On the wrong track?
Australia’s financial regulator has clashed with the big four banks over their refusal to offer tracker mortgages. However, Associate Professor David Tripe and Dr Mamiza Haq argue that trackers could lead to trouble ahead for both banks and customers alike.
As banks’ financial statements can be difficult to understand, it is not always obvious how their costs change when central bank rates change.
In October 2016, a small Queensland bank caused a big stir in Australia’s financial circles. Auswide Bank became the first in the country to offer a tracker mortgage – a home loan with an interest rate tied to the Reserve Bank of Australia cash rate, rather than a rate set by the bank.
The launch of the RBA Rate Tracker was all the more remarkable given that just weeks earlier, the big four banks had publicly stated that tracker mortgages would be unpopular because of the amount they would have to charge.
Auswide’s move was welcomed by Australia’s top financial regulator who disputed the big four’s claims and called for them to follow suit. Greg Medcraft, chairman of the Australian Securities and Investments Commission (ASIC), said trackers would ‘give customers greater trust and confidence in rates’ and allow them to switch mortgages more easily.
But which side is correct? And if tracker mortgages do provide a fairer deal, should other banks be forced to offer them – even though Mr Medcraft has held back from proposing legislation?
When a central bank such as the RBA adjusts its interest rates, you may expect that rates on loans and deposits would follow suit. This is one of the principles that underpin central banks’ decision making. However in practice it does not always happen as there are other factors which affect what banks pay, including supply and demand and conditions in international markets. Like other businesses, banks also try to preserve their profit margins.
As banks’ financial statements can be difficult to understand, it is not always obvious how their costs change when central bank rates change. In fact very little of a bank’s funding is acquired at the central bank’s rate, and any changes may have a very indirect and delayed effect on banks’ costs so sometimes they delay changing their interest rates, if they do so at all. At other times, the change in the central bank’s rate may reflect funding costs in the markets, so banks respond quickly and may even adjust rates by larger amounts.
Tracker rates were introduced in response to this uncertainty and to avoid disgruntled customers. Auswide Bank’s tracker, for example, offers a variable interest rate of 3.99% per annum (comparison rate 4.01% per annum), however the loan has a ‘floor’ - if the RBA cash rate falls to 0% or below the customer will continue to pay the fixed margin.
Trackers have often been introduced at times when interest rates are rising, or significantly higher than at present, so the cost for banks of making such adjustments has been relatively small.
However a fundamental problem is that underlying base interest rates don’t all move together. One example is the UK where, in the years before the global financial crisis (GFC), HSBC, Barclays, Lloyds Bank, Santander and Nationwide all introduced trackers tied to the Bank of England base rate.
However these products proved more attractive for customers than for the banks, particularly after the GFC. As the Bank of England’s base rate fell in the wake of the crisis, banks’ funding costs failed to keep pace. A key problem is that banks have not felt able to reduce interest rates on deposit accounts to the same extent, as to do so would force them into negative territory – effectively meaning they would have to charge customers for holding their money.
Australian banks have had exposure to different trends than the UK, but they have still faced events that upset the relationship between the RBA cash rate and interest costs. Since the onset of the GFC in 2007/08, banks raising funds in international markets have often had to pay a premium of 1% or more above central bank rates.
In response, banks have competed more aggressively for deposits in local markets, which has resulted in an increase in the cost of deposits and overall funding relative to the RBA benchmark. The situation has been aggravated by the new Basel III rules, which encourage banks to seek deposits for longer periods, and take them from households and businesses rather than raising funds in international markets.
Even though the RBA cash rate has not fallen to the level in the UK, the situation is similar in that interest rates on deposits and the cost of bank funding have not moved down by the same amount. Banks introducing tracker rates would do so at their peril, and would risk losses on their lending if the RBA’s cash rate were to fall significantly. Although Auswide Bank may be enthusiastic at the moment, it is hard to see it persisting with such a product should the cash rate fall further.
The best response for policy makers is not to insist that banks adopt tracker rates, but to do nothing at all. If the banks were made to adopt tracker mortgages in the current climate when interest rates are low, they would be likely to lock in higher margins than they would otherwise. If Reserve Bank rates fall, it could still cause them significant hardship. However when interest rates rise again as they will in due course, it would give them windfall gains at the expense of borrowers.
Dr Mamiza Haq is a Lecturer in Finance at UQ Business School
David Tripe is Associate Professor of Economics and Finance at Massey University, NZ