Banks enter the sweet spot of the cycle
It’s no wonder bank bosses have been the friendliest and most confident since late 2018, when they were hauled before the Hayne Royal Commission and held to account for their appalling treatment of customers.
A quick read of the latest RBA news Monetary Policy Statement underlines how benign the conditions are for the big banks.
The statement notes that with respect to their lucrative home lending operations, “most home lenders have fully passed through cash rate increases through July to their Standard Variable Rates (SVR), which serve as benchmark for some 65 per cent of outstanding variable-rate credit”.
Meanwhile, in the repositories…
But contrary to their rush to hike mortgage rates, banks have been unusually late in adjusting the rates they pay on deposits.
As the statement notes, “banks raise about 60% of their funding in the form of deposits.”
Although banks have increased the rates they pay on their demand and term deposits since May, the press release points out that “the average rate paid on demand deposits – which constitute the bulk of bank deposits – has increased less than the cash rate for the June quarter”.
Indeed, it is common for banks to announce significant rate hikes for certain types of deposits – their so-called “hero” products – while barely moving the rates paid on the bulk of their deposits.
Often, these “hero” deposits require customers to meet certain conditions, such as increasing their balance each month, to earn the highest interest rate.
Banks should also benefit from the other big development in the mortgage market: the growing popularity of variable (higher-margin) mortgages and the reduced appetite for lower-margin fixed-rate loans.
One of the seismic changes of the pandemic has been the large number of borrowers who have taken advantage of ultra-low fixed rate loans. So much so that 35% of banks’ mortgage portfolios now consist of fixed-rate loans, compared to 20% before the pandemic.
But market interest rates have risen sharply this year, which has made it considerably more expensive to take out a new fixed rate mortgage.
As the statement points out: “While fixed rates on new loans have risen to be significantly higher than rates on new variable rate loans, the share of new fixed rate loans has declined and is now well below market levels. beginning of 2020″.
The big banks will benefit as hundreds of billions of dollars in fixed-rate home loans mature over the next two years and are converted into higher-margin variable-rate loans.
According to the press release, “about a quarter of total mortgages are made up of loans whose fixed-rate terms are due to expire within the next two years”.
Mortgage still strong
The other good news for bankers is that the Australian economy is still robust, which means there is still a healthy appetite for home loans.
According to the release, “housing credit growth remains around 7.75% on a half-year annualized basis.”
To be sure, home lending slowed slightly in the three months to June as RBA rate hikes dampened activity in the housing market and put downward pressure on house prices.
But the statement notes that although commitments to homeowners and investors have eased, they “remain near their highest levels on record”.
Yet banks are feeling some pressure on their funding costs due to rising bond yields.
The extraordinary strength of the labor market means that banks are seeing a further improvement in the quality of their loan portfolios.
Banks are finding it more expensive to issue long-term bonds, with yields on three-year bonds jumping to nearly 5% in June for the first time since 2012, before falling back below 4% more recently.
In addition, banks are offering higher interest rates on new retail term deposits. And that puts upward pressure on funding costs, because when existing term deposits mature, the money is transferred into new, higher-rate deposits.
Moreover, customers are reacting to these higher rates by shifting more and more of their money from demand deposit accounts to term deposits. As a result, bank funding through term deposits, which had been falling steadily since 2019, is increasing.
Meanwhile, Australia’s buoyant labor market means there has been a continued decline in the number of people unable to keep up with their credit card and home loan payments.
The unemployment rate fell to a nearly 50-year low of 3.5% in June, and the Reserve Bank expects it to drop to around 3.25% by the end of this year, before to rise as the economy cools.
This extraordinary strength in the job market means that banks are seeing a further improvement in the quality of their loan portfolios.
Senior bankers report that they have seen a further drop in the number of credit card and home loan accounts where people are more than three months behind on their interest payments.
Additionally, the skyrocketing rise in house prices over the past two years means that the number of negative equity home loans – where the size of the bank loan is greater than the value of the house – has shrunk to just over a tiny fraction of the overall home loan portfolio. .
Strong house prices mean that even when borrowers are in financial difficulty, it is relatively easy for them to sell their homes to pay off their bank loans.
Meanwhile, the political climate is also relatively benign. Politicians appear to accept that banks have the right to raise mortgage rates alongside RBA rate hikes, although some criticize banks for being too slow to raise deposit rates.
Either way, the big banks will have to tread carefully. They know that the combination of rising mortgage rates and soaring profits can be a dangerous cocktail.
The author owns shares in major banks.