By Paul Morris*
Traditionally a lower Reserve Bank of New Zealand (RBNZ) Official Cash Rate (OCR) precipitates lower New Zealand bank interest rates.
But not recently.
Figure 1 below illustrates that 6-month deposit rates and new customer floating mortgage rates have actually been drifting higher since mid-2016 despite a lowering OCR.
This is nominally bad for borrowers but good for bonds, income assets and depositors, subject to some important caveats discussed below.
Figure 1; Core funding and retail deposit funding; Source Reserve Bank of New Zealand
The cause is primarily bank regulation and a change in the structure of bank funding
To a large extent this divergence can be attributed to changes in bank regulation in reaction to the Global Financial Crisis (GFC).
The GFC illustrated that then prevailing global bank regulation was insufficient to ensure the resilience of the banking sector to economic shocks. The reaction was higher international minimum regulatory standards which in large part have been adopted by the RBNZ as requirements for New Zealand bank registration. The result is arguably a safer banking sector, designed to avoid a repeat of GFC bank bail-outs, with enhanced supervision, larger layers of capital to absorb losses, and better access to liquidity/ funding.
The RBNZ’s prudential standards on bank liquidity have however had a material impact on the cost of a bank’s funding, by placing restrictions on its sources. To a large degree this explains what appears to be a structural increase in bank interest rates above the OCR, illustrated by Figure 1.
Banks must now meet minimum liquidity standards, including a Core Fund Ratio (CFR). The CFR requires a bank to fund at least 75% of its loan portfolio from stable sources. These sources are essentially retail and commercial (non-financial company) customer deposits, long term wholesale funding (longer than 1yr) and the bank’s own capital. That differs from pre-GFC when over half of local bank funding was from short dated wholesale money markets.
The difficulty is attracting stable funding
Household deposits, the most stable source of bank funding, account for roughly 40% of overall bank funding. Figure 2 illustrates that increasingly; deposit growth has been falling behind bank lending growth. This means banks are having to work ever harder to attract deposits or long dated wholesale market funding.
Attracting deposits in a low interest rate environment is difficult, as depositors look to higher yielding assets. It is even more challenging when consumers are confident and spending, contributing to a fall in what was never an impressive New Zealand household savings rate. This has forced banks to pay higher interest rates, even as the OCR has fallen. That may allow a bank to increase its market share of household deposits but RBNZ analysis noted that the overall deposit pool is less sensitive to a higher rate.
A bank’s shortfall in deposit funding needs to be filled from long term wholesale sources, e.g. through bond issuance. Changes in global bank regulation, recent credit rating downgrades and restrictions on funding from the local Australasian owned banks’ parent banks, all limit the quantum of wholesale funding available, at least at economic prices. Moreover, the RBNZ noted recently that independent of future lending growth, local banks have already NZ Dollar 45 billion of stable funding to replace from wholesale sources over the next 3 years.
This has all contributed to higher bank interest rates and a diminished relationship between the OCR and bank rates.
What are the ramifications?
Bad for borrowers
This situation is not great for borrowers, as banks increase lending rates in line with funding rates, to protect their net interest margin and profit. It also produces a constraint on the pace at which banks can grow lending. Combined with RBNZ macro prudential tools (e.g. LVR mortgage limits) the availability of credit to the economy may become more selective, and ultimately slow.
Good for bonds and income assets
To protect financial stability and reduce the risk of excessive credit growth the RBNZ is unlikely to be frowning on these tighter financial conditions. It may also mean its next OCR hike is postponed, and the extent of any hiking cycle diminished.
That may protect the value of income generating assets. Including large parts of the New Zealand share market, corporate bonds and property.
Good for depositors but note the caveat
Whereas pre-GFC deposit rates were close to the OCR they now offer a considerable extra return, for what are arguably less risky banks, thanks to regulation. It is however important to remember some caveats:
New Zealand bank deposits differ from many jurisdictions, including Australia, as there is now no official deposit guarantee scheme.
Some banks have been charging increasing deposit break fees, reiterating the illiquidity of deposits.
Finally, in theory at least, in the post GFC world banks are now less likely to receive a tax-payer bail-out or guarantee. Unlike Australia, New Zealand has a framework to resolve a failed bank. This is called Open Bank Resolution (OBR) and outlines to whom a failed bank’s losses should be assigned. Shareholders are the first to bear losses, followed by subordinated debt holders. If there are any remaining losses, these are allocated to the bank’s unsecured creditors, including its depositors. See here.
Figure 2; Annual increase in credit and deposit funding; Source; Statistics New Zealand, RBNZ.