Lending standards are dramatically tightening: Westpac

EXPERT OBSERVER

The significant increase in short-term wholesale interest rates and associated volatility has been a key topic of debate in markets throughout 2018.

Initially linked to higher borrowing costs in the US, a further spike in only Australian rates as the June quarter drew to a close saw participants' focus shift to domestic drivers of this pricing activity.

There are many market factors that have played a part in the surge in short-term interest rates. All are worthy of discussion, but in this instance we focus on the real economy's effect. Specifically, the broad-based deceleration in deposit growth.

While we believe that there is insufficient evidence to label the decline in deposit growth as the prime catalyst for higher short-term interest rates, deposit growth's persistent underperformance is critical to our view that the abnormally large market spreads present will, by and large, be sustained.

Put simply, if (in dollar terms) retail deposits increase at a lesser rate than credit, then Australian lenders’ reliance on wholesale funding must increase. This looks likely over the remainder of 2018 and 2019 if, as we anticipate, national and household income growth remain soft, led by weak wages growth; a downturn in employment growth; and the terms of trade.

Consumer saving and investing decisions are unlikely to provide a meaningful boost to deposit growth absent a shock because consumers already favour deposits (and super) over other asset types.

For superannuation deposits, weak income growth is not the only headwind. Over the past year, households' capacity to make voluntary contributions to super has been further reduced, limiting the flow of new fund inflows.

A falling allocation to domestic cash (in favour of offshore investment opportunities) amongst the industry has further restricted the flow of new deposits to Australian banks and other depository institutions. 

With the Australian economy expected to register growth at or below trend in 2018/ 2019 as global growth remains near its post-GFC peak, Australian investors' appetite for offshore assets is likely to persist.

The final point of note is the significant tightening of lending standards underway. This policy shift, yet again, is a negative for households' ability to accrue deposits. Specifically, those switching from interest only to principal and interest face a much higher total monthly payment.

Meanwhile, those who remain on interest–only terms will pay a higher interest rate now, and the majority will still inevitably have to move to principal and interest later to pay down the loan.

The longer that interest only terms are relied upon, the more rapid the required paydown becomes over the remainder of the 30-year term, unless a borrower is successful in refinancing the loan with another counterparty.

Elliot Clarke is a Senior Economist at Westpac

Andrew Hanlan is a Senior Economist at Westpac

Simon Murray is an Economist at Westpac