AU Lending Paper - University of Aucklanddocs.business.auckland.ac.nz/Doc/Paper-21_Dimitri.pdf · would be misleading to compare lending rates and ... financial crisis on interest

Global Financial Crisis, Competition and Loan Pricing in Australia

By

Ming-Hua Liua,

Dimitris Margaritisb*

Zhuo Qiaoc

Abstract In this study, we examine the impact of the global financial crisis on the pricing of four types of loans in Australia: mortgages, residentially secured small business lending, non-secured small business lending and personal loans. We find that after the onset of the crisis, there has been a shift in the loan pricing mix; the markup has increased and there has been a drop in both short- and long-term pass-through from funding costs to lending rates. Closer analysis indicates that the drop in short-term pass-through is due to the slower response of banks to increases in funding costs. We also find asymmetries in the way banks adjust lending rates in relation to funding costs in the long-run for non-secured small business lending and personal loans. The evidence shows that banks in Australia tightened lending standards and competed less aggressively for loans but more for deposits in response to heightened default risks following the global financial crisis. JEL classification: G21; E43 Key Words: Australian banks, Error correction model, Global financial crisis, Mortgages,

Personal loans, Small business loans

a Faculty of Business and Law, Auckland University of Technology, New Zealand.

b University of Auckland Business School, New Zealand.

c Faculty of Business Administration, University of Macau, Macao, China.

* Corresponding author. E-mail: [email protected]. Tel.: +64 9 373 7599 Ext. 87181; Fax: +64 9 373 7406.

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Global Financial Crisis, Competition and Loan Pricing in Australia

Abstract In this study, we examine the impact of the global financial crisis on the pricing of four types of loans in Australia: mortgages, residentially secured small business lending, non-secured small business lending and personal loans. We find that after the onset of the crisis, there has been a shift in the loan pricing mix; the markup has increased and there has been a drop in both short- and long-term pass-through from funding costs to lending rates. Closer analysis indicates that the drop in short-term pass-through is due to the slower response of banks to increases in funding costs. We also find asymmetries in the way banks adjust lending rates in relation to funding costs in the long-run for non-secured small business lending and personal loans. The evidence shows that banks in Australia tightened lending standards and competed less aggressively for loans but more for deposits in response to heightened default risks following the global financial crisis. 1. Introduction On 12 December 2010, the Australian government announced a banking reform package

aimed at boosting competition in the banking industry after the country’s four largest

lenders raised home mortgage rates well in excess of the 25 basis points (bps) hike in the

official cash rate in November 2010.1 The objective of the reform package was threefold:

(1) to empower customers to get a better deal from their banks, (2) to support small

lenders so that they can compete more effectively with the big banks, and (3) to secure

the long-term safety and sustainability of the financial system so that loans to Australian

households and small businesses can be reasonably priced. Effective 1 July 2011, exit

fees on new home loans were banned. And in August 2011, the Australian Government

announced that they would fully implement within one year all recommendations of a

1 Reacting promptly to the mortgage rate increase announcement, Australian Treasurer Wayne Swan said that ‘banks had a culture of arrogance and needed to be reined in.’ In their reply the Australian Bankers Association justified the banks’ decision to lift rates by almost double the official move on the grounds that banks marginal funding costs were building up at 2 bps each month for nearly a year since they last moved interest rates.

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report prepared by former Reserve Bank of Australia (RBA) Governor Bernie Fraser, to

encourage greater bank account portability by customers of banks and other financial

institutions.

The reform package was passed in light of a long standing debate about competition in

the market for banking services and, in particular, the market for home mortgages. The

relationship between the cash rate set by the Reserve Bank of Australia, the country’s

central bank, and mortgage rates set by lenders had come under more intense scrutiny

since the onset of the crisis. In response to the global financial crisis, the central bank cut

the official rate by a substantial margin, from 7.25% in August 2008 to 3% in May 2009.

However, banks did not pass on cash rate cuts to borrowers in full, leading to an outcry

from customers, commentators and politicians.

Even the Australian Prime Minister, Ms Julia Gillard, took exception to Australian bank

practices stating that: “People who are the customers of banks are entitled to be very

angry if they don't see interest rate reductions passed on.” A similar view was expressed

by Treasurer Wayne Swan, who said that "I think customers would be rightly angry if

their bank decided to withhold any cut." Banks were also criticized by senior opposition

politicians. According to Mr Warren Truss, leader of the National Party, “Home owners

are painfully aware that when interest rates go up the banks show remarkable dexterity in

passing on the rise - in full and immediately - but when rates fall they are notoriously

tardy in providing relief.” Greens MP, Mr Adam Bandt, said that he would introduce

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new laws to “to require banks to offer mortgages that will pass on any RBA interest rate

cuts in full.”

