Benchmark interest rates are rising and while it’s still only early days in the banking royal commission, the indiscretions are mounting, as are likely costs. The banks might feel the pinch but ultimately is going to be the customers that have to pay.
Since the US Federal Reserve first flagged higher US interest rates, I’ve been suggesting to our investors to add floating rate bonds and other securities to their portfolios.
The theory being very low interest rates – in some countries below zero – could not go much lower even if the Fed didn’t raise interest rates in the timeframes expected and the risk was to the upside. That is higher interest rates were anticipated and a good way to hedge against them was to invest in floating rate securities linked to benchmark rates.
Over the last six weeks, US benchmark rates have risen sharply. Given that the major financial institutions borrow US dollars via the bond market, costs of funding has increased.
There’s no specific event that has triggered the rise in benchmarks, but markets attribute it to a number of factors including:
- Greater supply of short dated US Treasury bonds since the government agreed to increase its debt ceiling, they’ve increased short term borrowing, pushing up short term interest rates competing for limited investment funds.
- New US tax legislation making it easier for US companies to repatriate funds back to the US. These funds were mostly held in short term investments.So, the exodus has left a vacuum and higher rates were needed to tempt other investors to satisfy market needs.
Changes to US benchmarks then fed through to our own benchmark bank bill swap rates.
The Australian 3 month bank bill swap rate, commonly used in pricing loans, is also up over 0.3 per cent. The bank bill swap rate is mostly a market observed rate of where banks will lend to each other and are indifferent between fixed and floating interest rates securities.
Source: Bloomberg, FIIG Securities
A 0.3 per cent rise doesn’t sound like much but borrowers on variable rate mortgages will be paying more interest, the cost of personal loans and credit card interest rates could also rise if the increase is sustained or moves even higher.
Meanwhile banks with thousands of fixed rate interest only loans will have to suffer the rise, impacting profit. They’ve already started to lift borrowing rates and while it’s getting more expensive for banks to borrow from each other and in overseas markets, they’ve been somewhat offsetting higher costs by keeping domestic deposit rates the same. Yet again it seems that customers are bottom of the food chain.
Sound bank capital management is important and can reduce the impact of higher benchmark interest rates. The banks generally should have hedges in place for this type of event, but regardless, costs should rise until fixed rate loans unwind, so not all costs will be able to be offset immediately by higher borrowing rates.
Ultimately, net interest margins and profits should be affected. Not a positive sign for higher shares prices.
Banking Royal Commission is likely to be another drain on profit
Revelations of misconduct by the major banks and AMP at the royal commission reminds me of reality TV – much of it is predictable, you don’t really want to watch, but still it’s compelling!
A natural step for the institutions is to shrink their businesses and ‘stick to their knitting’. We’ve already witnessed this with the sale of CBA wealth management businesses Colonial. Hiving off the troublesome operations seems like a good idea. Management have not had enough oversight and smaller, more concentrated operations should be easier to manage. Sale proceeds will increase capital and capital ratios, to satisfy APRA requirements.
The big question is the cost. These institutions need to be taught a lesson. It’s hard to put a number on likely penalties, possible legal suits and more stringent compliance requirements.
But there should be consequences and they are likely to hurt.
This article originally appeared in The Australian on 24 April 2018.