Bank interest rate margins – the difference

between what interest rates banks borrow at

and what they lend at – have been the subject

of much discussion in recent years, especially

since interest rates generally began to fall in

early 1990. Concern about the behaviour of

margins was an important stimulus to the

establishment, in October 1990, of the

Parliamentary inquiry into banking which

and remains, a widespread perception that

banks have widened their interest margins by

failing to pass on to borrowers the full extent

of falls in their funding costs. On the other

hand, the evidence available to the Reserve

Bank suggests that there has been no general

widening of margins in recent years. This

article presents that evidence.

Statements about behaviour of interest rate

margins are often made with reference to a

simple comparison of one lending rate and

one deposit rate. The most common examples

are:

• the difference between the business

indicator lending rate and the bank

bill/certificate of deposit rate;

• the difference between the business

indicator lending rate and the overnight

cash rate; and

• the difference between the housing

indicator lending rate and a savings

account deposit rate e.g. statement savings

account.

These sorts of measures have often been

used to try to justify claims that bank

customers have been disadvantaged by a

widening of margins. For instance:

• the gap between business indicator and

bank bill rates widened from little more

than 1 percentage point in early 1989 to

about4 percentage points more recently

(Graph 1A);

• the gap between business indicator and

overnight cash rates has widened from

about 2 percentage points in 1988 to about

4 percentage points (Graph 1B); and

• the gap between housing indicator and

statement account deposit rates widened

before receding to 7 percentage points or

so more recently (Graph 1C).

As indicators of margins, however, these

measures are simplistic and misleading. Banks

have many different types of loans and these

are funded by a variety of deposits and other

liabilities. No one category of either loans or

BANK INTEREST RATE MARGINS

deposits will necessarily be representative of

the full range:

• of all assets, about 35 per cent are loans to

business or bank bill acceptances (most of

which are for business). Loans to

households, for housing and other

purposes, account for a little over

30 per cent. The remainder include loans

to money market dealers, investments in

securities, and loans and investments in

foreign currencies (Graph 2A);

• of all liabilities, about 20 per cent is in

traditional current or savings deposits,

about the same amount in fixed deposits,

and 10 per cent in cash management and

call deposits. About 25 per cent is in bill

acceptances and certificates of deposit. The

remainder includes capital (equity and

subordinated debt) and foreign currency

borrowings (Graph 2B).

It is clearly not appropriate to take one type

of loan, such as housing, and attribute its

funding to one type of deposit. In practice,

banks operate today by meeting the effective

demand for loans at the ruling loan interest

rate and then raising liabilities to match the

new loans. In the first instance, these liabilities

are likely to be raised as call deposits or

certificates of deposit – so-called marginal

sources of funds – which will subsequently be

reduced as and if other liabilities grow to

replace them. Thus, the cost to banks of funds

for any type of loan is best viewed as the

average cost of all their sources of funds, not

just any one type of deposit or group of

deposits.

2. The data are derived from banks’ annual reports and include each group’s non-bank activities e.g. finance companies.

In order to obtain a representative picture

of banks’ overall margins, it is necessary to

look at average interest rates received and paid.

These do not fluctuate as sharply as some

indicator interest rates, and certainly by much

less than overnight cash rates or bank bill

yields which are common measures of banks’

cost of funds in the simple comparisons

mentioned earlier.

The most useful measure of banks’ margins

is the average net spread – i.e. the difference

between the average interest rate received

on all loans and investments (including

non-accrual loans) and the average interest

rate paid on deposits (including zero-interest

deposit accounts) and other interest-bearing

liabilities.

On their Australian domestic business, it is

estimated that average net spreads for the

points in the first half of the 1980s and about

4.5 percentage points in the second half.

In 1990 and 1991, average net spreads fell to

4 percentage points or less (Graph 3).

The calculation of average net spreads

includes non-accrual loans on which no

interest is being earned by banks. The average

spread on banks’ other loans and investments

– the average gross spread – is higher. Even

so, average gross spreads for the major

banks have not risen over the past few years

(Graph 3).

While spreads have been lower on average

in the second half of the 1980s, they have not

been uniformly so. As the graph shows,

spreads increased markedly in 1988 when

there were large inflows of low-interest

deposits to banks as investors sought security

for their savings in the wake of the sharemarket

crash in October 1987. Furthermore,

as deposit and loan interest rates change at

discrete intervals and not always exactly in

step, there can be large swings in spreads over

As a group, depositors have benefitted in

the past decade or so from a rise in the average

interest rate paid by banks on their balances,

especially after allowance is made for inflation.

Low-interest accounts – such as current

deposits and statement/investment/passbook

accounts – have declined sharply from

55 per cent of banks’ liabilities in 1981 to

about 20 per cent of liabilities in 1991

(Graph 4). There has been a corresponding

rise in the proportion of banks’ liabilities in

term, call and cash management deposits

which typically earn higher rates of interest.

Even within the “low-interest” accounts,

interest rates on some categories have risen

over the period.

