Here's how banks decide what interest rate you'll pay

Thursday, 21 May 2020

What does the official cash rate mean?

Ever wondered why, if the official cash rate (OCR) is 0.25 per cent, the lowest bank home loan rate is 2.79 per cent?

Interest rates are under pressure with the OCR at historic lows and other bank funding rates falling.

ANZ is now offering a one-year fixed-term rate of 2.79 per cent and Westpac and TSB announced on Thursday that they would match it. Westpac offered the 2.79 per cent rate out to two years fixed.

But what determines what banks charge borrowers, anyway? Here are a few of the factors involved.

Official cash rate

The official cash rate is what banks pay the Reserve Bank when they need to borrow money. Banks are now charged 50 basis points over the OCR to borrow from the central bank – which equates to 0.75 per cent at the current rate.

* Banks hit savers first when interest rates are falling

They then add a margin to that before setting rates for their customers.

In December, KPMG said the margin across the industry between what banks paid for the money they borrowed and what they charged for loans was 2.1 per cent.

In recent times, banks have passed on OCR movements in full to customers on floating mortgage rates, and a smaller amount of the movement to those on fixed rates.

Deposit rates

Banks get customer funding from term deposits, savings accounts and transactional accounts.

Banks get a significant chunk of their funding from deposits from customers.

If banks want to lower their home loan rates, they usually have to lower deposit rates, too, to maintain their margins. But if they get too low, customers may stop wanting to put their money in the bank.

Infometrics chief forecaster Gareth Kiernan said customer deposits accounted for about 70 per cent of New Zealand bank funding.

“The interest rate that banks offer on deposits has to be lower than the interest rate they charge on lending, so deposit rates play an important role in determining mortgage rates,' he said.

'In its recent Monetary Policy Statement, the Reserve Bank noted that international financial market uncertainty over the last couple of months had encouraged banks to try to source more funds domestically, which may explain why term deposit rates have not fallen as much as some wholesale rates.

'The banks will be conscious that further declines in deposit rates will continue to reduce people’s willingness to deposit with them.”

Antonia Watson, ANZ's chief executive, said it was difficult for banks to manage such a low interset rate environment.

Banking expert Claire Matthews, from Massey University, said customer money did not just come from term deposits - rates paid on other accounts would affect the rate at which they would lend money.

There were deposits in savings accounts, and accounts that did not receive any interest at all.

While these could often not be relied on to contain a set amount per customer in the same way as term deposits, banks would calculate at a general level what pool of money it might expect to have available - and what rate they were having to pay for access to it.

Even term deposits would have a range of interest rates applied, depending on how long they were fixed for.

Wholesale funding

Banks can also get money for loans from wholesale markets.

The official cash rate, set by the Reserve Bank, drives some of the funding costs of NZ banks.

Swap rates are currently at record lows.

Kiernan said the drivers of international long-term funding included gross domestic product (GDP) growth expectations, global inflation expectations and global monetary policy expectations.

“These are all interlinked, but at its most simple, the interest rate or return from a risk-free government bond issued for three years should be the average of market expectations for that country’s cash rate over the three-year period.

'There is likely to be some premium or margin for uncertainty as well. New Zealand-specific drivers affecting the interest rates that banks need to offer if they issue bonds include exchange rate expectations, New Zealand GDP, inflation, and monetary policy expectations – again, these are all interlinked.

“For example, as an investor from the US, if I believe that New Zealand’s economy is going to do better than the global economy over the life of the bond, that might drive a future appreciation in the exchange rate or New Zealand’s monetary settings.

'All other things being equal, that would mean I would accept a lower New Zealand wholesale rate now because the gain I make from the stronger future would make up for what looks like a low New Zealand wholesale rate. Of course, if all other investors saw things the same, they would all want to invest in New Zealand now, driving the New Zealand dollar up now, and therefore forcing the banks to offer a higher interest rate because the strong expected economic growth has then already been built into the exchange rate.

'There’s also country-specific or institution-specific risk premiums associated with these bonds. Essentially, like-for-like, US banks will generally be able to access funding more cheaply than their Australasian counterparts because they are part of a larger, and supposedly less risky, economy, and are probably also larger on average - and therefore supposedly less risky as well.”

Wholesale funding is also available domestically.

The Reserve Bank is working through a programme of quantitative easing, buying Government bonds, which it hopes will stop increases in Government spending from removing available money from the banking system and pushing up interest rates for private borrowers.

Balance for banks

ANZ chief executive Antonia Watson said it was a competitive environment for banks.

“If you look at interest rates there are plenty of signals there's only one way they’re going and that’s down. They’re certainly not likely to increase in the near term.”

She said while the rate that banks paid for deposits might put a floor under retail rates, there was no limit to how far wholesale rates might fall. She said the low rate environment was a difficult one for banks to manage, with lower margins. “There’s pressure on both sides of the balance sheet.”

The competitive environment was likely to last for some time, she said.