Banks responded to the criticism arguing that their funding costs had increased

substantially relative to the cash rate during the global financial crisis, and therefore, it

would be misleading to compare lending rates and the official policy rate set by the

central bank. According to the Australian Bankers Association (ABA), banks in Australia

have a responsibility to ensure that the banking system remains safe and to persuade

foreign investors to lend money to Australian banks. Otherwise, banks in Australia will

not have enough money to lend to households and small businesses. The chief executive

of the ABA, Mr David Bell, commented that a strong banking system requires solid

levels of profitability and that if Australian banks’ credit ratings are lowered by rating

agencies, the banks must pay a higher risk premium for funding.

International data show that the pass-through from official to bank interest rates has come

under a lot of pressure during the financial crisis. Large drops in pass-through rates have

been observed widely, especially in countries where widespread bank failures or

nationalizations have seen bank ratings being downgraded and access to long-term

funding severely restrained. In contrast, with stronger balance sheets Australian banks

have been more resilient in their lending practices. For example, during the second half of

2008, the RBA cut the official cash rate by a total of 300 basis points, and the average

mortgage rate fell by 200 basis points. On the other hand, in the period August 2007 to

December 2008, the U.S. Fed cut the federal funds rate by 500 basis points during, but

the average mortgage rate decreased by a mere 15 basis points.

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To shed more light on the loan pricing debate, in this paper, we examine how banks in

Australia price the four main types of retail lending in response to changes in the cost of

funds. The four types of loans are floating mortgages, small business loans secured by

property, non-secured small business loans and personal loans. Specifically, we examine:

(1) the long-term relationship between lending rates and the cost of funds; (2) the short-

term pass-through from changes in funding costs to lending rates; (3) whether there is an

asymmetry in both the short- and long-term response of banks lending rates to changes in

their cost of funds; and (4) the impact of the global financial crisis on the long- and short-

term relationship between lending rates and the cost of funds.

In the literature, several studies have examined the relationship between bank lending

rates and deposit rates set by banks and official policy rates set by the central bank (see

for example, Heffernan (1997), Hofmann and Mizen (2004), Sander and Kleimerier (2004),

Kleimerier and Sander (2006), Payne (2007), De Graeve et al. (2007), Liu et al. (2008),

Chong (2010)). Some studies have examined the relationship between bank retail rates and

wholesale market rates (e.g., Hannan and Berger (1991), Newmark and Shape (1992), Chong

et al. (2006), Wang and Thi (2010)), while other papers have examined the relationship

between lending rates and the cost of funds (e.g., Scholnick (1996), Sorensen and Werner

(2006), Liu et al. (2011)). Yet the evidence so far for analyzing the effects of the global

financial crisis on interest rate pass-through behavior by banks appears to be limited to a few

central bank studies focusing on the adjustment of retail bank interest rates to changes in

official policy rates (see ECB (2009)).

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Our results show that the global financial crisis has had an effect on the way Australian

banks set lending rates; markups have increased, the degree of long-term pass-through

has fallen for all types of lending we consider, and the degree of short-term pass-through

has also decreased, especially for small business loans and personal loans. Closer analysis

reveals an interesting pattern in the response of banks to changes in their funding costs.

Prior to the crisis, banks passed a large chunk of funding costs increases immediately to

their customers but very little of cost reductions while maintaining relatively low

markups. This practice appears to have been reversed during the financial crisis. Banks

responded to a squeeze in net interest margins early in the financial crisis by raising

markups. Our analysis shows that higher markups have provided banks with extra

cushion to accommodate funding cost pressures. By maintaining higher markups banks

have been able to pass on a larger (smaller) fraction of official rate cuts (hikes) to their

customers.2

This practice is more evident in the more competitive and high profile segment of the

lending market (i.e. mortgages). It is marginally significant for business lending, and it is

not significant in the least competitive market segment (i.e. personal loans). We also find

differences in the equilibrium adjustment speed of lending rates in relation to funding

costs. Banks adjust business lending rates faster when they are below equilibrium in

relation to their funding costs rather than when they are above equilibrium. On the other

hand, they adjust personal loan rates faster when they are above rather than below

equilibrium. Overall these results are indicative of how banks are competing across

2 Presumably such pricing mix should prove useful for banks to stem public opinion and political pressures about their lending policies.

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different segments of the lending market; the residential mortgage segment being the

most competitive and personal loans the least competitive.

The rest of the paper is organized as follows: Section 2 provides some background

information on the Australian banking system. Section 3 outlines the methodology used

in this study. Section 4 discusses the data and empirical results. Section 5 concludes the

paper.

2. The Australian banking system In 2010, the World Economic Forum’s financial development report ranked Australia 5th

among the world’s 57 leading financial systems. The Australian banking system, with 56

banks and total assets of A$2.7 trillion, is dominated by the four big banks; Australia and

New Zealand Bank (ANZ), Commonwealth Bank of Australia (CBA), National Australia

Bank (NAB) and Westpac Banking Corporation (WBC). They account for over 77% of

banking assets in Australia while the other eight domestic banks account for about 9%.

