-term wholesale debt initially rose relative to the cash rate but is now much closer to pre-crisis levels. In aggregate, it is estimated that the average cost of the major banks' funding, at the time of writing, is about 90 to 100 basis points higher relative to the cash rate, than it was in mid 2007 (Graph 16).

Most of the increase in the major banks' funding costs occurred during 2008 and early 2009, at the peak of the dislocation in markets. Since mid 2009, the major banks' overall funding costs are estimated to have moved broadly in line with the cash rate, reflecting offsetting factors. The continued upward pressure on longer term funding, as bonds issued pre-crisis are rolled over at higher spreads, together with a small increase in the cost of term deposits, has been broadly offset by a decline in the relative costs of short-term wholesale and fixed-rate funding.

The available evidence suggests that the overall 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 mainly reflects the larger rises in the cost of the regional banks' deposits and wholesale debt funding, and the large switch in their funding mix from securitisation to deposits (which are currently a relatively expensive source of funding).

Footnotes

See also Brown A, M Davies, D Fabbro and T Hanrick, (2010), ‘Recent Developments in Banks' Funding Costs and Lending Rates’, RBA Bulletin, March. [6]

For more details on banks' bond issuance see Black S, A Brassil and M Hack, (2010), ‘Recent Trends in Australian Banks' Bond Issuance’, RBA Bulletin, March, and for details on the wholesale funding guarantee see Schwartz C (2010) ‘The Australian Government Guarantee Scheme’, RBA Bulletin, March. [7]

The rates on new bonds are estimated using secondary market yields and cross-currency interest rate swap spreads for the relevant maturity on the day of issuance. [8]