The main reasons for this increase in the

interest cost of deposits were:

• savers have generally demanded higher

returns than they did in the 1970s – i.e.

most interest rates and investment returns

tended to be higher in the 1980s, especially

in “real” terms; and

short periods. One example was in mid 1990,

when banks appeared slow to reduce their loan

interest rates. Although competition among

the banks quickly reversed the rise in spreads,

this particular episode was one of the triggers

for the Parliamentary inquiry into banking

which followed.

The steadiness of average spreads in recent

years shows that, when all customers of the

major banks are taken together, there is no

evidence that banks have used margins as a

means of boosting profitability at the expense

of their customers. That does not mean that

every customer’s experience has been the

same – some are better off, some are worse

off, and some are, like the average, neither one

nor the other.

• competition among banks saw many new

deposit products introduced, usually with

more market-related interest rates than

had been offered on traditional deposit

accounts.

The trend increase in average deposit costs

has translated, perforce, into a corresponding

trend increase in the average interest rates

sought by banks on their loans and other

investments (see Graph 3). However, the

spread between the average rates received and

paid has not increased. What this means is

that, on average, borrowers are paying more

for their loans than they did a decade or so

ago but they are paying not the banks but

those people who lend money to or deposit

money with the banks.

For borrowers there has been a great

diversity of experience with bank interest rates.

Those who borrowed for a long term at fixed

interest rate have not faced any change in their

interest costs over the periods of their loans,

although they may face large changes in

interest costs if and when they seek to roll over

such loans. Most bank lending, however, is at

interest rates which can be varied during the

term of the loan. On these loans, banks usually

follow a two-step procedure in setting the

interest rates:

• head office determines indicator rates from

time to time in response to movements

in market short-term rates, to reflect

the general level of interest rates. Many

banks have different indicator rates for

different categories of business loans, one

for owner-occupied housing, one for

investment housing, and so on;

• for each business customer, a branch or

regional manager typically decides on a

margin, to reflect the overall

creditworthiness of that customer, to add

to the relevant indicator rate. These

customer margins are assessed within

guidelines provided by head office;

• for each housing or personal loan

customer, the bank usually charges the

indicator rate although there are

sometimes “special offers” for certain

customers, such as first-home buyers.

Fees are also relevant. Some, such as

application fees or establishment charges, are

once-only payments levied when a loan is first

arranged. Other fees, such as line fees, are

charged continuously over the life of the loan

and are, in effect, an additional interest

margin.

Indicator rates are set with reference to

movements in the banks’ cost of funds, with

an additional allowance made for costs

associated with prudential requirements

(non-callable deposits and the Prime Assets

Ratio requirement), expected average losses

on bad debts for that type of loan, handling

charges, a contribution to overhead operating

costs, and a return on the capital required to

support the loan.

The process of setting a customer’s margin

above the relevant indicator rate varies with

the size of the loan. For small loans (up to

usually determined by branch managers, who

assess the credit risk of each proposal, using

guidelines laid down by head offices. For

medium-sized loans (up to several million

dollars), decisions on customer margins may

be taken by regional managers. For larger

loans, decisions are usually taken at head

offices.

For large borrowers, customer margins are

usually small – within a range up to about

1 percentage point. The reason margins are

small for these customers is that they tend to

be large well-established businesses which

have a good loan history and ready access to

other sources of funds (for example, by issues

of securities such as promissory notes,

convertible notes, or preference shares) and

will generally be prepared to pay only a small

premium to an intermediary for finance.

For smaller borrowers, customer margins

are wider reflecting the fact that, on average,

the risks are greater. Generally, the range is

up to 4 percentage points, with an average of

about 2 percentage points. Higher rates are

usually charged on unapproved borrowings

(where, for example, a customer has exceeded

the maximum limit on an overdraft) and on

loans where the customer is in default.

In recent years, banks have increased the

customer margins for some borrowers to

reflect changed assessments of the credit risk

represented by their loans to those customers.

It could be argued, with the benefit of

hindsight, that the banks should have applied

greater customer margins at the time some

loans were made. In any event, experience has

shown that banks underestimated the average

level of risk in business lending and some

reassessment of these risks – and hence of the

risk margins built into lending interest rates –

was necessary.

Despite considerable publicity suggesting

that increases in customer margins have been

large and widespread, evidence available to

the Reserve Bank suggests that they have been

minimal and have had little effect on banks’

average interest spreads. Between August

1990 and September 1991, when business

indicator rates fell from 17.0 per cent to

13.5 per cent, there was only a small increase

in the sizes of customer margins – e.g. the

percentage of loans on which the customer

margin exceeded 2 percentage points

rose from 27 per cent in August 1990 to

31 per cent in September 1991 (Graph 5).

Banks are intermediaries which borrow

from one section of the community and lend

to another. In the normal course, they cannot

give their borrowers a larger cut in loan

interest rates than their depositors are willing

to give to them. Banks must earn reasonable

profits if they are to remain viable and be in a

position to meet the financing needs of the

community in the future. On the other hand,

when bank managements make mistakes it is

appropriate that their shareholders bear the

brunt of this through lower profits and

dividends. That is essentially what has been

occurring.