Foreign banks are well represented, as at 2010 there were 9 foreign subsidiary banks and

35 foreign branch banks, accounting for about 13% of banking assets. While a number of

them are active in the retail banking sector, the majority are in commercial banking and

investment banking (see Australian Trade Commission (2011)). The top four foreign

banks are ING Bank (Australia), Citigroup, HSBC Australia and Rabobank Australia.

Australian banks are among the most profitable, healthy and least affected by the global

financial crisis in the world. Among the Top-100 banks in the world (ranked by assets),

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only nine banks are rated AA or higher by Standard & Poor’s and four out of the nine

banks are from Australia.

Consumer loans have been growing rapidly in Australia over the past few decades. As at

September 2010, total consumer credit amounted to A$1.1 trillion, accounting for 70% of

all bank loans and advances in Australia. The consumer loan market is dominated even

more by the big four banks, with a market share of 87%. The other domestic banks

account for about 7% and foreign banks for 5% of consumer loans extended by banks.

The majority of consumer lending is mortgage lending, accounting for 89% as at

September 2010. Housing loans have grown at an average rate of 15% per year over the

two decades to 2007 and by 8% after the onset of the global financial crisis. The range of

mortgage products has also expanded rapidly. They include home equity loans, low-doc

loans, high loan-to-value ratio loans, interest-only loans as well as niche products such as

non-conforming, shared appreciation and reverse mortgages. Sub-prime equivalent

mortgages accounted for less than 2% of mortgages in 2007 and almost all were issued

by non-bank financial institutions (see RBA (2010), (2011)).

Securitization accounted for over 20% of new housing loans as at 2007 (RBA (2010)). It

is mainly used by non-bank lenders such as mortgage originators as a source of funding

since they do not have a balance sheet or a capital base to finance their lending. After the

onset of the financial crisis, business models relying on securitization were no longer

viable. As a result, some non-bank financial institutions either stopped lending or were

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acquired by larger institutions. However, their withdrawal had little impact on the

housing loan market as the major banks were able to fill the gap and increased their

market share to over 75%.

Unlike many other countries, housing loans in Australia are priced mostly on a variable

rate of interest. Historically, 75% of mortgages are written under a floating rate and most

of the remaining mortgages have rates fixed for less than five years. Fixed-rate mortgages

have almost always come with restrictions on prepayments whereas floating-rate

mortgages provide homeowners in Australia with greater flexibility in making

prepayments. The attractiveness of this flexibility is further enhanced by the fact that

interest payments for owner-occupied property are not tax-deductible (see RBA (2010)).

Small businesses in Australia, like elsewhere, rely on banks and other types of financial

institutions for debt financing as they have no access to capital markets. Most small

business lending in Australia is secured by residential property. As there is no proper

definition of small business lending, the two measures adopted by the Reserve Bank of

Australia are: (1) lending to unincorporated enterprises; and (2) loans with an initial value

of less than A$2 million. It is assumed that loans more than A$2 million are extended to

larger businesses whereas loans less than A$2 million are made to small businesses.

Using these two measures, official statistics show that lending to small business grew

steadily over recent decades to 2008, and the outstanding amount has remained virtually

unchanged after 2008.

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As at September 2010, the amount of all business loans smaller than A$2 million was

about A$200 billion, accounting for around 30% of total bank loans to business. Once

again, the big banks accounted for the majority (86%) of small business lending, the

smaller banks accounted for most of the remaining loans. Foreign banks’ market share is

insignificant as they do not have a sizable branch network (see RBA (2011)). Most of the

lending to small businesses (67%) is done through commercial bills and other loans with

floating interest rates, while the remaining 33% of lending is priced at fixed rates with an

original maturity between one and five years (RBA (2011)).

In terms of funding, banks in Australia rely on deposits as well as on domestic and

international capital markets; and the funding mix was quite stable before the crisis (see

Brown et al. (2010)). Table 1 shows the composition of banks’ funding in Australia. The

table shows that in response to the global financial crisis, both regional banks and the

major banks in Australia have reduced their reliance on short-term capital market

borrowing and securitization and increased their domestic deposits and long-term capital

market borrowings. This is especially true for the regional banks and, to a lesser extent,

for foreign-owned banks.

[INSERT TABLE 1 ABOUT HERE]

Deposits and long-term debt are typically regarded as more stable albeit more expensive

sources of funding than short-term debt. As a result, competition for deposits, term

deposits in particular, has intensified in Australia since mid-2008, leading to a significant

increase in deposit rates relative to the policy rate set by the central bank, the cash rate.

