Does attacking bank profits makes sense?

I was surprised to hear Bill English come out and tell banks to reduce their profitability.  This statement is ridiculous – it is like telling people to go out and cut their wages.

However, Bernard Hickey bet me to the punch in criticising this.  This quote sums up how I feel:

I actually like that our banks are profitable. The alternative is unprofitable banks that collapse at the slightest breeze

There is one more issue though.  The RBNZ feels that banks are not being competitive.  [Note:  I am not bringing up the deposit guarantee scheme.  If the government is not charging an appropriate fee for the guarantee then they are being silly – we shouldn’t attack the bank’s for that.]

Now, if there is a competition issue there could be scope for intervention.  But wait a second, Kiwibank and PSIS are offering lower floating rates (5.99% and 5.75% respectively) – why isn’t the existence of this competition driving down prices?  If we believe that people are willing to pay a margin on their floating rate if they go with a big bank then we have to ask “do we think Kiwibank and PSIS are being uncompetitive” – as they are setting the floor for interest rates.

I’ll tell you why floating rates are so much higher than near term fixed rates – uncertainty.  People are willing to pay a premium on floating as they are uncertain about the degree with which rates will fall in the future, so they value the flexibility.  Furthermore, the return on floating rates will be volatile (as they can change at any moment) so banks want to charge a premium – as they are facing uncertainty (people value a certain return above an uncertain return).  I don’t see what is unfair here.

If we force the banks to cut rates (with the same cost structure), they will reduce lending FFS.  Is that really what we want in the middle of a long-recession?

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  • steve

    Isn’t the point that margins between the OCR and bank lending rates used to be much tighter, and now they are much wider? Therefore much the savings that banks have with a lower OCR are not being passed on to consumers.

    The reason though is pretty clear, banks don’t want to lend at the mo, because its riskier than it used to be, so by them having greater margins, they have more incentive to lend, and hence keep the economy going. the additional risk of lending is now being factored into interest rates, which wasn’t reflected in the past (or didn’t exist pre recession).

  • It would make sense to me if Bill English were worried about KiwiBank’s profitability — it’s an SOE. It would make sense to me if RBNZ worried about some banks not being profitable enough and consequently a risk under deposit insurance. It makes NO sense to me why Bill English should think the profits of private banks any of his business. Except for that it’s populist, of course. Ugh.

    National should know better.

  • @steve

    I’m not really convinced that margins are the key indicator here – as margins are simply a gap between cost and benefit.

    Ultimately rates are being set by supply and demand – the fact that we have risk has reduced the supply of loans which implies that the interest rate will be higher. Cutting the OCR helps in two ways – by reducing the cost of funding, and by reducing the opportunity cost of reserves. As the OCR gets lower the impact of these channels weakens.

    Agree with you on risk at the moment – banks are reacting to higher risk. I don’t really see what is wrong with that 🙂

  • steve

    @Eric Crampton

    he wants rates lower so people borrow more and stimulate the economy. its a recession.

  • @Eric Crampton

    People think that we have an organised state sometimes – and what is “fair” is what benefits them, while what is “unfair” is what hurts them. This is why economics should be compulsory at school …

  • @steve

    There is a fine line between doing things in government to help smooth the recession and interfering with voluntary trade to get votes. The banks are unable to pass on greater savings for a reason – we want them to remain viable businesses after all.

    If banks aren’t passing on rate cuts, then we can be sure that interest rates would have been pushing higher in the absence of RBNZ cuts. Furthermore, we can be sure that there are good reasons why households shouldn’t be increasing borrowing levels.

  • @steve: of course that’s what he wants. But it’s none of his business, on two fronts. First, interest rates are set at market clearing: if he forces banks to charge below-clearing rates, we wind up with even more credit-rationing than we otherwise might have. Second, it can be seen as a signal to RBNZ that their cuts haven’t been substantial enough to cut the market rate as yet and so more are desired; government isn’t meant to telegraph interest rate desires to our independent central bank.

  • steve

    @Matt Nolan
    I agree, what English is saying is the kind of thing the Democrats said to the Banks in America in the 90’s that caused too much sub-prime lending in the first place.

