Investors were unfazed by news of another inquiry into the banking sector yesterday. Following fierce criticism of the failure of the big four banks to pass on the Reserve Bank of Australia (RBA) rate cuts in full, the Federal Government yesterday announced an inquiry into home loan pricing. The Australian Competition and Consumer Commission (ACCC) has been charged with conducting the inquiry into pricing of residential mortgage products, to commence immediately.
Investors appeared unbothered by the announcement, with the National Australia Bank Ltd. (ASX: NAB) share price increasing by 0.57% yesterday, while the Australia and New Zealand Banking Group (ASX: ANZ) share price was up 0.65%. The Commonwealth Bank of Australia (ASX: CBA) share price was up 0.38% by the end of the day, while the Westpac Banking Corp (ASX: WBC) share price was up 0.52%, as investors barely reacted to the news.
The RBA has cut the cash rate by 75 basis points in total across June, July, and October this year. Across the same period, the big four banks have on average cut home loan rates by just three-quarters of this amount.
Following the most recent 25 basis point cut in October, the big four announced cuts to home loan rates of between 13 and 25 basis points, depending on the loan type. A combination of the failure to pass on rate cuts in full and delays in implementing cuts is estimated by Treasury to have generated $569 million in revenue between the big four.
The focus of the inquiry
The ACCC's inquiry will focus on the period since 1 January this year, examining the pricing of residential mortgage products and obstacles that prevent borrowers from switching lenders. The enquiry will include smaller banks and non-bank lenders, but with three quarters of the market, the focus will be on the big four. Key areas of examination will be:
- how banks set interest rates on home loans, allowing for borrowing costs and profit margins
- what the differences are between headline rates and the rates customers actually pay
- whether, and how much, the prices paid by new and existing customers differ
- what barriers prevent customers from switching loan providers and how these could be removed.
A preliminary report is due on 30 March 2020, with the final report due six months later.
From the Reserve Bank's perspective, the stimulatory impact of rate cuts is muted when not passed on by banks to borrowers. Reducing mortgage rates leaves more spending money in wallets that can be used to stimulate the economy. When rate cuts are not passed on in full, the effect is less powerful.
Whilst the Federal Government and Reserve Bank have made clear they expect most, if not all, of the recent cuts to be reflected in lower interest rates, the banks have pointed to shareholders and depositors as reasons to hold back. In making choices about how much of the recent rate cuts to pass on, banks must balance the needs of multiple stakeholders.
The other side of interest rates
Our record low interest rates are hardly a positive for depositors, who are left earning negligible (if any) returns on money in the bank. As deposit rates near zero it becomes increasingly difficult to reduce the interest banks pay on this source of funds. And with interest rates at all-time lows, cuts can only go so far before they begin to threaten bank margins. The cash rate, after all, is only one component of banks' costs of lending.
Bank funding comes from a range of sources, not all of which are directly linked to the cash rate. As interest rates decrease, each 25 basis point reduction accounts for a higher percentage of the total rate, meaning the potential impact on bank profits from passing on cuts in full is greater.
Banks have to balance not only the interests of borrowers and depositors, but shareholders too. The big four have long been known for reliable dividends; certain shareholders, particularly retirees, rely on these to fund their lifestyles. Superannuation funds are also major shareholders in each of the big four.
In the wake of the Royal Commission, the big four banks have seen their return on equity drop to around 12%, the lowest level since the GFC. A reasonable level of return on investment is required not only to support shareholder investment, but to support credit ratings. Credit ratings, in turn, influence the rate at which the banks can access wholesale funding, which then impacts the rates at which banks can lend to retail customers.
Any decision regarding interest rates involves a delicate tight rope walk balancing the needs of borrowers, depositors, shareholders, and the wider community. Yet exactly how this balancing act is performed, and the influence of each of the factors that go into setting mortgage rates, has long been shrouded in secrecy. The inquiry aims to shed light on this, uncovering the weight of each of the ingredients in the pricing pie.
So what comes next?
The banks have largely welcomed the inquiry, seeing it as an opportunity to educate and explain to the public the complex decision making that goes into pricing mortgages. Of course, the big four are in peak form for any inquiry given that the memory of the Royal Commission is still fresh. Teams at each are hard at work implementing initiatives borne of the Commission, as well as the potentially game changing Consumer Data Right (CDR).
Chairman of the ACCC, Rod Sims, wants consumers to understand how and why banks make the decisions they do about the rates charged on home loans. He encourages consumers to become active players in the mortgage market, taking the opportunity to switch for a better rate when the opportunity presents.
The introduction of the CDR should make switching easier by mandating that banks share customer data (at the customer's request) with other companies. This could ease the transition to another bank or financial services provider for customers who are looking to make the switch. Increased competition in the mortgage sector could prove bruising for the big four, who reap a significant proportion of their profits from home loans.
Foolish takeaway
The ACCC inquiry made headlines yesterday but it seemed the major banks and investors were largely unmoved. Inquiry fatigue perhaps? Whether that remains the case depends on what the ACCC uncovers. ANZ, CBA, NAB, and WBC have thus far shown little inclination to explain what they insist are 'complex' pricing decisions. Perhaps they would would prefer their mortgage pricing alchemy to remain under wraps. But when faced with the powers of the ACCC, the big four may have little choice but to unveil their home loan pricing principles.