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Before the onset of the global financial crisis, deposit rates were about 150 basis points

below the cash rate. During the crisis, the cost of banks’ new deposits was only slightly

below the cash rate. For example, the average term-deposit special rate -- the most

relevant rate for term deposit pricing (Brown et al. (2010)) -- was over 70 basis points

above the benchmark rates for debt of equivalent terms in late 2010, compared with 60

basis points prior to the financial crisis. For at-call savings deposits, the average rate was

40 basis points below the cash rate in late 2010, compared with 100 basis points below

the cash rate prior to the financial crisis (see RBA (2010)). Banks’ lending rates have also

risen relative to the cash rate during the crisis, with increases being the largest for

business and personal loans (see Brown et al. (2010)). About two-thirds of business loan

rates are tied to the bank bill swap rate (Deans and Stewart (2012)).

3. Methodology

In this paper, we examine the relationship between four types of lending rates and the

cost of funds both in the long run and in the short run, with particular emphasis on the

effects of the global financial crisis on bank pricing behavior in Australia. Firstly, the

long-term relationship between the lending rate and the cost of funds is specified as

follows (see Scholnick (1996) and Chong et al. (2006)):

tttttt xDDxy *3210 (1)

where ty is the lending rate; tx represents the cost of funds; and tD is a dummy variable

for the recent global financial crisis. It is equal to 0 for the period prior to the bankruptcy

of Lehman Brothers in September 2008 and 1 for the period after. t is the error term.

0 measures the markup and 1 measures the degree of the long-term pass-through.

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When 1 is equal to one, the long-run adjustment is complete (see Rousseas (1985)).

2 measures the change in the mark-up and 3 captures the change in the slope, i.e. the

change in long-term pass-through after September 2008.

Secondly, to study the short-run relationship between the various lending rates and the

cost of funds, we use the standard two-step Engle-Granger error-correction model (ECM).

The ECM representation is as follows:

1 2 1 3 4 1* *t t t t t t t ty x D x D (2)

where denotes the first-difference operator; 1t is the residual of the long-term

relationship given by Equation (1) and it represents the degree of disequilibrium at

time 1t ; tD is a dummy variable for the global financial crisis as mentioned above;

and t is the disturbance term. 1 measures the response of lending rates to changes in

the cost of funds in the short term (i.e., within a one-month period), and 2 captures the

error correction adjustment speed when rates are away from their long-term equilibrium

level with the cost of funds. 3 measures the change in the degree of pass-through in the

short-term and 4 captures the change in the equilibrium adjustment speed during the

crisis period.

Thirdly, we extend the error-correction model to incorporate asymmetries in lending rate

adjustments. We assess the short-term response of lending rates to changes in funding

costs, separating funding cost increases from decreases, for both periods before and after

the onset of the financial crisis. And we examine if there is a significant difference in the

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adjustment speed when lending rates are above than below their long-term equilibrium

relationship with the cost of funds. The asymmetric dynamic adjustment model for

lending rates is expressed as:

1 1 2 1 2 1 3 3(1 )t t t t t t t t t ty x x x D x D (3)

where 1 measures the impact response to increases in funding costs ( tx ); 1

measures the impact response following decreases in funding costs ( tx ); and 3 and 3

assess if there are any changes in the associated impact responses after September 2008.

2 measures the error correction adjustment speed when the lending rates are above their

equilibrium relationship with funding costs; 2 measures the error correction adjustment

speed when the lending rates are below their equilibrium relationship with funding costs;

and is a dummy variable set equal to 1 if the residual error ( 1t ) is positive and 0

otherwise. We use Wald tests to test for asymmetries in the relevant response coefficients,

i.e., 1 = 1

(equality of short-term pass-through for the period before the crisis),

1 3 1 3 (equality of short-term pass-through during the crisis) and 2 = 2

(equality of equilibrium adjustment speed).

4. Data and analysis of results

4.1 The data

The monthly interest rate data on the four types of lending rates (standard floating-rate

mortgage rate, secured and non-secured small business variable lending rates for term

loans, variable personal lending rate for term loans) and various funding costs (average

term-deposit rate, average term-deposit special rate, 6-month overnight indexed swap

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rate) were downloaded from the Reserve Bank of Australia’s database. The average term-

deposit rate is the average rate of A$10,000 term deposits across all terms offered by the

five largest banks in Australia, including both the advertised ‘special’ and regular rates.

The average term-deposit special rate is a weighted average rate of the five largest banks'

‘special’ rates on A$10,000 term deposits of all terms. As the average term-deposit rates

of all terms are only available from February 2002, our sampling period is from February

2002 to July 2012, covering a time span of about 11 years. The sample size is 126

months.

To measure the impact of the global financial crisis, we examine bank lending behavior

over February 2002–September 2008 (i.e., prior to the bankruptcy of Lehman Brothers)

and October 2008–July 2012 (i.e., after the bankruptcy of Lehman Brothers).3 Figure 1

presents a time plot of the data series over the sampling period.

