Top of mind for any bank management team at the moment will be the Reserve Bank of New Zealand’s proposal to increase the amount of capital New Zealand banks must hold and the impact this could have on the bank performance and shareholder. The focus on balance sheet management, cost of capital and margin protection is becoming ever more present in the light of what’s potentially on the horizon should these proposed changes comes into force.
What’s in bank headlights today?
Over the last few weeks we’ve started to see a move towards margin protection in the property investment loan space. We’re aware that some of the banks have already started the conversation with their clients as the future increases in the base rates for investment property loans with increases of around 25 basis points uplift already seen in one bank. Traditionally investment property has always attracted higher capital holding ratios and therefore it’s no surprise that we should see these increases at this stage in a banks rate protection strategy.
Why is this weeks OCR review an important one to watch?
As the law of economics subscribes, capital moves to where its best used, most efficient, and gets the greatest return. Within recent history we’ve seen the Australian banks move capital across product portfolios, across geographic territories and even into new services, all driven by the need to get the best return on shareholders capital. The loan portfolios held by banks are also risk weighted by industry and financial performance and this drives how much capital is required to be held in order to meet their liquidity ratios with the Reserve Bank.
With this is mind if OCR was to drop on Thursday, banks would be remiss not to be forward looking in terms of recovering any future potential cost from proposed increases in capital.
Slaves to three masters
It’s important to remember that banks have three masters, shareholders, depositors and borrowers. Without this threesome they don’t function and there is an equal need to keep all happy. Shareholders in this part of the world like bank shares for the fact they pay good dividends, depositors want a modest return on their cash and borrowers want cheap debt. A potential drop in OCR provides a mechanism for the banks to move the tables around in the name of “Reserve Bank Guidance” but by no means to they have to pass on reductions to depositors and borrowers. They may take it as an opportunity to move the tables to enhance their net margin between what they take in interest income from borrowers and pay out as interest expense to depositors.
Goldilocks and the Three Bears
If the OCR drops (and there is plenty of support of a drop of 25 basis points amongst the economist community for that to happen), what are the options for the banks?
- Leave all rates unchanged
This option would be acceptable to depositors; however borrowers would not be happy. It’s also not the outcome the Reserve Bank is looking to drive, and an opportunity lost for bank management to protect their own financial position.
- Pass on the drop to borrowers and depositors
Under this option the cost of borrowing would come down, depositors will receive less interest on their money in the bank and the banks net interest margin would remain unchanged.
- Drop deposit rates and hold borrower rates
The most aggressive scenario and one that might please the shareholders but won’t please the bank clients or the market. It has the greatest effect on the banks net interest margin, however not considered the most likely outcome.
- Pass on some but not all of an OCR drop to borrowers
Potential under this scenario for the banks to pass on some but not all of the cut to both borrowers and depositors giving banks so room to increase net interest margin. This would give them the headroom for future negative movements from potential capital changes but not be seen as being too aggressive by the market.
What does this mean for you and your home loan?
No one has a crystal ball so there is no way to be sure of the lowest cost interest rate option. That said, short-term fixed rates (e.g. 1 year) has been where we have recommended clients lock rates until recently. This has proved a very good strategy over the last few years.
With the potential of increasing capital costs and the market pricing in 2 further rate cuts, 3-year rates of around 3.95% are looking more and more attractive.
We encourage our customers to think about what’s important to them. If you need cash flow certainty the 3-year rate would be our pick. If you’d be comfortable should interest rates start to rise, then the 1-year rate is still a great bet. Regardless of your choice we encourage our clients to accelerate loan repayment above the bank minimums while rates are low. This will protect you against any future rate rises as you can always reduce to minimum repayments when rates do rise.
Everyone’s situation is different so it’s important to talk to your adviser about your current and likely future circumstances when setting rate and repayment amounts.
Conclusion
While there are many options available to the banks, our view is that margin protection will drive the decisions they make next week as they work through the Reserve Bank Capital adequacy review and await the outcome of the proposed capital changes.