Interest Rate Disparity between RBA and Major Australian Banks - Essay Example

MAF202 MONEY AND CAPITAL MARKETS – ASIGNMENT T1 Executive Summary Reserve Bank of Australia (RBA) has the responsibility of regulating the monetary policy in Australia. It uses cash rate as a tool to implement its strategy towards setting the monetary policy of the country. RBA strives for controlling the inflation rate and maintaining full employment in Australia. Recently RBA decided to ease its monetary policy by cutting down its cash rates during November-December, 2011 for speeding up the economic development of the nation. However, it has been found that the major banks in Australia did not give full response to these rate cuts by cutting its interest rates at lower levels than cash rate. Hence, there has been widening of spread between cash rate and the interest rates set by the major banks. Banks have argued to such anomaly by mentioning that the rising costs of funds have led them to take such decisions. Since the Global Financial Crisis (GFC), banks have relied more on debt funding which are expensive sources of fund than equity and others. If we look at the recent global economic scenario, it can be found that the euro-zone crisis situation is still unresolved, and economic growth rate is expected to slowdown in 2012. There have been no rate cuts by the central bank of UK since 2009. In India recently there have been rate cuts by Reserve Bank of India and banks have started responding to it positively. Central bank of China follows a tightly regulated monetary policy and is expected to have rate cuts in 2012. Table of Contents Table of Contents 3 Interest Rate Disparity between RBA and major Australian Banks 4 1.Overview 4 2.Determination of Inter-Bank Interest Rates by RBA 4 3.Banks’ Response to RBA’s Interest Rate Cuts 9 4.Effects of Inter-Bank Lending Cuts by the Central Banks of Other Nations 11 4.1UK 11 4.2India 12 4.3China 12 5.Conclusion 13 References 14 Interest Rate Disparity between RBA and major Australian Banks 1. Overview Reserve Bank of Australia (RBA) is the central bank of Australia established in the year 2006. Its principal task is to control and regulate the monetary policy of Australia (Reserve Bank of Australia, 2012a). RBA uses cash rate as a tool to control the pressure of inflation in Australia. RBA targets to keep the inflation rate in and around 2% to 3%. This refers to the monetary policy followed by RBA. RBA’s monetary policy also includes curbing unemployment rate and assuring a stable economic growth of the country as its other objectives. When the inflation rate goes beyond the target of RBA, the cash rate is enhanced. Otherwise RBA tries to reduce the cash rate when it feels that inflation is not posing a great threat and Australia can have a faster economic growth. 2. Determination of Inter-Bank Interest Rates by RBA RBA regulates the monetary policy of Australia by setting up the lending rates on loans available in the money market on an overnight basis. These rates of interest set by RBA have an influence on the rest of the interest rates in Australian economy. Subsequently it has an effect on how the lenders and borrowers behave in the money market. RBA strives to fulfill the following objectives while setting up the interest rates: a. Ensuring that the Australian currency is stabilized. b. To ensure that full employment condition is maintained in Australia. c. To work for the welfare and economic prosperity of Australian people (Reserve Bank of Australia, 2012b). Hence, the monetary policy of RBA includes maintaining an inflation rate around 2 to 3% (Graph 1). This is achieved through changing the cash rate by RBA (Graph 2). There is a close resemblance between interest rates in different money market instruments and the cash rate set by RBA (Graph 3). Graph 1 Source: (Reserve Bank of Australia, 2012c) Graph 2 Source: (Reserve Bank of Australia, 2012d) Graph 3 Source: (Reserve Bank of Australia, 2012e) The decision regarding the monetary policy by RBA and its explanations are all announced through a release in media. If there is a decision about any changes in the cash rate, it is effective from the day immediately following the media release. One of the most recent media release announced by RBA took place on April 3, 2012. RBA decided not to change the cash rate which is at 4.25 per cent level now Reserve Bank of Australia, 2012e). Various factors are taken into consideration while deciding upon the inter-bank interest rates set by RBA. In today’s world, economic activities in Australia are mainly governed by the transactions that take place through the banks. All these transactions involve inter-bank fund transfers. This process gives rise to obligations for different banks against each other, the final settlement of which occurs in the money market. All the banks in Australia have an account with RBA which are known as Exchange Settlement Accounts (ESAs). The settlement of inter-bank fund transfer takes place through these ES accounts or funds. ES funds and its demand in the market influences RBA’s decision over changes in the cash rate. These demands are created because of transactions that take place between the banks and RBA and not because of inter-bank transactions (Campbell, 1997). The factors contributing to the recent RBA’s decision of not changing the cash rate in April, 2012 can be summarized as follows: a. World economy is forecasted to grow at a lower rate in the year 2012. This growth rate would be slower than the