[INSERT FIGURE 1 ABOUT HERE]

Table 2 provides descriptive statistics for the data over the entire sample period. As

expected lending rates for floating-rate mortgages are the lowest and for personal loans

are the highest. Residentially-secured small business loans have lower borrowing cost

than those of non-secured loans.


3 Zivot-Andrews unit root tests (not reported in the paper) confirm that a structural break in the series occurred in October 2008.

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The average term-deposit rate over the sampling period is 4.00% per annum. The average

special term-deposit rate is much higher at 5.46% while the average six-month fixed

swap rate is at 5.09%.4 In comparison, the average lending rates are 7.31% for floating-

rate mortgage rates, 7.91% and 8.57% for secured and non-secured small business loans,

respectively, while the average rate for personal loans is the highest at 13.16% per year.

Funding costs have generally been lower during the crisis period. 5 For example, the

average term-deposit rate during the crisis period at 3.89% per annum is 17 basis points

lower than the rate prevailed prior to the crisis. The special term-deposit rate at 5.44%

during the crisis period is 2 bps lower than the rate before the crisis. During the crisis

period the six-month swap rate at 3.79% is 176 bps lower than the rate before the crisis.

On the lending side, the average floating mortgage lending rate during the crisis is 36 bps

lower at 7.08% than the average rate prior to the crisis. But the spread with the cash rate

has increased from 121 bps prior to the crisis to 292 bps during the crisis. The average

lending rates for small business and personal loans are much higher in the second period,

at 64bps, 78 bps and 222 bps for secured small business lending, non-secured small

business lending and personal lending, respectively.

The pair-wise correlation coefficients between the four types of lending rates and cost of

funds measures are shown in Table 3. Among the lending rates, the floating mortgage 4 The average cash rate set by the Reserve Bank of Australia over the sampling period was 5.12% and the median rate was 5.25% per annum. The mean and median for the cash rate for the periods prior to and during the crisis are 4.16% and 4.5% per annum, respectively. 5 To save space, we do not report the descriptive statistics for the two sub periods in Table 1.

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rate has the strongest correlation with the three measures of cost of funds. The correlation

coefficient between the secured small business lending rate and the three measures of

cost of funds is slightly higher than that for the non-secured small business lending rate.


4.2 The long-term relationship

To analyze the long-term relationship between the cost of funds and the four types of

lending rates, we estimate Equation (1) using fully-modified OLS (FMOLS) and report

the results in Table 4.6 Panel A reports results using the swap rate as a measure of

funding costs. Panel B reports results using the special deposit rate as a measure of

funding costs whereas Panel C reports results using both the swap rate and special deposit

rate as measures of the cost of funds.


Table 4 shows that the markup for all four types of lending rates has increased as a result

of the global financial crisis, with the largest increase estimated for personal loans. For

small business loans, the increase in markup for non-secured loans is slightly higher than

for secured loans. The increase in markup after the onset of the global financial crisis is

statistically significant for all four types of loans.

6 Preliminary analysis using a battery of tests -- i.e. unit root tests (ADF, Saikkonen and Lütkepohl (2002)), Granger causality, and cointegration tests (Engle-Granger, Johansen, Saikkonen and Lütkepohl (2000)) indicated that: (a) changes in the cost of funds cause lending rates to change; (b) all interest rate series are unit-root I(1) processes; and (c) all lending rates are cointegrated with the cost of funds. In carrying out this analysis we have allowed for structural change using a shift dummy. The results of these tests are not reported here but are available from the authors upon request.

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Before the financial crisis, the markup for secured business lending was lower than that

for mortgages. However, after the onset of the global financial crisis, the opposite is true.

The difference in markup between mortgage rates and the secured small business lending

rates has increased, ranging from 171 to 198 bps (171 bps in Panel A, 198 bps in Panel B

and 181 in Panel C). This is consistent with an estimate of 180 basis points by the

Reserve Bank of Australia as at late 2010. According to the Reserve Bank of Australia,

the fact that lending rates on residentially secured small business loans are higher than

lending rates on residentially secured housing loans is a common concern of small

businesses in Australia (RBA (2011)).

The difference in markup between home mortgages and the other types of loans reflects

the more risky nature of lending across the different segments of the market. And as

small business lending and personal loans became riskier during the financial crisis, this

discrepancy accentuated further. Prior to the global financial crisis, banks in Australia

competed aggressively for mortgages and small business loans. After the onset of the

global financial crisis, the non-performing small business loans as a share of banks’ total

small business loan portfolio increased from under 1% between 2005 and 2007 to 2.5%

in September 2010. In response, banks began to tighten lending standards, reduce the

loan growth rate and increase risk margins.7 For example, banks imposed higher loan-to-

7 Although lending to small businesses and individuals may involve more non-interest expenses than mortgages, the extra expense is often recovered through fees that banks charge when processing the loan application. Due to data limitations, we could not include such fees in our study.

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valuation ratios, required more stringent collaterals and higher interest coverage ratios.

