Here's why Australia's big banks could justify raising mortgage rates

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  • UBS bank says higher funding costs may now be a “structural feature” of the Australian market.
  • The bank’s Australian economics team says the big four banks would be “arguably justified” in raising mortgage rates by 0.10-0.15%.
  • Any move by the big banks would follow other lenders including Macquarie and AMP, which have raised rates to offset higher funding costs.

  • Higher funding costs for Australian banks may be here to stay, UBS says.

    The rising cost of capital in the domestic banking market has already forced smaller lenders to raise mortgage rates to alleviate margin pressures.

    And the shift has been accompanied by an increasing amount of analyst speculation about a). What’s causing it; and b). Whether the big banks may follow suit and raise rates themselves.

    The Australian economics team at UBS said the recent combination of forces pushing up funding costs may represent a “structural change” in market pricing for the domestic market.

    In view of that, the analysts said that a move by the big banks to offset those costs and raise rates is now “arguably justified”. Any additional rate rise would likely be in the vicinity of 10-15 basis points (0.10-0.15%).

    Earlier this year, widening spreads between benchmark interest rates and the rates banks charge each other for short-term lending appeared to be a global problem.

    But as this chart from UBS highlights, funding pressures elsewhere have eased while rate spreads in Australia remain elevated:

    Liquidity pressures

    UBS said one reason that higher funding costs may now be a “structural feature of the Australian market” is the ongoing credit-deposit gap faced by domestic banks.

    It’s not the first time it’s happened. Such a scenario also occurred in 2016, but that was caused by a rapid rise in credit growth. Now credit growth is slowing, but deposits are slowing even faster.

    On the retail side, the analysts highlighted that Australia’s household savings rate — “a key driver of deposits growth” — is now at a decade-low of 2.1%.

    The slowdown may also have been exacerbated by more people switching back into principal & interest loan repayments as interest-only loan terms expire.

    Meanwhile, corporate deposits have also been in decline. UBS attributed that trend to a decline in cash deposits held by managed investment funds, which are now at their lowest level since 2008.

    And earlier this month, JP Morgan cited another factor pushing the credit-deposit gap higher: ongoing government bond issuance as the federal budget moves back into surplus, which effectively causes funds to drain out of the private sector.

    Add it all up, and the funding gap (credits less deposits) has now risen to a record-high of $444 billion:

    Wholesale funding markets

    “With a record funding gap and slowing deposits growth, Australian banks have been more reliant on sourcing funding through wholesale markets,” UBS said.

    However, various factors are causing the Bank Bill Swap Rate (BBSW — the inter-bank lending rate for short-term finance) to remain higher than the Overnight Indexed Swap rate (OIS — derived from benchmark cash rates).

    “The persistence of higher BBSW-OIS spreads seems likely to be at least partly related to the rise in cross currency basis,” the analysts said.

    Australian banks raise part of their funding requirements in offshore markets, most of which is in US dollars. The cross-currency (XCCY) basis is the cost of bringing principal & interest payments made in US dollars back into AUD.

    As the chart below shows, the XCCY basis “has lifted to very elevated levels”.

    So while Aussie banks still need to raise funds offshore, “it remains cheaper to fund domestically than in the US, because of the high cost of bringing the funds back to AUD,” UBS said.

    And there’s another problem: the Bank of Japan, which indicated earlier this week that it may be considering a shift in its ultra-easy monetary policy settings.

    That could act as a catalyst to push Japanese rates up, which in turn would make domestic investments attractive for big Japanese capital flows that are currently invested offshore.

    “Debt issuers have much to be thankful for when it comes to Japan and the monetary policy stance,” ANZ senior rates strategist Martin Whetton said in a research note this afternoon.

    “Australian banks and corporates have been able to use the cross currency basis flow to issue in foreign currency, particularly USD.”

    However, reduced Japanese demand “would add to the costs of funding for these borrowers”, Whetton said. “For banks, this would be a significant new imposition.”

    Another feature of the market for bank funding costs is that upward pressure on the BBSW is usually exacerbated at the end of each quarter, as banks move to lock in funding for the next three months.

    So, will the banks raise rates?

    “Given the current political sensitivities and the decline in BBSW into mid-quarter, it is a finely balanced decision and the banks may decide to absorb” some of the hit to margins, UBS said.

    The analysts added that a rate hike of 10-15 basis points by the big banks also needs to be considered in the context of a market which has generally seen falling interest rates over the last few years.

    However, the prospect of potential rate increases “is another incremental negative for the housing market at a time when there are no shortages of potential drags”.

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