Australian banks are aware that although increased rates will likely raise profits in the medium term, they are unlikely to maintain the bumper profits banks have become accustomed to over the last 12 months.
Although higher rates raise net interest margins, they also stymie mortgage demand, which in turn reduces gross profit. Despite this, nominal demand for personal loan and credit card debt has shot up as a result of inflation. Combined with higher rates, this has offered banks an alternative route towards greater profits.
Since 2010 the cash rate (the rate at which banks lend to each other, which sets the benchmark for interest rates in the wider economy) had been steadily lowered by the Reserve Bank of Australia (RBA). This process was accelerated at the onset of the Covid-19 pandemic to help rescue the economy. However, the inflation that has arisen globally in the wake of lockdown restrictions being removed has pushed the RBA and other central banks across the world to raise rates.
Since April 2022 the cash rate targeted by the RBA has risen steadily. The RBA announced its latest hike on May 3, 2023: a 25 basis points increase to 3.85% from the March 2023 target of 3.6%. For context, in April 2022 the cash rate hovered just slightly above zero at 0.10%.
Rate hikes and the impact on bank profitability
Unsurprisingly, these rate hikes have had a significant impact on Australia’s retail banking sector. The most immediate impact is profitability. The differential between the cost of acquiring funds and the revenue acquired from lending it out is the bank’s net interest margin, which when multiplied by the volume of lending carried out by the bank approximately generates a bank’s profit (excluding staff costs from the equation).
Raising rates significantly enough above zero gives banks the opportunity to raise lending rates faster and/or higher than rates on savings accounts, improving the bank’s net interest margin. Thus far, this is exactly what retail banks in Australia have done. In February 2023, CommBank announced that in H1 2023 its net interest margin reached 2.10% (up 23 basis points on H2 2022) and it had generated a profit of A$5.2bn ($3.5bn) (an increase of 10% on H1 2022).
Yet while the profitability of banking in Australia has been boosted by rate rises, do not expect profits to remain as high as they are right now in perpetuity. As mentioned, profitability is a function of both net interest margin and lending volume. While the first quickly rises in response to rate hike the latter falls with a time lag.
Mortgage lending dips
This is increasingly evident in data published by the Australian Bureau of Statistics on the state of mortgage lending in the country. The total value of new home loans credited has been on the decline since around the same period that interest rates begun to rise in 2022. This trend has affected all forms of mortgage lending, whether for owner-occupiers, investors, or first-time buyers. This fall is almost entirely due to the decline in demand for fixed-rate mortgages; the volume of lending attributable to variable-rate mortgages has remained comparatively stable, only starting to dip in early 2023.
So, although banks have been able to capitalise on higher margins, this benefit is being gradually offset by declining mortgage demand. As a result, the bumper profits banks have experienced since the start of this hiking cycle are unlikely to persist.
Yet it is worth noting that although demand for mortgage credit has been on the decline, other classes of credit have seen their demand remain stable or even climb over the past 12 months. As per RBA data, credit card expenditure in Australia has not been strongly affected by rate hikes.
Demand for personal loans on the rise since 2021
Both the number and the value of such transactions have roughly increased along the trend path they have followed since May 2020. Although there are signs of a plateau in expenditure since late 2022, at the time of writing there is no evidence of a decline.
Meanwhile, demand for personal loans for household and personal goods has increased notably. Despite the increased cost of credit, the volume of personal loans offered for these types of goods has been on the rise since early 2021. This is likely the result of consumers relying on this credit to make up for income lost as a result of price inflation exceeding the growth rate of nominal wages. So, while banks in Australia have seen demand for mortgage loans decline, demand for credit has not fallen across the board.
Ciaran Yates is an associate analyst, financial services at GlobalData