As a result, the total amount of small business loans, with a size of less than A$2 million,

remained little changed at A$200 billion and the amount of loans extended to

unincorporated businesses remained at about A$100 billion between early 2008 and

September 2010.

The slowdown in credit growth to small businesses also reflected demand factors. Higher

uncertainty about the future of the global economy and demand for their products and

services led small businesses to reduce their capital expenditures and financial leverage.

In 2009, 82% of small businesses surveyed by PwC/East & Partners Business Barometer

were concerned about the availability of credit, but by 2010, this number dropped to 37%.

Small businesses were more concerned with revenues, future cash flows and the global

economic outlook instead of the availability of credit according to various surveys (RBA

(2011)).

Another reason for the difference in the markup between home mortgage and secured

small business loans is the higher economic and/or regulatory capital that banks must set

aside for such loans. Small business loans have higher expected losses as well as

unexpected losses. Higher expected losses will lead to higher provision for loan losses

and higher unexpected losses will lead to higher economic capital and/or regulatory

capital that banks must set aside to protect themselves from bankruptcy. According to

RBA (2011), the probability of default of small business loans is more than two times

higher than that of standard mortgages. Further, the loss given default rate for small

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business loans is close to 30% of the loan’s value versus 20% of housing loans.

According to the BIS capital adequacy requirement, mortgage carries risk weighting of

50%, whereas other types of lending have a 100% risk weighting in terms of credit risk.

In Australia, commercial banks typically hold about three times as much economic

capital against small business lending as against residential mortgages (RBA (2011)).

Similar arguments can be reasonably made for the difference in markup between

residentially secured mortgage rates and unsecured small business lending rates, as well

as for the markup difference between residentially secured mortgage rates and personal

loan rates.

Prior to the financial crisis, the degree of pass-through for the four types of loans we

consider is estimated to be about one. Panel C of Table 4 shows that the relative between

the swap rate and special deposit rate range from 0.84 and 0.23 for mortgages to 0.39 and

0.73 for personal loans. Similarly the relative contribution of the swap rate and special

deposit rate to pass-through are 0.81 and 0.34, respectively, for secured business loans

and 0.78 and 0.36 for non-secured business loans. These results show that banks in

Australia price different types of loans against different measures or benchmarks of cost

of funds. The floating-rate mortgages and small business lending (secured or non-secured)

are priced more on the basis of the six-month swap rate whereas personal loans are priced

more on the basis of the average term-deposit special rate.

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After the onset of the global financial crisis, the degree of the long-term pass-through has

decreased for all four types of loans. The drop in pass-through is greater for secured and

non-secured small business loans and for personal loans as compared to mortgages. This

is consistent across all measures of cost of funds in Panels A, B and C.8

The degree of long-term pass through depends on the degree of market power of lenders

(see De Bondt, 2002). Berger and Hannan (1989) and Pilloff and Rhoades (2002) show

that in markets where a low degree of market power exists, loan rates and/or bank profits

are also lower, and vice versa. The decrease in the long-term pass-through rate for all

types of loans in the crisis period may reflect at the margin the lower degree of

competition among banks as they tighten lending standards and reject loan applications

and rely more heavily on fixed markups in their loan pricing mix in the face of increased

credit risks.

The finding that the decrease in pass-through during the crisis was lowest for mortgages

shows that banks in Australia typically have a lower degree of market power in this

segment of the market. Mortgages are popular for both banks and non-bank financial

institutions, big or small. As a plain-vanilla product, mortgages are much easier to

evaluate in terms of the credit-worthiness of the borrower as well as the value of

collateral. Our results are consistent with the observation by the Reserve Bank of

8 This finding is also consistent with the view of RBA (see RBA (2010)) that after the onset of the global financial crisis and as a result of a significant increase in banks’ exposures to liquidity and credit risks “there has been some lessening in the degree of competition on the lending side but competition to attract funds has increased.”

21

Australia (2010) that “the supply of credit in Australia, particularly lending for housing,

has generally remained adequate.”

On the other hand, small business and personal loans are less attractive as a result of their

uncertain cash flows and high transaction costs. Our empirical results support the view by

the Reserve Bank of Australia that competition for small business lending eased after the

onset of the global financial crisis (RBA (2011)). According to RBA, competition in

lending tends to be cyclical. When the economy is growing strongly, banks are more

likely to compete aggressively for business lending by relaxing lending standards and

reducing their margins. On the other hand, when uncertainty about the economic outlook

increases and loan losses start to increase, banks are more likely to adopt a more

conservative approach.

After the onset of the global financial crisis, funding became a main concern for banks

worldwide. Reflecting the global trend, in Australia, banks appeared to have also

switched from competing aggressively for loans to competing for core deposits (see also

footnote 8 above). While funding costs have decreased in absolute terms as discussed

before, they have increased relative to the official cash rate.

