Submission to the Inquiry into Competition within the Australian Banking Sector 5. Net Interest Margins and Spreads

As discussed in the previous two sections, the effects of competition and global financial market developments have had a substantial effect on the behaviour of banks' lending rates and funding costs over the past couple of decades. In addition, housing lending has increased as a share of banks' assets, and this earns a lower interest margin than business lending. In aggregate, these forces have resulted in the major banks' margins contracting from around 5 per cent in the mid 1980s to a low of about 2¼ per cent in 2008 (Graph 26). Over the past few years, margins have fluctuated within a relatively narrow range between 2¼ and 2½ per cent. Banks' margins fell to the lower end of this range early in the financial crisis as funding costs rose ahead of lending rates, but margins have since returned to around the top end of the range. There has, however, been some variation across the major banks.

The net interest margins of the regional banks have declined since the onset of the crisis, mainly reflecting the larger increase in their funding costs they have experienced, but have risen a little for some of these banks over the past year. Overall, since mid 2007, the regional banks' net interest margins have fallen by between 20–45 basis points (Graph 27).

The reported increase in the average of the major banks' net interest margins is a little less than the estimated increase in the spread between their lending rates and their funding costs (Graph 28). This is because changes in interest margins are affected by a number of factors in addition to the effects of movements in banks' lending rates and funding costs discussed in the previous two sections:

• In addition to its loans, a bank's asset portfolio also includes liquid assets and other debt securities, which tend to earn a lower average return than loans. The banks' net interest margins have been compressed by the fall in interest rates on liquid assets relative to average loan rates since mid 2007, and the increased share of liquid assets in total assets, partly in response to anticipated regulatory changes.
• Increased loan impairments have reduced net interest margins through the loss of interest on non-accrual items. This effect has been offset somewhat by higher risk margins on lending, particularly on business loans, which have had higher rates of impairment compared to housing loans.
• Banks use derivatives to hedge the interest rate risk on their asset and liabilities. The effect of interest rate derivatives on margins can vary substantially over a short period of time, although over an entire interest rate cycle, the effect of interest rate derivatives tend to balance out.
• Working in the other direction, the increase in banks' equity funding would have boosted their margins.