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‘Lending spread’ key to Aussie banks’ profitability

‘Lending spread’ key to Aussie banks’ profitability
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A long-term low-interest rate environment didn’t adversely affect Australian banking profitability, the RBA has found.

Australia’s ‘differently operating’ banking sector bucked theoretical global trends and modelling for long-term low-interest rate period consequences, Reserve Bank of Australia (RBA) research has found.

In analysing the nation’s most recent long-term stint of low-interest rates — to learn lessons for any future return of low-interest rates — RBA researcher, Anthony Brassil, concluded that the profitability of Australian banks has “likely been less adversely affected than what the international literature would predict”, but that ‘the flip side’ is “that the ‘pass-through’ of monetary policy to lending rates may have been more muted,” he has explained.

That is, the apparent ability of Australia’s major banks to maintain their ‘lending spreads’ as rates have fallen has ensured these banks remained profitable and resilient to further shocks, “thereby improving financial stability”.

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This has, however, likely come at the cost of lower pass-through to lending rates, he outlined.

In that context, the high share of variable-rate loans in Australia means that even muted ‘pass-through’ feeds through to the interest rates households pay much faster than in jurisdictions with long-term fixed-rate loans, “thereby enhancing the effectiveness of policy via the cash flow channel,” he highlighted, citing previous work by La Cava, Hughson, and Kaplan (2016).

Interestingly, he noted that this also means Australian households bear more interest rate risk than in other jurisdictions.

“Over time, many of these households respond to this risk by building up substantial buffers of excess repayments, so [macroeconomic] financial stability need not be lower as a result of households bearing this risk,” Mr Brassil stated.

“But new borrowers and those unable to build buffers remain vulnerable to this risk.”

Reasons behind the research

In his research discussion paper titled The Consequences of Low Interest Rates for the Australian Banking Sector, for the Economic Research Department of the RBA, Mr Brassil sought to explore how a vast international literature on the consequences of low interest rates for various banking sectors related to the Australian banking sector.

Somewhat uniquely, Mr Brassil confirmed that it indeed operated “differently to other jurisdictions”.

He then used a recent advance in ‘macro-financial modelling’ to explore whether pass-through in Australia could turn negative – the so called ‘reversal rate’ – and he found that the features of the Australian banking system mean a reversal rate is “highly unlikely to exist in Australia.”

Modern banking is complex

As Mr Brassil pointed out, although interest rates are expected to continue rising in the short-term, the long-term trends that led to “more than a decade of low global interest rates after the global financial crisis” are “not expected to materially reverse”.

Therefore, there is benefit in learning from the recent period of low interest rates given the high probability that they will return at some point in the future, he said.

“To that end, I seek to understand the consequences of low interest rates for the Australian banking sector,” Mr Brassil clarified.

“This is not a straightforward question to answer because modern banking is complex.

“Not only do banks lend money and take deposits, they also borrow from overseas, hold government bonds, and hold deposits at the RBA.

“Banks also need to manage the losses that arise from their loans not being repaid and ensure they meet regulatory requirements.

“So, there are many channels through which low interest rates could affect how banks operate.

“Answering this question is further complicated by the fact that the Australian banking sector operates differently from the banking sectors in other countries, so we should not treat the vast international literature that explores the consequences of low interest rates as being a precise description of how low rates affect Australian banks,” Mr Brassil concluded.

[Related: Mortgage serviceability a test in 2023]

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