Table 5 shows that the spread between the rate for bonus savings accounts and the cash

rate increased from –185 bps per annum to 0 bps between December 2007 and December

2010. Similarly, the spread between the special term-deposit rate and the cash rate

22

increased from 0 bps in December 2007 to 240 bps in December 2009, before dropping to

140 bps in December 2010.


4.3 The short-term relationship

The short-run dynamics are modeled by an error-correction model (ECM). The results for

the symmetric ECM (Equation 2) are reported in Table 6.9


Table 6 shows that prior to the global financial crisis, the degree of short-term pass-

through (combined effect of the swap and term-deposit special rates) is very similar for

all four types of lending. The effect of the term-deposit special rate change is only

significant for personal loans. In this case, the magnitude of the special term-deposit rate

effect is greater than the effect of the swap rate. After the onset of the global financial

crisis, the short-term degree of pass-through has deceased for personal loans and for both

types of small business loans, but has remained unchanged for mortgages. These changes

are consistent with a reassessment of credit risks across different segments of the market

by banks after the onset of the global financial crisis.

9 We only report results for a model that uses both the swap rate and the special deposit rate as measures of bank costs. We allow for short-term response coefficients to be different between the two periods but limit this to the response of the special deposit rate. There was no statistical support for allowing changes in the response of both measures of funding costs across the two periods. We have not allowed changes in the error correction adjustment coefficients between the two periods as there was no statistical support for different adjustment speeds. We also included lagged changes of x and y in the specification of

Equation (2) but they were not statistically significant. We conclude that our empirical specification is sufficient in terms of capturing the dynamics of bank adjustment costs in the pricing of the various types of loans.

23

Due to significant information asymmetries present in small business lending and

personal loans, banks typically encounter both adverse selection and moral hazard

problems if they decide to increase lending rates in response to rising funding cost

pressures (see Stiglitz and Weiss, 1981). After the onset of the global financial crisis, the

uncertainty about the global economy has increased enormously and small businesses

have been greatly concerned about the demand for their products and services and their

cash flows. Faced with higher borrower default probability and loss given default, banks

have been reluctant to raise lending rates significantly over a short period of time. Instead,

lenders are more likely to ration the amount of credit extended when there is an increase

in credit risks. This is consistent with the fact that lending to small business has remained

almost unchanged during the crisis period.

Thus confronted with increases in non-performing loans and uncertainty about the global

economic outlook, banks have not been as aggressive as before the crisis in lending to

small businesses. RBA (2011) concludes that lower lending by smaller banks and non-

bank financial institutions is likely to have been the main reason for reduced competition

in the market for small business loans. Loans extended by non-bank financial institutions

decreased by almost 50% after the onset of the global financial crisis and lending by

smaller banks was much lower than its peak in 2008. The major banks in Australia,

however, continued to increase their lending to small business, resulting in a significant

increase in their market share in the sector.

24

Further, the price elasticity of demand for mortgages is typically higher than that for

small business loans and personal loans. Anecdotal evidence indicates that home loan

applicants are very sensitive to even slight variations in mortgage rates and tend to

bargain hunt. On the other hand, the search and switching costs for small business and

personal loan borrowers are much higher. After the onset of the global financial crisis

and with the exit of small banks and non-bank financial institutions from the small

business loan market, small business borrowers were left with less choice when it comes

to shopping around for the best deals.

The range of interest rates charged for small business loans has widened after the onset of

the financial crisis. In June 2007, the spread between the highest and lowest rate charged

by the major Australian banks was 35 bps, compared with 120 bps in January 2011,

providing further evidence of non-price competition in this market segment (RBA, 2011).

Lending fees on loans and bank bill facilities increased by about 24% in the 2009

financial year and fees on undrawn facilities increased significantly as banks attempted to

re-price their exposures to credit and liquidity risks. In comparison, bank fee income

from businesses, small and large, increased by 13% during the 2009 financial year. As

lending fees accounted for about half of total fees on businesses, it meant that other fees

such as merchant service fees and fees on deposit accounts remained more or less

unchanged.

Table 6 shows that, as expected, the estimates of the error correction coefficient are

negative and statistically significant for all four types of loans. Lending rates are mean-

25

reverting to their long-run equilibrium relationship with the cost of funds; i.e., they tend

to adjust upwards when they are below the long-term equilibrium level and adjust

downwards when they are above their long-term equilibrium level. The speed of

adjustment to equilibrium is faster for mortgages compared to the other types of lending.

We find no evidence of significant changes in the speed of adjustment after the onset of

the global financial crisis.

