Most of us are familiar with the concept of the Yin and Yang. It is the idea that all things exist as inseparable and contradictory opposites, female-male, dark-light and old-young. Can the Yin and Yang concept act as a crystal ball, and give us insight into what bank interest returns might be in the near future?
Cash is as an asset, right? Your cash in the bank is yours to hold, spend or invest, but the answer is a matter of perspective. For a bank, it owes you the amount of cash you hold on deposit. A bank must lend the cash or perform profit seeking activities to pay your interest.
Cash is inseparably the bank’s liability (Yin) as well as your asset (Yang)!
To be able to pay interest on cash we know banks lend money. We also know that bank boards are legally obliged to maximise shareholder returns, which effectively means grow profits. Banks can grow profits chiefly by:
a) lending more; or
b) lending more profitably.
So what are conditions like for selling debt in Australia? Australia has amongst the highest household debt levels in the developed world. Not a good starting point to grow lending and earnings. Lower interest rates would help. Also, it does not help that the Australian Prudential Regulation Authority (APRA) is trying to slow lending growth to investors.
Of course if incomes rise, demand for debt may increase independently of interest rates. Evidence points to Australian household income growth slowing. Population growth helps (more potential borrowers) but is a relatively steady factor.
Households will demand more debt if they can increasingly afford more debt, but with low wage growth interest rates are the key factor in determining affordability. Wage price growth has continued to fall beyond expectations.
Average hours worked has been falling, which helps blunt the argument that low unemployment could cause wage inflation.
With high debt levels, an ageing population, and a cyclical property construction boom already underway, demand for debt at current interest rates is unlikely to accelerate, especially if banks keep raising mortgage interest rates.
As lending more is getting difficult, lending more profitably becomes the focus!
Lending more profitably
What about making more profit from existing loans? By lowering the interest they pay on cash deposits, staff costs and technology costs, banks can grow their profit all else equal. Banks face other costs, some of which are beyond their control of course. The ANZ just announced a fall in overall costs, the first in many years, so cost cutting has started.
However, a big cost for the banks is the interest they pay depositors. We have actually seen this play out, as term deposit rates have been falling independently and steadily between the Reserve Bank of Australia (RBA) rate cuts.
- On the 3 August, 2016 the RBA cut the overnight cash rate to 1.50 per cent
- A headline 12 Month Term Deposits rate of 2.83 per cent (8 August, 2016) could be found
- This same equivalent deposit rate is now 2.55 per cent (27 October, 2017)
- The RBA rate has been on hold over this period!
We have seen the banks raise interest rates on loans (their assets) to boost profits in 2017. The margin between the RBA rate and mortgages is very wide relative to recent history.
However, the strategy of raising interest rates outside of RBA moves, may have run its course, as households may reduce debt and reduce spending in other discretionary areas reducing demand for debt in other parts of the economy. Retail spending has weakened since the banks increased mortgage rates independently of the RBA, and house price growth has also slowed. Also, mortgage arrears are rising and won’t be helped if interest rates are lifted by the banks out of step with the RBA.
Finally, the banks invite the unwanted attention of politicians when they raise rates independently of the RBA.
There comes a tipping point when the banks’ profits through raising mortgage rates (Yin), greatly impacts household discretionary income (Yang) and reduces the amount of lending occurring, higher interest rates can trigger an increase in defaults.
Hopefully it is clear that the banks’ main lever to boost profit without immediately discouraging lending, from here on in, is to cut the interest they pay to savers, if that’s the Yin, the Yang is less interest income for conservative investors!
We are not alone.
Think deposit rates can’t fall further? Approximate interest returns on a one-year term deposit in the UK - around 0.60 per cent, US - around 1.5 per cent, Canada – around 1.7 per cent. The UK, US and Canada are developed economies that we have much in common with, whose households have generally endured low wage growth and ageing demographics similar to ours.
What could cause interest rates on deposits to rise and reverse the current trend?
Falling rates on cash and deposits may persist until we see either the RBA react to inflationary pressure by raising interest rates, or until economic growth picks up and the economy begins to overheat.
There is little evidence to support rising consumer price inflation as measured by the Australian Bureau of Statistics or an overheating economy. GDP growth is nearly as low as it was during the global financial crisis.
So long as banks are told to slow down lending by APRA, and given the recent mortgage rate increases have begun to slow lending, and possibly raise mortgage arrears, the banks have less options at their disposal to boost profitability.
Low economic and wage growth, and stagnant disposable income make it unlikely we see mortgage lending pick up in the short term unless mortgage interest rates fall to encourage more borrowing. Something the regulators are trying to curb at least for investment property purchases.
The likelihood is high that the banks will maintain their sights on lowering their cost of doing business, including lowering the return on cash they offer depositors. Savers will be vulnerable as the banks desperately search for profit growth.
There is a heightened risk that Australian’s relying on cash as a long-term investment to support their needs, see their living standards fall. Diversification is often thought to be principally about protecting capital, but increasingly it is about diversifying your sources of income, in case one source dries up. Usually when we think of risks undermining retirement income, we are typically concerned with dividends being cut during a recession, or a persistent vacancy on investment property meaning rent is not received.
Moving forward, when we see the Yin and Yang at play, and if we emphasise that your bank interest income is the bank’s interest expense, i.e. your asset, is the bank’s liability, we can see for those requiring income, cash is not a risk-free asset.
Especially when our banks have trouble boosting profit through increased lending activity, which is the traditional way to grow their profit.
Evan Tsipas is a partner at RSM.