More give, less take from banks
Do you get a fair return on your savings? And what returns do the major banks earn over and above the interest rate they pay you on your cash? Indeed, why do the banks “cap” the returns on your savings accounts at all? These are all interesting questions that I will use to prime today’s column.
We have become so conditioned to being subject to a fixed cap on our savings rates — either via a term deposit or through variable rates that adjust in line with the RBA’s target cash rate — that the notion of not having an interest rate cap seems positively odd.
But imagine if a bank turned around to you and said, “Instead of fixing your 12-month term deposit rate at, say, 5%, we are going to target giving you a 5% return, and if we can earn more on our lending and investing activities, we will pay you more. In this way, when the bank does well, you do well”.
Today the banks are implicitly saying the opposite: namely, “We will pay you 5% per annum fixed, and everything we earn above that we are keeping 100% for ourselves and our shareholders”.
To get to the bottom of this you need to first understand your relationship with the banks. When you put your money on deposit you are actually lending to them. In fact, legally and economically, you are a senior-ranking “creditor”. You are in the same position as the bank is when it lends money to you to buy a home. It is funny how nobody thinks of savings like this!
Yet on almost all your “at-call “or “transactional” savings accounts, you get little if any return (i.e., the banks usually pay zero interest rates). However, the longer you are willing to commit to lend to, or finance, the banks, the higher the interest rate they will normally offer you. Now this makes sense. The price of money ordinarily rises with the term of the loan.
What then do the banks actually do with your money? At its most basic level, they take the cash you lent them, which, formally, is a “liability” the bank must repay you, and use that money to make new loans to small businesses, corporations, and households. Roughly 60% of your money will be invested in residential and investment property loans. The remaining 40% will be lent to businesses, from SMEs to large companies.
The bank then generates two forms of return over and above the (much lower) interest rate it pays you. First, it charges businesses and households substantially higher rates than those which you earn on your savings accounts.
According to RBA data, the average “discounted” home loan rate following Tuesday’s cut should be around 6.8% per annum. In comparison, the average bank pays a 0% interest rate on your transaction account. If we take the average “bonus” savings account, the typical bank is paying you about 5.2%.
In this case, therefore, the spread between the interest rate the bank earns on its home loans and the interest rate it pays you on your cash is about 1.6% per annum.
Remember, however, that 40% of your money is being lent to businesses. Again using RBA data adjusted for Tuesday’s cut, the average small business pays a 9.7% per annum interest rate on its bank loans. If the small business offers up a home as security for the loan, the interest rate will be just under 9%.
So when it comes to small business lending, the interest rate the banks earn (or “spread”) beyond that which they pay you in your “bonus” savings account are between 3.6% and 4.5% per annum.
What about the rates the banks charge on personal loans and credit cards? According to the RBA, the average personal loan rate is around 15% per annum, while the average “discounted” credit card rate is 13.2%.
Once again, the banks are earning substantial interest rates beyond what they pay on your savings. In fact, multiples more in the case of personal loans and credit cards, even after accounting for loan losses.
All told, the RBA estimates that the average net interest rate the major banks generate beyond the interest they pay on their funding is about 2.4% per annum.
Regional banks earn a materially lower 1.6% per annum spread, or “net interest margin”. Why do they do worse? They pay higher rates to the people that fund them. So why do they have to pay more than the majors? Because their “credit ratings” are lower. This means their perceived risk is higher.
(As an aside, I have previously argued that the risk of catastrophic loss in a simple, “narrow” bank like a “regional” is less than that associated with a much more complex conglomerate like the majors, which are stretched across Australian and foreign operations, and all manner of other activities, including funds management, and proprietary trading.)
The average 2.4% interest rate the majors generate above their cost of funds is then boosted significantly further by “non-interest income”, which mainly refers to “fees”.
That’s the easy part. The much more complex aspect of the business of banking is that these enterprises take the cash (or “equity”) they get from their shareholders and use it to make loans to businesses and home owners that are worth multiples of that equity. That is, they are highly “leveraged”.
More specifically, they borrow for the relatively short term from people like you and me, and from institutional investors (roughly 50% of their money comes from mums and dads, 40% from institutions and 10% from shareholders), and then lend that money out for up to 30 years as home loans.
This begs the question: what happens if I want my money back? If, for example, I have put $100 in my savings account, and the bank has used that money to offer 30-year home loans, how can the bank possibly repay me my money?
The short answer is it can’t. The business of banking is based on what is known in the jargon as an “asset-liability mismatch". Every once in a while mums and dads decide they don't trust the bank anymore, and rush to withdraw their cash en masse. At the same time, the institutional investors that lend the banks the other 40% of their funding for terms ordinarily less than five years may also refuse to roll over these loans.
Under the law, if you do not have a reasonable expectation of meeting your current liabilities (e.g., repaying your depositors), you are, by definition, trading insolvent. So if there were ever a “run” on a retail bank, with large volumes of depositors asking for their money back, the bank would be legally insolvent in the absence of some other support from taxpayers.
In order to address this flaw at the heart of banking, which every few decades tends to lead to banking crises (in the 1890s around 90% of all private banks in Australia failed), governments have developed a number of safeguards.
The first protection was to create a taxpayer bank that was explicitly established to lend to the banks, and thus supply them with so-called “liquidity”, during crises. This is known as the Reserve Bank of Australia, and a self-described part of its mandate is to serve as a “lender of last resort” to the banking system.
A second, more recent, protection was to supply a minimum taxpayer guarantee of retail deposits. That is, if the bank fails, the government will guarantee that a minimum dollar sum will be repaid to you.
A third protection used during the global financial crisis (for the first time) was to have Australian taxpayers guarantee the banks’ institutional debts. That is, the government told the banks’ institutional lenders that if the banks ever defaulted on these loans, taxpayers would step in and pick up the tab.
If you think through this carefully, you start wondering about what is a fair distribution of returns between banks and their creditors (i.e., you and me). You ask yourself the question, "With all this taxpayer support, should I be expecting more bang for my buck on my savings?"
We have learnt today that ignoring all the fees banks produce on their products, they are able, on average, to generate net interest rates of around 2.4% per annum beyond what they pay their funders: viz., savers and their institutional lenders.
In thinking about the question of fairness, I will leave you with one chart. It was recently published by the Reserve Bank of Australia, and it shows the major banks’ “returns on equity”. In the last half-year, these annualised at close to a 20% rate.
Regional banks manage to attract shareholders with much lower, early-teen, returns on equity. We need more give, and less take.
Christopher Joye is a leading financial economist. The above article is not investment advice.