4.4 Asymmetric adjustment The results of the asymmetric adjustment model (Equation 3) are reported in Table 7.10

They reveal some interesting patterns in banks’ pricing behavior. For the period prior to

the crisis we find that banks were quick to raise lending rates when the cost of funds was

going up but very slow to lower them when the cost of funds was going down. The

difference in the asymmetric response of banks to funding cost changes is statistically

significant (at 5%) for all the four types of lending we consider. But this pattern appears

to have been reversed during the crisis period. We find that banks appear to be a lot

slower in responding to funding cost increases and much faster in passing on funding cost

reductions to their customers. And this difference in response pattern is statistically

significant for mortgages (at 5%) and for secured and non-secured business lending (at

10%). However, it is not significant for personal loans. This finding indicates that the

drop in pass-through during the crisis period we reported earlier is predominantly driven

by the (slower) response of banks to pass on increases rather than decreases in funding

costs to their customers.

10 We report results for a model that uses the special deposit rate as a measure of funding costs for personal loans and the swap rate as a measure of funding costs for the other three types of lending. There was no statistical support for using both measures of funding costs in the specification of the asymmetric model.

26

Regarding the asymmetry in the long-run adjustment of lending rates to changes in

funding costs, we find evidence of statistically significant asymmetric adjustment speed

for non-secured small business lending and personal loans but not for mortgages or

residential mortgage-secured small business lending. Adjustment appears to be slower

when non-secured loan rates are above equilibrium in relation to funding costs than when

they are below, indicating that banks adjust faster lending rates up than down over the

long-run. The opposite is true for personal loans. In this instance, banks are closing the

gap between actual and desired lending rates faster when rates are above rather than

below their desired level. These asymmetries are statistically significant at 10% level of

significance.


Our findings are indicative of the competition among banks for market share in the highly

popular residential mortgage market.

5. Conclusion In this paper, we have examined how banks in Australia price their loans, focusing on

changes in pricing behavior that may have occurred after the onset of the global financial

crisis. In particular, we examined: (a) changes in the pricing mix, markup versus pass-

through, between the two periods; (b) the long-term pass-through from cost of funds to

27

lending rates; (c) the short-term pass-through of changes in funding costs; and (d)

asymmetries in loan pricing adjustment speed and short-term pass-through.

We find that after onset of the global financial crisis, the markup has increased, the

degree of long-term pass-through has fallen for all four types of lending we consider, and

the degree of short-term pass-through has remained unchanged for mortgages, but has

decreased for small business loans and personal loans. Closer analysis indicates the drop

in pass-through during the crisis period is concentrated in the slower response of banks in

passing on increases in funding costs. The drop in pass-through is partly offset by banks’

faster response in passing on reductions in funding costs to their customers. Although the

RBA has reduced the policy rate significantly since the onset of the global financial crisis,

both the banks’ funding cost relative to the official policy rate and lending risks have

increased. Banks appear to have absorbed increases in their cost structure by lifting the

markup in their loan pricing mix early in the crisis period.

The global financial crisis has reduced availability of funds to banks. With securitization

out of the question, banks in Australia, like those in other countries, were forced to

compete more aggressively for core deposits and less aggressively for lending, especially

for small business lending and personal loans, as they tightened their lending standards

and deleveraged by increasing their equity capital. Nevertheless, our findings show that

the global financial crisis had the least impact on mortgage rates, but a much greater

impact on small business lending and personal loans.

28

Our results show that among the four products, mortgage rates are more competitively

priced in comparison to small business loans and personal loans. Overall, we find mixed

evidence in support or otherwise of statements made by government officials in Australia

regarding the lack of competition and fair pricing in the market for home mortgages and

small business loans.

29

References

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Chong, B. S., 2010, Interest rate deregulation: Monetary policy efficacy and rate rigidity. Journal of Banking and Finance 34, 1299 – 1307.

Deans, C., Stewart, C., 2012. Banks’ funding costs and lending rates. RBA Bulletin March Quarter, 37-43. De Bondt, G.J., 2002. Retail bank interest rate pass-through: New evidence from the Euro area level. Working paper No.136, European Central Bank Working Paper Series. De Graeve, F., De Jonghe, O., Vennet, R. V., 2007, Competition, transmission and bank pricing policies: Evidence from Belgian loan and deposits markets. Journal of Banking and Finance 31, 259-278. ECB (European Central Bank), 2009. Recent developments in the retail bank interest rate pass-through in the Euro area. ECB Monthly Bulletin (August). Hannan, T.H., Berger, A.N., 1991, The rigidity of prices: Evidence from the banking industry, American Economic Review 81, 938-945. Heffernan, S.A., 1997, Modelling British interest rate adjustment: An error correction approach, Economica 64, 211-231. Hofmann, B., Mizen, P., 2004. Interest rate pass-through and monetary transmission: Evidence from individual financial institutions’ retail rates, Economica 71, 99–123. Kleimerier, S., Sander, H., 2006, Expected and unexpected monetary policy impulses and interest rate pass-through in Euro-zone retail banking markets, Journal of Banking and Finance 30, 1839-1870. Liu, M.-H., Margaritis, D., Tourani-Rad, T., 2008, Monetary policy transparency and pass-through of retail interest rates, