John Bolton on how retail banks make money and why mortgage rates are increasing  

By John Bolton*

There has been some discussion recently on bank margins, caused by mortgage rates going up (particularly the floating housing rate) but the OCR not moving.

Any expert commentary on this typically comes from the banks themselves, and the issue is explained away as higher funding costs. Whilst banks are facing higher funding costs (mostly domestically), this is only a part truth. The reality is that the industry is looking to mortgage margins to restore profitability from a tough 2016. 

Roughly 80% of bank income comes from net interest income – the difference between what banks receive in interest from loans less the cost of funding those loans (customer deposits and wholesale funding.) Only 20% of bank income comes from fees of which roughly half comes from funds management and insurance and the other half from payments. 

Over 80% of bank funding comes from retail deposits with less than 20% coming from wholesale funding. 

In 2010, the Reserve Bank introduced a core funding ratio to improve the financial stability of NZ banks. It was driven by the liquidity events surrounding the Global Financial Crisis and the reliance banks had at the time to short-term wholesale funds. 

Banks are required to maintain a core funding ratio of 75% where core funding is retail deposits, and wholesale deposits with maturities of more than one year. Having a core ratio makes it harder for banks to fund growth. This is what banks are pointing to as the driver of higher funding costs. 

Of retail funding, roughly 10% comes from non-interest bearing (NIB) deposits like transaction accounts, 45% comes from savings products, and 45% comes from term deposits. We have $159 billion of NZ dollar household deposits. 

The challenge for banks has been that as interest rates have fallen over the past decade, they have not been able to reduce deposit rates at the same pace. As a result, the net margin between the two has contracted. 

Let’s use a textbook example and assume a loan is 100% funded by a non-interest bearing transaction account. As the OCR drops the cost of the ‘free funds’ doesn’t change, so if the borrower rate falls then the bank’s margin is squeezed. 

What if the loan was funded by a savings account? As rates fall, the borrower rate falls but now the bank can also reduce the savings rate to preserve margin. However, the bank cannot drop the savings rate as far or as fast as borrower rates, and as a consequence, margins still contract but not as much. 

The same is true of term deposits, but investors are far more sensitive to the absolute interest rate. That’s why term deposit rates (circa 4%) are higher than the OCR at 1.75%. It’s also where the growth is, so although overall funding costs are very low, it’s a lot more expensive to grow.

Let’s broaden our understanding of bank profits. It’s basically a function of four things: 

1. The margin between lending and deposits
2. The level of debt growth
3. New sources of income (fees)
4. Expense growth 

For the past 20 years banks have experienced rapid debt growth of 8% on a cumulative annual basis. This has driven interest growth, negated in part by price competition from banks chasing market share. 

At the same time, the expense-to-income ratio of banks has been trending down and is now down to 40%. By growing revenue faster than costs and having a low expense-to-income ratio, banks have had a stellar run of profit growth. I suspect that is coming to an end. 

Tuning the engine 

In the past, banks have managed to wring additional margin and fees out of existing client accounts. This was good at the time, but much of this is unsustainable and will increasingly be an Achilles heel. 

For a while during the early 2000’s consumers were hit with lots of ‘new’ fees – honour fees, penalty fees, transaction fees, account fees. Since then, a lot of these fees have been quietly unwound due to competition and customer churn. 

Banks have also focused on managing interest rate sensitivity. Consumer finance lending is evidence of this. Standard credit cards have an interest rate of 21% and personal loans are typically around 16% against overall cost of funds of 2.30%. The credit losses on these products typically runs at around 1.50%-2.00% so unsecured lending is very profitable for banks. Competition is increasing from smaller banks entering the market (Co-Operative Bank recently launched a credit card with a 12.95% rate on it) and has been the catalyst for the arrival of peer-to-peer lending. Squirrel Money offers personal loans from as low as 8.95%. 

Meanwhile, the interest paid on most savings accounts has whittled down to less than 0.50%. Both non-interest bearing accounts and savings accounts offer banks a very low cost source of funding. The issue isn’t so much high funding costs, but that very low interest rates have reduced bank margins. 

Undone by customers

Profit pressures have been building inside banks as far back as the GFC. At the time, the reprieve for banks was switching from fixed to floating rates. At its peak (April 2012) floating mortgages were $110 billion or 63% of total lending. This generated an extra $500m of industry revenue. Revenue that has since reversed itself out leaving a revenue hole.

The multifaceted challenge

The challenge for banks is on a number of fronts. 

Banks cannot squeeze any additional margin out of existing legacy products like credit cards, personal loans or savings accounts. If anything, these products are under increasing threat from new entrants and disruptors. 

Fee income is static and whilst KiwiSaver is attractive, it’s a longer term play. And regardless, disruptors like Vanguard in the US (and Simplicity KiwiSaver in NZ) are likely to shake up the industry. 

Just as revenue growth is drying up, expenses are under pressure especially from technology. Bank platforms are very expensive to maintain, and large parts of the cost are capitalised, increasing depreciation expenses. This becomes a tax on future earnings and puts banks under more pressure. 

But ultimately the biggest challenge is housing. The RBNZ has said enough is enough when it comes to housing debt. They have put a number of measures in place to apply the brakes to debt growth. Thus making ‘managing-the-margin’ the only game in town. 

Reading the tea leaves 

The only short-term way to recover profitability is through margins and especially housing margins which make up 60% of all lending. The single fastest way to increase revenue is to increase the floating rate margin which reprices $51 billion of lending with almost immediate effect.  