    I was just pointing out his motives, not that I agree with his methods.

  • @Matt. You’re right: economics should be compulsory. Public understanding of economics is abysmal.

  • Miguel Sanchez

    The difference between floating and fixed-term loans is more substantial than simply interest rate risk. A floating-rate loan is essentially an overdraft – the bank charges interest on the outstanding balance, but there’s no fixed repayment schedule as there is for a fixed-term loan (even if that term is as short as 3 months, as the ANZ is now offering). Considering the problems that banks are having with maintaining their funding, it’s quite possible that they would value having a known schedule for repayment of principal, and would offer a discount for it accordingly.

    As for the supposed lack of passthrough, the average 6-month fixed rate has fallen about 20pts since the last OCR cut, and more like 30pts since mid-March. 1-year fixed rates are down around 10pts. Both of them are at least 100pts below floating rates. The only reason to remain fully floating right now is a belief that these rates will go even lower from here, in defiance of the obvious pressures against them. Why should borrowers be rewarded for being greedy?

  • @steve

    Fair enough – that is indeed his cheeky little motive. Thought he would know better being an economist though 😉

  • @Eric Crampton

    The only issue is who would teach it? We would need teachers that understand economics as well – or else we may end up with a highly normative education program that makes things worse.

  • @Miguel Sanchez

    “the bank charges interest on the outstanding balance, but there’s no fixed repayment schedule as there is for a fixed-term loan”

    That is indeed a potentially important fact.

    I wonder what the bank would offer for a floating rate if you offered to commit to a repayment schedule? This would reveal the value from this element.

    “The only reason to remain fully floating right now is a belief that these rates will go even lower from here, in defiance of the obvious pressures against them. Why should borrowers be rewarded for being greedy?”

    100% agree with you!

  • insider

    Hang on aren’t we forgetting past practice where any upward movement has been mirrored by rapid similar moves in floating rates? The banks have been quick to blame the OCR and so set the expectation that the OCR dictates the floating rate. Now it has moved and they are not responding so they are fair game for criticism for suddenly changing the rules of their behaviour, especially if their margins are fattening.

    You’d think that they would accept tighter margins to encourage more borrowing, much like retailers having regular sales to maintain cashflow, but it seems different for banks for reasons unknown to me.

    Yes I want all banks to be profitable, as I would any business, but there seems to be a disjoint with that expectation, the privileged support they have been given by the taxpayer and the relatively high returns shareholders have been enjoying over the years.

    Surely those mean that the inherent risks in banking are low and so the returns should not be 30% on equity but more like a 7-10% utility company.

    Am I being over simplistic?

  • Miguel Sanchez

    @Matt Nolan

    “I wonder what the bank would offer for a floating rate if you offered to commit to a repayment schedule? This would reveal the value from this element.”

    Well that’s where ANZ’s 3 month fixed rate comes in – it’s virtually a floating interest rate, but it’s 5.35% compared to the ‘real’ floating rate of 6.45%.

  • @insider

    Hi Insider,

    One thing I would note is that the banks severely limited increases (and sometimes even cut) as the RBNZ had lifted rates over the past 5 years. They did this because there was competition – and because wholesale markets were offering cheap credit.

    Now we have the opposite – so it seems understandable that they would be not cut as heavily.

  • @Miguel Sanchez

    Dirty old 3 month rates, very interesting.

    I agree that the disjoint between the very short fixed and the floating must be because of something like the value of payments – rather than wholesale funding costs.

    People just like to act like they are being ripped off – and the government seems willing to cultivate this for votes. When someone is offering you 3 months fixed at 5.35% holding floating seems ridiculous – the people doing it are likely to be the people who want to avoid repayments methinks …

  • Miguel Sanchez

    @insider

    “You’d think that they would accept tighter margins to encourage more borrowing, much like retailers having regular sales to maintain cashflow, but it seems different for banks for reasons unknown to me.”

    I would have thought the differences between a retailer and a bank were bloody obvious – bank’s don’t hold any stock that they ‘need’ to sell, and they get plenty of cashflow from existing loans, so no need to keep making new ones if the margin’s aren’t attractive.

