When the major banks announced last month they were increasing their home loan rates by more than the RBA's rate rise there was, understandably, a considerable level of disappointment over what many considered to be excessive rate increases.
With the average Australian family already struggling under a heavy home loan debt burden many feared the latest rate rises would place even more households under severe financial stress.
As the tables below show someone with a $350,000 variable rate home loan over twenty five years would have been $57 worse off per month if the banks had matched the RBA increase but, because rates jumped by more than the RBA's 25 basis point move, borrowers are instead between $80 and $103 worse off - considerably more than otherwise could have been the case.
Major bank standard variable home loan rates
Major bank standard variable home loan rate if they matched the Nov RBA increase
And when you consider that around one-third of the seven million households in this country have a mortgage (with the vast majority of these being variable rate loans) it's no wonder there was such an outcry. And let's not forget the other one-third of households who are renting. Their dreams of home ownership are evaporating fast with high property prices and ever increasing home loan costs to contend with.
As a result of the banks' decisions there's been much discussion and debate about why the banks took the actions they did especially since they knew there would be a considerable public and political backlash. Put simply I think there are two reasons why they did what they did - because they could and according to them, because they had to.
Because they could
Variable rates are variable
It might seem pretty obvious now but banks (and any other lender for that matter) can legally (unless there's a contractual obligation preventing it) increase, decrease or maintain their variable rate pricing as they see fit. While they have the legal right to do this in practice the banks have historically followed and matched the RBA's lead and as a result most borrowers expect and accept rate increases and decreases on this basis.
Over recent times however the banks have moved away from this norm and variable rate borrowers may now need to brace themselves for movements independent of and in addition to increases the RBA may instigate.
Lack of competition
While banks are able to raise their rates from a legal standpoint, they can, importantly, also do so from a competitive one as well. Australia's four pillar banking policy has supported and sustained an oligopoly (that is, a market controlled by a few large suppliers like our grocery market which is dominated by Woolworths, Coles and Franklins) - something I previously alluded to in my earlier column Beyond The Banks.
This policy is a double edged sword. On the plus side we have a very strong banking sector which for instance, helped protect our economy when the global financial crisis hit. On the flip side however, it doesn't do much for competition, choice and of course cost.
Existing smaller players and new entrants are finding it difficult, if not impossible to match the big banks' marketing spend and get access to funding lines on similar terms as the banks (with corresponding pricing, profit and growth constraints).
As a result the banks have, as illustrated in the table below, maintained their domination of the home loans market and today still collectively control around 90% of all loans written. Furthermore, as the above tables show, home loan pricing (ex NAB) is pretty much the same so there's not necessarily a huge advantage swapping between one bank and another - and as far as the NAB is concerned, there's no guarantee it will hold its rate differential indefinitely.
Source: ABS Housing Finance Commitments Sep 2010
Because they have to
Increased funding costs
Turning to the other reason, one of the main causes cited for above RBA rate increases by the majors is that their cost of funds has increased post global financial crisis. That is, their long-term funding which is now maturing and accounts for a large part of their borrowings has gone up considerably as the capital market is now demanding a higher return due to perceived higher risk.
While most agree and accept that funding costs have increased, there is a question (as yet unanswered) as to by how much and consequently there is some debate about whether the bank's rate increases truly reflect increased costs. For instance, the banks fund their loans from a number of sources, including short-term borrowings and from depositors, which may or may not have moved in line with their long-term funding costs.
Profit growth
The second reason the banks had to increase their rates is because they're in the business of making money for their shareholders. And because home loans comprise a significant portion of their income producing assets they must ensure revenue from this asset class is growing - which they can do by writing more business and/or increasing the net revenue these assets generate.
Furthermore, shareholder expectations have been set with the banks producing record profits individually and collectively over the past few years including the majors generating over $20 billion in cash profits during the last reporting season. Shareholders are demanding good dividend yields and sustained capital growth which can only be achieved by ever increasing profits. This means that the banks net lending margin will have to be at least maintained, if not widened, and hence there's not likely to be much respite for the average home loan borrower in the near term.