We first saw this last year when banks did not pass on floating rate cuts as the OCR dropped. However, the big move was recently shifting the floating rate up 0.15% at the same time as moving fixed rates. 

A 0.15% increase in the housing floating rate delivers $76m of additional industry revenue on an annualised basis. Fixed rate loans ($170 billion) also have expanding margins, but it takes longer to hit the bottom line. 

The wholesale margin on floating rate loans (assuming an average 0.50% discount on the advertised rate) is 3.20% versus 2.30% for a 1 year fixed rate. Don’t focus on the absolute margin as this could be debated around funding costs. The point is that floating rate loans are 50% more profitable than fixed rate loans. Because any interest rate change impacts the whole floating book at once, banks will not compete with each other and follow each other’s rate moves. 

So in summary, banks will push up mortgage margins, corralled by tighter credit conditions, and motivated by growing profit pressures elsewhere in their businesses.

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*John Bolton is the "Chief Squirrel" and Managing Director at Squirrel Financial Services. This article was first posted on the Squirrel website, and is used here with permission.

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23 Comments

"The only short-term way to recover profitability is through margins and especially housing margins "
Quite right, but it is VERY short term as the expansion of margins deters new lending (mortage rates put people off/don't allow banks to lend on their asseement ratios). As New Landing shrinks, the margin has to be widened again to protect profitability, and the cycle continues.
Mortgage rates are likely to rise far further than many people expect, for this and other reasons.

Interesting comment, my view is exactly opposite, namely
"Mortgage rates are likely to rise far LESS than many people expect"

Unless you're Ted Stanton. He says they are going down and house prices are uppity up up.

Of course banks will only be to enjoy higher floating margins while there is still reasonable demand for credit. Assuming fixed rates are to move higher (but who would know with a 'milignant narcissist' as US president) one would expect credit demand to move in the opposite direction. The banks may well need the current floating margin to compete for loan book growth in a slower growing credit market.

'milignant narcissist' as US president)
You are obviously a deluded bigot

Thats an apt description of the pres, yes.

@andrewmunro No I think it's you your cohorts suffering from said bigotry.

the banks are all closing branches in NZ (lowering their cost base).
the days of free flowing credit and rapid expansion of the loan book is over,
they are hunkering down finding ways to maintain what they have already created.

Making it easier for new entrants to enyer the market place

"The reality is that the industry is looking to mortgage margins to restore profitability from a tough 2016. "
Tough? Last year my gross was half the previous five year average, imagine what my net was. That's a tough reality, not crying cause cause their bloated profits dropped a tiny bit.

Interesting that JB commentary speaks nothing of his own broker commissions though... which presumably add cost and need to be recovered in margin....on increasing loan sizes. Nice cheeky little plug for his P2P lending biz though hehe ;)

Hey MisterB I deleted two pages just to get it down to this! To be fair not sure I plugged my business (other than a small tilt to Squirrel Money). Equally I didn't form an opinion on whether what banks are doing is right or wrong, simply what is happening and why it is happening. I think its useful to help borrowers understand so that they can interpret why housing rates are increasing.

My view is that the Reserve Bank will not move the OCR for quite some time. NZD is too high. Tight credit conditions will squeeze the economy enough to offset the need for higher rates. RBNZ knows full well that tight credit conditions will also push up housing rates. They commented on it when putting the Core Funding ratio up to 75%. Ideally they would have liked to have seen it earlier, like middle of last year.

Well thought out response JB and in reflection a well thought out piece. kudos :) I was evidently reading too much between the lines eh. Some of the responses seemed pretty anti-bank 'price gouging' ... but I guess that's to be expected by borrowers, not investors. 2 sides, same coin, so both will never be happy.

Big picture, still seems like it's a funding driven issue though -- some banks offering rates in the early 4s for mortgages and nearly 4 for tds of the same tenor .... must squeeze margin. I guess as all the GDS's come out, we'll know one way or the other in terms of margins.

Maybe one day Nzers will save more than they borrow? [Tui ad?]

Redcows - the big difference is, what did that do to your tradeable share price ? Nothing I suspect because you don't have one of those, but they do. They fancy staying in business alot longer than you do I suspect.

Thanks, JB for another knowledgeable article with good insight

I agree, great summary.
Mr Redcows, banks will want to increase your margin for another reason as well - from your comments they'll need to hold more equity against your loans as you will be higher risk now. Sorry about that.

Don't be. No loans ATM.

I am a bit lost , the Banks can borrow from the RBNZ at the OCR in the short term to balance their books , not so ?

OCR =overnight cash rate, very short term

How the OCR works

Most registered banks hold settlement accounts at the Reserve Bank, which are used to settle obligations with each other at the end of the day. For example, if you write out a cheque or make an EFTPOS payment, the money is paid by your bank to the bank of the recipient. Many hundreds of thousands of such transactions are made every day. The Bank pays interest on settlement account balances, and charges interest on overnight borrowing, at rates related to the OCR. These rates are reviewed from time to time, as is the OCR

http://www.rbnz.govt.nz/monetary-policy/about-monetary-policy/what-is-th...

lol @ 'Achilles heal'

lol - I'd like to claim it was intentional. Shouldn't have dropped english for math in seventh form. My bad.

Sorry, I did spot that but forgot to fix it when posting the article. Got it now.

For the past 20 years banks have experienced rapid debt growth of 8% on a cumulative annual basis.

Got to keep house prices going up in order to keep those bonuses flowing.