Originally published by BetaShares
The decision by major banks over recent weeks to unilaterally raise interest rates on residential property loans, especially for investors, appears to be officially sanctioned and could helpfully ease demand pressures in the Sydney and Melbourne housing markets. That said, greed can be good! These actions could also conveniently help boost bank net-interest margins, which could lead to a re-rating in bank valuations on the share market.
Macro-Prudential Controls – time to tighten the screws?
Reflecting concerns with the strength in Sydney and Melbourne property markets in particular, the Australian Prudential (LON:PRU) Regulation Authority (APRA), in conjunction with the RBA, announced a series of so-called “macro-prudential” controls in late 2014. These measures required banks to limit certain types of “high risk” loans, such as those with high loan-to-valuation ratios, lengthy terms, or provided on an interest-only basis. The regulators also insisted banks limit growth in their property investor loan books to 10% p.a. Perhaps feeling confident that these measures would work, the RBA felt able to cut official interest rates twice in 2015 and twice again in 2016.
That said, with hindsight it now appears the macro-prudential controls put in place were not sufficient to contain these housing pressures, particularly in light of the further drop in interest rates. Indeed, property prices in both Sydney and Melbourne rebounded last year, which led to much consternation in official circles. Reflecting these signs of renewed property exuberance, the RBA moved to a more neutral policy bias late last year, despite the fact that inflation remains below its 2 to 3 % target band, and both the unemployment rate and the $A are uncomfortably high.
There is now growing speculation that macro-prudential controls will be tightened further. Specifically, there is speculation that regulators will move to further limit growth in bank investor loan books to no more than 5% p.a. There’s even some speculation that the RBA could raise rates to prick an alleged “bubble” mentality among investors.
Acting Alone: Banks heed the call to reign in exuberant investor lending
Of course, there’s another way to reign in investor lending without requiring the RBA to raise official interest rates or insisting banks quantity-ration the level of credit provided – price rationing, through unilaterally raising lending rates.
Indeed, over recent weeks all major bank have moved to lift interest rates on investor property loans by at least around 25 basis points, and even interest rates on owner occupier loans – especially those provided on an interest-only basis – have also been increased. To the extent these interest rates increases dampen demand for credit, it will obviate the need for the RBA to lift rates – with potentially harmful consequences for the economy more broadly.
Price rationing can help profitability
But there’s also a handy pay-off for banks in taking this action – it boosts net-profit margins, and possibly reduces the need for further capital raising down the track.
While some banks have argued that recent interest rate increases reflect higher funding costs, this point is debatable – as RBA research suggests, at least over the second half of 2016, funding costs “have been little changed”.* Over the past two years, moreover, the RBA noted overall home lending rates have not fallen by as much as debt funding costs, which the RBA suggests was “partly in order to offset some of the increase in overall funding costs attributable to increases in equity funding.”
In other words, banks have sought to claw back some of the downward pressure on profitability – arising from the regulatory requirement to decrease leverage – by boosting net-interest margins. In this regard, the need to reign in property lending – as desired by the RBA and APRA – now gives banks another opportunity to restore profitability further, which is clearly good for banks and arguably (at least as far as the RBA and APRA is concerned) good for the economy also!
As seen in the chart below, relative to the overall market, financial sector valuations are not as cheap as when we last considered this issue – but they are not overly expensive either. And as evident in recent weeks, moreover, banks remains one of the few sectors of the economy that retain some pricing power – and appear to be officially sanctioned to use it!
That said, the banks’ actions still leave certain challenges in place. For starters, to the degree the lift in lending rates curtails demand, it will slow bank credit growth at the margin. But given officials want credit growth to slow in any case, it’s probably best for banks to be able to do this via increased net-interest margins, rather than through an RBA-driven increase in overall funding costs.
The other challenge is on the macro-prudential policy front – ensuring banks’ efforts to cut lending is not undone by non-bank providers rushing in quickly to offer alternative sources of credit at cheaper rates.