Competition as a solution
Many pundits, including the government, believe increased competition will result in lower mortgage rates. In theory this is true (remember that's how the old wholesale funders like RAMS, Wizard and Aussie took market share away from the banks until the majors responded by buying all or part of them and taking them out of the market) but achieving this in practice is somewhat problematic given the bank's competitive stranglehold.
In the short-term the banks' real competition could come from the mutuals - the building societies and credit unions. They, collectively, have the strength to take them on and would be a popular choice among borrowers and savers alike because unlike the banks the mutuals use their profits for the benefit of their customers through lower home loan costs and higher savings rates. Individually though, they have no hope of competing with the banks because of their size, financial strength and ability to access long-term funding unless for instance, they work collaboratively and/or get some form of government assistance.
Interestingly recent reports indicate the government is considering the mutuals as part of a fifth pillar policy and is considering options to help them grow and compete, including providing some form of government guarantee to help them raise long-term funds. This would be a welcome development but for it to work there'd have to be significant changes in the way mutuals operate (for instance they may have to be more willing to deal with brokers) and they'd have to invest in their systems and processes to ensure they could cope with (hopefully) significant loan volume increases.
Other options
While looking at ways to increase competition should be applauded there are steps the banks could take to help build customer loyalty and alleviate some of the adverse effects of rate increases. Here are some suggestions:
Stop subsidising new borrowers
In order to entice new borrowers banks offer incentives like discount and honeymoon rates. While any schemes that help lessen the burden for borrowers is welcome, especially first time borrowers, the unfortunate fact is that existing borrowers tend to subsidise new borrowers. It seems almost perverse that a loyal existing customer should be paying more than a new customer and so a more equitable pricing scheme should be introduced that places all borrowers on equal footing. This might make it a little more difficult for new borrowers but if overall rate reductions could be passed on, it could better for everyone as a whole.
Reward loyalty
It's in the banks' interests to keep their customers for as long as possible so why not offer something that rewards loyalty? For instance, a program of annual rate reductions (say a 1% reduction over three to five years subject to satisfactory account conduct) would be welcome by most borrowers and would not only motivate them to keep up their repayments but stick with their lender as well. Furthermore, there'd be no need for banks to charge hefty exit fees on variable rate loans to keep customers and/or cover discounted new business rates. All of these would be big financial and PR wins for the banks.
Fix variable rate margins
To overcome borrower uncertainty over the timing and extent of interest rate movements the banks could price their variable rate loans at a fixed margin over the RBA's cash target rate. For instance, the margin might be 2% which in today's terms, would set the pricing for a variable rate loan at 6.75%. Borrowers would then have the comfort and certainty knowing that for the life of their loan their mortgage repayments will go up and down exactly in line with RBA movements.
Price for risk
The banks market their home loan products on a one-price-fits-all basis meaning there's no pricing for risk other than on a mass market basis. Again, good customers will be subsidizing more risky customers. Consideration could be given for rewarding lower risk customers with lower rates. On the flip side however, this would mean those perceived as greater risk may have to pay a little more unless and until their risk profiles improve.
Stop paying brokers
A somewhat controversial suggestion (since brokers supply banks with around 40% of their new business) but if brokers earned their income by charging borrowers on a fee-for-service basis lenders wouldn't have to pay trail commissions.
These savings could be passed on in the form of lower home loan rates meaning borrowers could save a considerable amount in interest costs. For instance, using the $350,000 loan example above, a 25 basis point interest rate reduction (reflecting the ongoing trail commission a broker could receive) would save around $57 a month or over $17,000 in interest over the life of the loan - something a borrower might consider is worth paying a broker a reasonable upfront fee for.
Is more competition the answer to the banks' domination of the home loans market? Do you think the mutuals can compete with the big banks? What should the banks be doing to look after their existing and new home loan customers? (Share your views below)
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