growth experienced in the year 2011. China’s growth rate has also eased out. However the economic conditions in several countries in Europe are still very weak. The sentiment towards the financial market has showed signs of improvement. It is because of the fact that positive steps have been taken for combating the debt crisis in many parts of Europe. However, these issues are still not resolved completely. b. With respect to the economy of Australia, the growth in output was below par for the year 2011. The decline took place in spite of all the spending in private investments that took in previous year. Significant differences are noticeable with respect to performance standards across different regions and sectors in Australia. The household sector also did not show any significant improvement. The unemployment rate has experienced some changes but those are not so much alarming in nature. c. The financial conditions in Australia also did not experience much significant changes during the last month. The borrowing rates of interest were nearly equal to the average-term debt interest rates. The credit growth rate was also modest in nature. With respect to easing of trade, the foreign exchange rate also remained high. d. Inflation rate also remained within the target level. RBA expects that the inflation would be within the limits for the year ahead. Growth in productivity is necessary to fulfill the objective of RBA of maintaining the inflation rate at the expected level. e. There was an interest cut during the late 2011. The growth rate in demand has slowed down since then. By the next scheduled meeting, members of RBA would have an access to more information regarding factors like output, demand, prices, etc., which have an impact on the inflation rates. Hence, RBA considered taking into account all those information before deciding on its next adjustment in monetary policy and interest rates (Reserve Bank of Australia, 2012f). 3. Banks’ Response to RBA’s Interest Rate Cuts RBA reduces the cash rate as a part of its monetary policy in an expectation that the rate cuts will pass on to the interest rate cuts by the major banks in Australia. Most recent interest rate cuts imposed by RBA took place in the months of November and December, 2011. Cash rate was reduced by 25 basis points in each case. However, during the past few years there has been an increase in the spread between cash rate and the lending rates on all loan products offered by the major banks in Australia (Graph 4). Graph 4 Source: (Reserve Bank of Australia, 2012d) The increase in these interest rates varied across different types of loans depending on the banks’ perception about the credit risk of the borrowers and the pace with which each type of loan can be re-priced (Reserve Bank of Australia, 2010). The costs of funding, specially the costs of raising foreign funds, has been attributed to the increase in the spread of lending rates offered by banks and the cash rate (Kingsbury, 2012). In the year 2011, the spread reduced by around 10 basis points. It was because, the major banks increased its discount rates on the new mortgage loans offered by them in order to increase its market share. This was done in the midst of existing market competition for lending mortgage loans. However, during late 2011 and beginning of 2012, these discount rates were reduced by small amounts leading to an increase in spread between variable lending rates and cash rate (Deans & Stewart, 2012, p.42). The banks usually give away loans by utilizing the funds that they receive in the form of deposits. The interest rate margin between the lending rate and the deposit can be considered as the profit margin for banks while lending different types of loans to public. However, the major banks need to rely on funding from overseas other than these deposit rates in order to fulfill the demand of loans by public. Due to recession, banks have relied more on debt funding which are expensive sources of funds and thereby leading to the increase in funding costs for banks. Hence, rise in debt funding costs contributed towards increase in spread of major banks’ lending rates and RBA’s cash rate. 4. Effects of Inter-Bank Lending Cuts by the Central Banks of Other Nations 4.1 UK Bank of England is held responsible for regulating the monetary policy of UK. Monetary Policy Committee (MPC) of the bank sets interest rates to meet the target inflation rate as its primary objective. MPC discusses on the interest rates on a monthly basis. These interest rates correspond to the rates at which financial institutions borrow money from Bank of England. These interest rates have an impact in all types of lending and borrowing rates set by banks in UK. As the interest rates are lowered by MPC, it leads to increase in spending by public due to decreasing borrowing costs. The opposite happens when the interest rates are enhanced. The official bank rate in UK has been held constant at 0.5% since March, 2009. It was last reduced by 0.5% in 2009 (Bank of England, n.d.). With the fear of recession hitting back UK again and with the prevailing euro-zone crisis, MPC is quite skeptical about increasing the bank rate. Economic growth in UK is supposed to be at a very low pace in 2012, lower than 2011 levels. Banks and other financial institutions in UK also have corresponded with the bank rate with no further increase or decrease in interest rates in the recent past. 4.2 India Reserve Bank of India (RBI) is the central bank of India which regulates