  • insider

    @Matt Nolan

    Matt if true, that makes sense. I thought the RB had said that that had not happened. To me it seems counter intuitive they are fattening margins in the low times but Tripe says margins are highest when rates are lower.

  • insider

    @Miguel Sanchez
    Miguel

    Aren’t the interest rates paid on deposits a bit like the stuff in the stock room? Their cost needs to be funded somehow surely? What about shareholder expectations? Won’t that drive a need to sell more loans?

    Also banks have been saying for years they are now retailers and trying to flog every god damn thing they can to you the moment you walk through the door, so I’m not sure the difference is that obvious.

  • Miguel Sanchez

    Another thing to remember is that floating rates are simply not where the competition happens in NZ – even with the recent movements, less than a quarter of loans are floating, compared to 3/4 in Australia. Brian Gaynor in the weekend Herald was suggesting that margins on floating rates are about 100pts wider here than in Australia but nearly 100pts narrower for fixed rates – sounds a bit large to me, but that’s where we need to focus our attention.

  • Miguel Sanchez

    @insider

    The difference is that the banks dictate the price of the ‘stock’ – I’d like to meet a retailer who can claim that. And don’t forget that it’s not just deposits, there’s wholesale market funding as well, and banks have found it tougher to get funding that way. To stretch the analogy a bit further, it would be like a retailer pleading with a wholesaler to provide them with some stock.

  • Andrew Coleman

    Many people have two mortgages with the same institution: a large fixed mortgage, and a smaller floating mortgage, possibly because they can pay this one down at a faster rate than the minimum payment. Sometimes when the fixed rate mortgage terminates and needs resetting, people wait to reset it. Either way, once people have a relationship with a bank, they aren’t going to change their mortgage simply because of the floating rate. Consequently, most people don’t have much bargaining power: they are not going to change their whole mortgage structure because of the rate on the floating component. Banks can then charge high rates without much risk of losing existing customers. Moreover, most new customers are primarily looking at fixed rates, and so banks can keep high floating rates without risking new customers either.

    Let’s have a look at the numbers

    In March 2008 there were 345000 floating mortgages worth $19b, ($55000 each) and 959000 fixed mortgages worth $128b ($133000 each), or a total of 1300 000 mortgages.

    In March 2009 there were 462000 floating mortgages ($75000 each) and 883000 fixed mortgages worth $119b ($134000 each), a total of 1340 000 mortgages.

    If one looks at the marginal increase in mortgages, there are 117000 new floating mortgages worth $16b or $136000 each.

    hence
    (1) banks are having no problem finding floating customers;
    (2) At the margin, the new floating mortgages look to be fixed mortgages that have expired and haven’t been refixed yet (that marginal number is suspiciously close to the average fixed mortgage);
    (3) [conjecture] as customers probably aren’t taking out a mortgage at a new bank (do they all meet the new minimum deposit requirement?) banks can probably get away with charging what they like.

    No wonder Grant Spenser is a bit disappointed. More than anyone else at the Reserve Bank, he knows what private banks do, and probably realises they could lower floating mortgage rates if they wanted to, but they have no incentive to do so when their customers probably aren’t beating a path to the exit door. And since the Bank wants to fine tune the economy by lowering short term interest rates, it probably feels thwarted. Hence the open mouth operations to put pressure on the private banks.

  • insider

    @Miguel Sanchez

    Isn’t one of the arguments around rates at the moment because they can’t control that price and that they are having to increase deposit rates to compete with some of the bond offers around? A friend in retail deposits was telling me they were really struggling to attract cash. So do they really have such control?

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  • Miguel Sanchez

    @insider

    13% annual growth in deposits doesn’t suggest they’re having much trouble getting money in the door overall. But they may well be struggling to attract longer-term deposits, which are in more direct competition with the recent bond offers.

  • steve

    Matt Nolan :
    @steve
    Fair enough – that is indeed his cheeky little motive. Thought he would know better being an economist though

    I thought he was a farmer? Though I see he has commerce and an english literature degrees. Assuming its in economics I guess its better than a history of statistics.

  • Interesting comments everyone. I will try to respond tomorrow. I am currently tied down, and want to spend a bit of time with your comments before I reply 🙂

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