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Interest rates: What do they really mean?

Supplier: Finlease (Australia) By: Michael Ryan
08 June, 2010

I have certainly had my fair share of trying to explain why fixed interest rates are what they are today when it comes to Equipment Finance or any Fixed Rate product for that matter.

Too often fixed rates for equipment or fixed property loans are compared to the official cash rate or the honeymoon home variable rate. That would be ideal for all of us but not reality. I thought it was timely that I put my fingers to the keyboard and put something out there to try and shed some light on it all.

The simplest and most straight forward answer is when someone invests their money over a longer period of time they expect a greater return. The expectation is that if it takes longer to get your initial investment back, then the return for that investment should be greater than a shorter term investment.

Without going into an economics lesson, we all know that interest rates are determined via the Reserve Bank Australia (RBA) through its Monetary Policy by influencing the supply of cash in the money market. The instrument used to affect this is known as the Cash Rate.

Changes in the cash rate affect the key rates for banks and financial intermediaries. For example, an increase in the cash rate (tightening) will mean higher mortgage, personal, credit card and business loan rates. A higher cash rate looks to slow economic growth, reduce demand for goods and services (control inflation) and influence the level of full employment. It is the major control mechanism for accelerating or decelerating the pace of our economy.

As a result of the role the RBA plays in the banking system, this cash rate has a close correlation with how the money market rates come about. All monetary transactions between the banks (cheques, electronic transfers, credit card purchases etc) are "settled" every night through the RBA system.

The RBA requires each bank to hold surplus credit funds in a settlement account. Each night the banks go about debiting and crediting each other. Where surplus funds are held by a bank in the settlement account the RBA pays the bank interest on the surplus funds based on the official overnight cash rate set by the RBA. Conversely, when one bank is short, it borrows from another bank and interest charged at the overnight cash rate.
 
The overnight cash rate is what I call the feeder for all other interest rates to be calculated from.

Generally speaking banks lend to home purchasers, credit card users and businesses. Banks source their funds from customer deposits, the wholesale market and securitisation. These funds come at a cost and depend on a range of factors including the cash rate, competition, international events, the bank's own credit rating and the availability of funds from the wholesale market (both domestically and internationally).

Since the Global Financial Crisis (GFC) began in late 2007 the banks cost of funds have increased over and above what was previously considered the norm when it comes to the price of fixed rate funding today. This cost increase is primarily due to less investors willing to make funds available for the banks to borrow, and that in turn forces the price or cost to borrow higher (bank margins are a discussion for another day).

It is interesting to note that the Australian Bureau of Statistics revealed as at September 2009 that the Australian Banks had provided borrowings totalling $1.4 trillion to its customers.

This funding was made up of:

  1. Retail Deposits = 52% or $734 billion (our deposits)
  2. Local Wholesale Funding = 22% or $307 billion
  3. Overseas Wholesale Funding = 26% or $366 billion (borrowed from offshore sources).

Total = $1.4 trillion

Like us, banks must pay interest for all their funding whether it is funded from deposits or via domestic/international debt. The rate a bank will pay on its wholesale debt will depend on its credit rating, competition and the cash rate. The interest it will pay to its customers for their deposits will mostly depend on its ability to penetrate the household and business sector for deposits and what the competition is offering in the market.

As a result of the GFC the Australian Government provided a guarantee on retail deposits placed with banks and for funds borrowed by banks. This guarantee assisted the banks gain access to funding in the marketplace and was voluntary but it came at a cost for the bank (called an issuance fee). The fee paid to the government ranged depending on the banks credit rating. This disadvantaged the smaller banks as it added to the cost of funds over and above what the big 4 banks experienced. This fee impacted the cost of funds ranging from 0.7% to 1.4% depending on the banks credit rating.

The Official Cash Rate as at the 5th of May 2010 is 4.5% which reflects an increase of 0.25% on the previous month. The 90 day bank bill rate is commonly viewed as the short term funding cost benchmark in the market (don't forget the bank adds its margin to the rate).

The difference between this rate and the official cash rate can indicate changes to the banks' short term funding costs. This is a good starting point for us to get a feeling for the day to day rates that are charged in the market place. The Australian Financial Review (AFR) published this rate at 4.74% for close of business 5th of May.

Generally speaking Bank Bills are the cheapest form of short term funding (up to 180 days) for business finance. The published bank bill rate does not include the banks margin. Depending on what you use the money for will determine the margin a bank will apply taking into account such factors as term, strength of client, and supporting security. When we look at longer term rates say, 3 and 5 year money, we start to look at what is called the Swap Rate as guide to what bank's cost of funds are doing. 

When it comes to equipment finance we are still very fortunate in the way in which banks lend money. By this I mean when compared to arranging finance for a house or commercial property you are required to come up with 20-30% deposit before the bank will lend the money + all the associated legal and government costs associated with that purchase.
 
In contrast, equipment finance more often than not is 100% financed (i.e. no deposit). The irony here is that whilst a deposit is required on property finance and property is considered an appreciating asset the reverse applies to equipment.

From the moment a new piece equipment or motor vehicle is delivered the value drops by at least 20% in most cases and continues to slide until it reaches a stable market value. The risk factor for a bank when lending on equipment dictates that their return on money will need to be higher than that on a property loan due to the risk factor.

The secondary market for a home is much more buoyant (less risk) as everybody needs a home whereas not everybody needs a second hand piece of equipment. If the shoe was on the other foot would you be asking for the same return for these two different types of investments?

Another factor contributing to why interest rates differ between home loan and equipment finance rates, the fact that the money is sourced from different channels by the banks to on-lend to the business community. Home loan funding is mostly done on a variable rate which is funded on day to day, month to month, quarter to quarter funding programs.

Equipment rates however are based on medium to longer term funding programs and the rates on equipment are on a fixed rate and a fixed term structure. This method gives rise to why the rates are higher on this fact alone let alone where the bank sources it money from. Interestingly, the Commonwealth Bank website currently has on offer a term deposit rate of 7% for a 5 year term. This means that the bank would need to lend out at rates of around 9% + in order to meet its obligation on that term deposit and make a return.

I am consistently seeing 5 year fixed rates for commercial property advertised around the 8.95% mark so equipment finance rates in the 9% + range is looking very attractive when all is said and done.

For whatever comfort the following comment is worth, it is interesting to note that according to the statistics provided to the Australian Bankers Association "data to early 2009 shows that bank's interest rate margins remain at low levels. In late 1995, bank margins were almost 4% and are now 2.15%.” It would appear in more recent times that this margin is now on the way up again.

The Westpac Chief Executive Officer Gail Kelly made the comment that "finance deals made before the global financial crises were being priced at rates that didn’t account for the risk involved and weren't sustainable." 

With the recent turmoil in Greece and the massive bailout provided by the European Union it will be interesting to the see the stance of the RBA with regard to Australia’s Monetary Policy over the next few months.

This article has been prepared by Michael Ryan of Finlease an equipment specialist finance broker, more tips and advice can be found at www.finlease.com.au.