Aussie banks need to hike rates just to cover costs, says Morgan Stanley

The Australian parents of New Zealand's major banks need to raise their floating home loan rates by 10 to 15 basis points simply to cover their increase in funding costs this year and maintain home loan profitability, Morgan Stanley analyst Richard Wiles says.

Wiles expects a hike in standard home loan variable rates soon after Australia’s August 21 Federal election. He notes Prime Minister Julia Gillard’s decision to call an early election is good news for banks because they can hike variable home loan rates sooner rather than later.

“We believe a standard variable rate (SVR) rise of 10-15 basis points, independent of Reserve Bank of Australia rates, will be necessary just to offset the increase in average funding costs this year, and maintain home loan profitability,” says Wiles.

Standard variable rate loans are the most popular form of home loans in Australia.

“Furthermore, as average funding costs continue to rise, the ability to make additional SVR increases is likely to be a key driver of the 2011 (financial year) bank margin outlook,” says Wiles.

The Reserve Bank of Australia (RBA), meanwhile, has indicated it could lift interest rates in the middle of the election campaign. The Australian cash rate is currently 4.5% with the RBA board next meeting on August 3.

Wiles says the banks’ have faced an average cost of funding increase of up to 2 basis points per month so far this year with the European sovereign debt crisis slowing activity in, and increasing costs in international wholesale funding markets.

In New Zealand, the big banks - ASB, ANZ, BNZ and Westpac - are all Australian owned and face similar funding pressures. ANZ raised NZ$350 million in a five-year bond issue this month which will pay investors interest at 165 basis points over the swap rate, 30 basis points more than the bank is paying through its previous five year bond issue which was priced as recently as March.

Andl the Reserve Bank's core funding ratio (CFR), which was introduced in April, requires banks to fund 65% of their loans from either retail deposits or from wholesale funding sources with maturities of more than one year. Introduced in the wake of the Global Financial Crisis (GFC) amid Reserve Bank concerns the banks are vulnerable if ‘hot’ international wholesale money markets freeze as they did when Lehman Brothers collapsed, the CFR could be increased to 75% by mid-2012.

Meanwhile, Wiles says every 10 basis points the Australian banks' raise their variable rates by, adds A$525 million, or about 2%, to their profit. SVR increases are the "most important aspect" of the major banks’ market power. Wiles estimates there are A$725 billion worth of home loans in Australia, which comprise 42% of the total loans written by the major banks.

Bank funding costs could face additional increases through proposals from the Basel Committee on Banking Supervision that are designed to improve stability in the global banking system in the wake of the GFC. These include a countercyclical capital buffer proposal, which would be imposed when, in the view of national authorities, excess aggregate credit growth was judged to be associated with a build up of system wide risk.

The Basel Committee says this would help ensure the banking system has an adequate capital buffer to protect itself against future potential losses.

  But a side effect of the these proposals, which are set to be delivered at the November G20 leaders summit in Seoul, is likely to be higher costs for banking customers and, as RBA  governor Glenn Stevens noted in a Sydney speech this week, a slowdown in economic activity.

* This article was first published in our email for paid subscribers earlier today. See here for more details and to subscribe.