So, when the RBA lifted interest rates by a quarter of a percentage point on Tuesday, the cost of borrowing money, in the overnight market from other banks, also went up by 0.25 per cent.
This overnight rate is the anchor for all other short-term lending rates in the market, such as the rate for lending over one-month, three months and so on. That’s because if a bank can earn a certain interest rate for lending money overnight, it will demand a higher rate for extending money for longer terms.
In fact, the three-month bank bill swap rate (BBSW) is the commonly used reference rate upon which most lending rates across the economy are priced.
So, when the overnight interest rates are increased by the RBA, base interest rates across the economy go up.
To offset this increase in base interest rates, the banks simply increase the rate they charge borrowers, such as customers on variable mortgage rates.
All things being equal, banks simply raise mortgage rates to neutralise this increase in the cost of money. That’s the intention.
How do the banks boost profit margins?
A higher home loan rate is basically the whole point of the RBA raising interest rates. By increasing borrowing costs in the economy, consumption is meant to slow, reducing demand and therefore upward pressure on prices.
The RBA might be annoyed if it had cut rates and the banks never passed it on, but it’s not likely to have any problems with banks raising rates the full amount.
But there are a few moving parts within the banking system that means rising rates are good for banks, not simply because the absolute rate they charge borrowers goes up.
One is that most loans written by Australian banks are financed by deposits. Some of these deposits, such as term deposits, pay relatively high-interest rates while some deposits, such as a savings or transaction account, don’t pay anything at all.
When interest rates are high in an absolute sense, the loans that are financed by those zero cost deposits are very profitable. But as rates fall and the banks lower mortgage rates, the margin benefit from those cheap deposits is diminished. When that process reverses, the banks benefit.
Another reason why banks prefer rising interest rates is that they have a fairly large pool of cash that is effectively sitting idle, and cannot be lent. This includes the cash it keeps on hand as capital that acts as a buffer for soured loans.
The banks invest these funds …….