When interest rates eventually fall, banks will face a critical decision
Borrowers hanging out for interest-rate relief may be in for a longer-than-expected wait. Thanks to last week’s inflation data, financial markets are betting there’s roughly a one-in-four chance of a rate cut this year.
Only a week ago, those same markets implied that a cut in late 2024 was a sure thing, which shows you we shouldn’t take these predictions too literally. Nonetheless, here’s something we can be more certain about: when interest rates eventually fall, Australia’s banking giants will face a key decision.
Do the major banks use the change in rates as an opportunity to prop up their sagging profit margins at the expense of customers, as they often did in the past? Or are such tactics no longer an option for bankers in this environment of fierce political scrutiny of big business, and cost-of-living pressures?
The pressure on bank profit margins will be a key focus for investors in the coming round of earnings results for the sector.Credit: Dominic Lorrimer
This debate has been bubbling away among bank-watchers for months, as investors try to assess the outlook for the industry (and make sense of soaring bank share prices).
One theory to explain the recent bank share price strength is that official interest-rate cuts would give the banks a chance to “reprice” home loans, by moving mortgage rates by a different amount to the RBA (in a way that suits the bank’s bottom line).
Banks certainly have a history of making such changes, also known as “out-of-cycle” rate moves. They did it in the mid-and-late 2000s, when home loan rates rose by more than the RBA’s cash rate, and banks blamed higher funding costs.
‘The banks will always try to protect their profits. But they will come under increasing political pressure by doing so.’
Jefferies analyst Matthew Wilson
So, will our banks be tempted to do something similar when RBA governor Michele Bullock eventually oversees a rate cut?
After a recent decline in the profitability of retail banking, some believe the banks will give it a try.
Jefferies analyst Matthew Wilson says that when interest rates fall, banks would try to cut their mortgage rates by less, and deposit rates by more, than the RBA, to manage profits. Wilson also believes rate cuts are still a long way off – and says any move by banks to offset the negative profit impact of rate cuts would make them a target for political attacks.
“The banks will always try to protect their profits. But they will come under increasing political pressure by doing so,” Wilson says.
Hopes of rate cuts have driven sharemarkets higher, although Wilson adds that cuts are fundamentally negative for bank profitability.
Investors will get a clearer picture on bank profits over the next fortnight, with the release of financial results from National Australia Bank, Macquarie Group, Westpac and ANZ Bank, and a trading update from Commonwealth Bank.
The banks will undoubtedly produce multibillion-dollar profits, given their vast loan portfolios, but they are also expected to show a further decline in net interest margins (funding costs compared with what banks charge for loans).
Given the expected decline in margin, some investors might like to see banks acting to claw back some profit when the RBA eventually moves its cash rate higher. However, the recent political attacks on supermarkets illustrate the potential backlash against a bank that sought to limit passing on RBA cuts.
As a result, some analysts believe repricing mortgages is probably not worth the pain for the banks.
Alphinity principal Andrew Martin says that while the banks previously have been able to reprice their loans “out-of-cycle”, he doesn’t think we’re in a time when they can no longer get away with it. He cites the lingering effects of the 2018 banking royal commission into industry misconduct.
Citi’s Brendan Sproules has highlighted the “political difficulties with repricing loans,” as one factor in his argument that bank share prices were over-valued.
A recent note from Macquarie analysts said: “Given the current political landscape and increased focus on social aspects, we think it will be difficult for banks to reprice mortgages, particularly in an election year,” they said.
A further reason: much of the recent decline in banking profits has been self-inflicted, as the result of a price war. Banks decided the best option was to compete harder to retaon customers and, as a result, earnings were squeezed.
It would be a brave bank boss who decided to stick the neck out and claw back some of this lost profit by giving borrowers only part of any RBA rate cuts, whenever they may happen.
The Business Briefing newsletter delivers major stories, exclusive coverage and expert opinion. Sign up to get it every weekday morning.