Kuta Beach

Kuta Beach

Tuesday, 2 November 2010

Banks Lifting Rates Over RBA Rate

Today the RBA lifted the official cash rate by 25 basis points from 4.5 per cent to 4.75 per cent.

The Commonwealth Bank immediately lifted its standard variable mortgage rate by 45 basis points, almost double the increase in the official cash rate.

Many mortgage holders are up in arms, claiming that the banks have no right to lift interest rates over and above that of Australia's central bank.

But I think otherwise.

The cash rate and the mortgage rates are two completely different interest rates. The cash rate is the rate at which banks lend to each other overnight. The variable mortgage rate is the rate at which home buyers borrow from the bank to buy homes. They are two completely different products. To say that these two rates must be perfectly correlated is like saying that the price of oil and the price of coal must be the same. They are different products hence they have different prices.

One key factor that influences the rate at which banks lend money is risk. The higher the risk of the borrower, the higher the interest rate the banks need to charge in order to compensate for the risk. For example, if the bank were lending to the government (i.e. purchasing government treasury bonds) there is very low risk that the government will default and hence bond rates are usually low at around 4 to 5 per cent per annum depending on the country as well as other factors. However, if the bank is lending to people who are starting their own business, there is a fair chance that a significant number of them will default. The bank must therefore increase interest rates so that the increase in interest repayments the bank gets compensates for the expected loss because of these defaults.

The same concept applies to mortgage loans. When banks lend to people to buy homes, this is a fairly safe loan compared to business loans and credit card loans, but there are still risks. Many things can go wrong--house prices could go down and borrowers may lose their jobs. It therefore makes sense for banks to keep interest rates high to protect themselves against borrowers who do not pay what is owed to the banks.

The only argument against the lifting of interest rates by banks is the argument that thre is not enough competition in the banking sector in Australia. This argument may have some merit as the Australian banking sector seems to be dominated by four major players. However, there are other banks out there. Many people do not like being slugged with fees on their transaction accounts, but by switching to ME Bank (Members Equity Bank) they can avoid fees. Many don't like the interest rates that the big four banks charge, but there are dozens of building societies, credit unions, and other small players who provide cheaper loans. But I have spoken to many people and suggested they switch bank. None of them do. Either they are too lazy or they say they like their bank.

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