its monetary policy. It does so to promote economic growth of the country and controlling inflation. RBI uses various interest rates as tools to regulate the monetary policy. Repo rate is one such key lending rate of RBI. There has been a recent cut in the repo rate by 50 basis points in April 2012. This is the first interest rate cut by RBI since 2009. There has been a continuous rise in repo rate made by RBI during the past one year which amounts to around 125 basis points. The recent rate cut has been in line with increase in GDP and small decline in inflation rate (Subbarao, 2012). The rate cut was made with the expectation that the banks in India will respond to it by decreasing its lending rates for the public. This rate cut has already affected the Indian banking industry and they have started reducing their lending rates. 4.3 China The central bank of China is called as The People’s Bank of China (PBC) and it has the responsibility to regulate the monetary policy in China. There has been an increase in the interest rates by PBC in the past. It was done to curb the rising inflation rate in the country. There was a rise in the deposit reserve requirement ratio by PBC amounting to 300 basis points during the year 2011. PBC is expected to follow a policy of sustainable development in 2012 (The People’s Bank of China, 2012). Hence the year 2011 has been a year of tight monetary policy followed by PBC. However, with the ongoing instability in global market because of the euro-zone crisis, there has been a slowdown in the growth of China. Hence, PBC is expected to lower its interest rates, thereby easing out on its monetary policy. The monetary policy of China is well regulated by PBC and there is not much disparity in interest rates set by PBC and the banks in China. 5. Conclusion RBA regulates the monetary policy in Australia. It uses cash rate as one of its tool to influence the interest rates set by the major banks in Australia. The main objectives of RBA are to control inflation and promote economic growth of the country. The lending rates of major banks in Australia are supposed to correspond to the cash rate. RBA has made many rate cuts in the recent past but the banks did not decrease its interest rates to such levels as made by RBA. There has been an increasing spread between the cash rate and the lending rates by major banks in Australia. This has been attributed to the increase in funding costs of banks since recession. If we look at the monetary policies adopted by other nations, it can be found that UK is passing through hard times because of the euro-zone crisis and its central bank have not changed the interest rates for years. For the developing nations like India there has been a rate cut only recently and the banks responded to it. For China, there has been no major rate cuts recently but is expected to ease its monetary policy in 2012. References Bank of England. (no date). How Monetary Policy Works. [Online]. Available at: http://www.bankofengland.co.uk/monetarypolicy/Pages/how.aspx. [Accessed on April 23, 2012]. Campbell, F. (1997). The Implementation of Monetary Policy: Domestic Market Operations. [Online]. Available at: http://www.rba.gov.au/mkt-operations/resources/implementation-mp.html. [Accessed on April 23, 2012]. Deans, C. & Stewart, C. (March, 2012). Banks’ Funding Costs and Lending Rates. RBA Bulletin. [Pdf]. Available at: http://www.rba.gov.au/publications/bulletin/2012/mar/pdf/bu-0312-5.pdf. [Accessed on April 23, 2012]. Kingsbury, N. M. (March 2012). Evidence shows banks’ funding stance on interest rates was correct: expert. The Conversation. [Online]. Available at: http://theconversation.edu.au/evidence-shows-banks-funding-stance-on-interest-rates-was-correct-expert-5601. [Accessed on April 23, 2012]. Reserve Bank of Australia, (2012b). About Monetary Policy. [Online]. Available at: http://www.rba.gov.au/monetary-policy/about.html#t1. [Accessed on April 23, 2012]. Reserve Bank of Australia. (2010). Inquiry into Competition within the Australian Banking Sector – November 2010. [Online]. Available at: http://www.rba.gov.au/publications/submissions/inq-comp-aus-bank-sect-1110/lending.html. [Accessed on April 23, 2012]. Reserve Bank of Australia. (2012a). Welcome to the Website of Australia’s Central Bank. [Online]. Available at: http://www.rba.gov.au/. [Accessed on April 23, 2012]. Reserve Bank of Australia. (2012c). Inflation Target. [Online]. Available at: http://www.rba.gov.au/monetary-policy/inflation-target.html. [Accessed on April 23, 2012]. Reserve Bank of Australia. (2012d). Chart Pack: Interest Rates. [Online]. Available at: http://www.rba.gov.au/chart-pack/interest-rates.html. [Accessed on April 23, 2012]. Reserve Bank of Australia. (2012e). Media Release. 2012-09. [Online]. Available at: http://www.rba.gov.au/media-releases/2012/mr-12-09.html. [Accessed on April 23, 2012]. Reserve Bank of Australia. (2012f). Minutes of the Monetary Policy Meeting of the Reserve Bank Board. [Online]. Available at: http://www.rba.gov.au/monetary-policy/rba-board-minutes/2012/03042012.html. [Accessed on April 23, 2012]. Subbarao, D. (2012). Monetary Policy Statement 2012-13. Reserve Bank of India. [Online]. Available at: http://rbi.org.in/scripts/NotificationUser.aspx?Id=7136&Mode=0. [Accessed on April 23, 2012]. The People’s Bank of China. (2012). China Monetary Policy Report Quarter Four, 2011. [Pdf]. Available at: http://www.pbc.gov.cn/image_public/UserFiles/english/upload/File/2011Q4.pdf. [Accessed on April 23, 2012]. Read More