05 January 2012

Dear Investor,

Happy New Year!

The team at La Trobe Financial wishes all our investors a very safe, prosperous and happy new year. The year ahead promises to be one of continued volatility in investment markets. The challenge for investors will be to preserve capital, whilst continuing to build their wealth. Some asset classes are likely to struggle, but the overall strength of the Australian economy should continue to present excellent investment opportunities.

RBA's grip slips

The days before Christmas saw an announcement that could change the way Australians view their home loans. ANZ announced that it would look at its interest rates on the second Friday of each month, effectively severing the connection with the Reserve Bank of Australia's (RBA's) interest rate review on the first Tuesday of each month.

Further, ANZ director, Iain Macfarlane, who headed the RBA for a decade before retiring in 2006, said that the suggestion that banks should price mortgages on the back of official cash rates was a convention unique to Australia, with no basis in "economic logic or any legal requirement."

The subtext of these comments was the increasing perception by the banks that they were being judged against a yardstick (the RBA official cash rate or 'OCR') that has little effect on their actual costs and profits. Is this right? To make a judgment, we first need to consider how Australia's banks fund the loans that they write and what drives their interest rate decisions.

Banks and borrower rates

Banks operating in Australia have diverse funding bases, with most funding sourced from deposits (approx. 50%) and short-term (20%) and long-term (20%) wholesale debt. As the chart below shows, since 2007 the banks have significantly increased their reliance on deposits (particularly term deposits) and long-term debt, largely from international money markets. These increases have allowed a greatly reduced reliance on short-term debt and thus have reflected the push for more stable funding in the wake of the Global Financial Crisis ("GFC").

What influences bank borrower rates?

Banks adjust their borrower rates in response to a combination of factors. These factors include competitive considerations such as the individual bank's appetite for new loans and the borrower rates set by their competitors. They also include cost factors such as:

  • movements in the RBA's OCR;
  • the cost of funding from the wholesale money market in Australia and overseas; and
  • the cost of attracting customer deposits;

How do the cost factors affect bank funding costs?

The OCR is the overnight money market interest rate targeted by the RBA to be paid by banks. The RBA board meets on a monthly basis to determine the OCR (currently 4.25%).

Like all borrowers, banks themselves pay to borrow money from wholesale money markets (domestic and international). Since the GFC, both short and long-term funding costs have been volatile and this has elevated rates.

Competition for deposits in Australia has intensified since around mid 2008, resulting in a significant increase in deposit rates relative to market benchmark rates. As the chart below shows the average cost of the major banks' new deposits has risen noticeably relative to the cash rate; currently it is estimated to be only slightly below the cash rate, whereas prior to the onset of the financial crisis, it was about 150 basis points below the cash rate.

Source: RBA, UBS

For most of the last decade, banks' funding sources and the cost of funding has been relatively predictable. Movements in the OCR from RBA have broadly matched changes in total bank funding costs. Since the GFC, this relationship has weakened as banks have found it difficult to access funds and those funds have become more expensive. Since January 2008 banks have been consistently increasing rates above the RBA increases and not passing on rate cuts in full.

Will the banks be able to continue to move in line with future RBA rate movements?

Australian banks source a significant proportion of their wholesale funding from banks in Europe. The Eurozone crisis has meant that banks are having trouble accessing long-term wholesale markets. When they can access them, the prices are historically expensive. While the banks are able to fund their currently modest growth in lending using customer deposits, they still have to refinance existing wholesale funding as it matures. The longer the Eurozone crisis persists the more likely that banks will have to pass on the increased cost of funds to customers, be they borrowers, depositors or shareholders.

What are the effects for investors?

The net effect of the increased cost in bank funding is the strong likelihood of an increase in borrower rates. This could have the effect of stifling economic growth and putting downward pressure on equities markets as corporate profits decrease.

However, of all nations in the world, Australia is well placed to survive the economic difficulties. ANZ CEO, Mike Smith, rated the prospect of a recession or credit squeeze in Australia as "... very, very low." Further, in affirming Australia's AAA credit rating, ratings agency Moody's noted Australia's very low level of public debt, which sits at about 15% of GDP. As the table below shows, this compares extremely favourably to the rest of the developed world.

So investors can expect continued volatility in 2012. But Australia's great economic strength also makes this a time of great opportunity.

Best regards,
Chris Andrews

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Chris Andrews
Head of Funds Management

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e  candrews@latrobefinancial.com.au

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La Trobe is one of Australia's leading independent specialist mortgage Financiers. Its business includes residential mortgages, commercial mortgages, and investment services operating one of Australia's largest Mortgage Funds under AFSL 222213. It employs over 145 staff and has raised over AUD$10Billion to assist over 100,000 customers since inception in 1952.

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