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Written by Matt Kirk Published: August 21 2020 Innovation
It’s a well-known fact that term deposit and at call rates regularly fluctuate between providers, driven by several factors including competition to acquire new business. What’s not so well known is why banks move their rates even when the Reserve Bank of Australia (RBA) keeps cash rates steady.
How banks determine rates essentially comes down to the official cash rate set by the RBA, and the availability of and need for funding by the banks. The regulatory environment also plays an important part in the process.
The RBA’s official cash rate provides the starting point from which all rates are set, with adjustments for yield curve and term premium. Chart 1 shows the correlation between the declining cash rate and declining interest rates over time. But the change in the cash rate alone doesn’t explain the rate differentials between banks.
If we look at the spread between term deposit rates and cash, since late 2011 the spread has hovered around 50 points (compared to -1.50% pre GFC).
This spread can be explained, in part, by how banks fund themselves. Banks have three primary sources of funding:
Given that banks have several options for funding, the rates between all three will dictate where the bank will choose to raise money. For Australian banks, retail depositors are highly desirable given that, compared to most international peers, Australia is underweight in ‘sticky’ retail deposits. This makes banks more dependent on institutional investors (particularly offshore institutional) who are prone to being more fickle than retail Australian investors.
Under the regulatory environment, banks need stable sources of income, and that means they need to compete for those more stable retail deposits. This drive for retail deposits tends to create an underlying bidding war for deposits, which can drive rates up. When institutional demand for bank debt investments wanes, this bidding war can become more intense, as was the case in 2009-10 after the financial crisis reduced the number of institutional investors.
If you think of the banking system as a whole, that spread is going to have to land at a level which encourages retail deposits to give the banks the right amount of funds to meet their regulatory requirements. But the level also needs to be profitable for the banks. If the spread goes too low, banks will need to chase investors with a higher rate. What Chart 2 shows is that ~50 points over cash is what banks need to offer to entice depositors.
Another factor that determines rates is the bank’s credit rating. Not all banks are rated equally, and the lower a bank’s credit rating, the riskier it is deemed to be and the higher the interest rates it charges (in other words, higher borrowing costs). A lower credit rating can also impact a bank’s ability to access non-core sources of deposits and wholesale funding. This difference in spreads between deposits and debt, and the level and source of funding for the bank, can impact the rate that banks offer investors.
All of this works within a process that is increasingly responding to regulations that impact banks’ funding requirements and need for stable funding sources. This includes various ratios, such as the Net Stable Funding Ratio (NSFR) and the Liquidity Coverage Ratio (LCR), which are now monitored both by regulators and investors.
One of the reasons the spreads moved higher post-2011 was due to these new regulations. Prior to the GFC, banks borrowed large amounts of short-term money market debt because it was cheap. When markets collapsed, there was a mass exit out of short-term money market debt. Banks faced liquidity problems and so the regulator stepped in and introduced new rules stipulating that banks must be more responsible with how they fund themselves. This push for more stable lending sources can drive differences in rates between banks depending on their funding requirements.
While the official cash rate – driven by the economic environment – sets the base point, it is the supply and demand for different types of investors which drives the rate setting by the banks, tempered by a regulatory overlay.
If we look at the spreads over common terms between banks, you can see the differential between providers is up to 0.8% p.a. depending on term.
Source: Cashwerkz, as at 12 June 2019
What this translates to for clients is a significant difference in returns over time. That’s where Cashwerkz can help. Our streamlined switching of term deposits upon maturity to a new rate with a different term deposit provider gives your clients the freedom to maximise returns. Your clients can choose from a range of term deposits and at call accounts from an extensive selection of Australian banks and financial institutions.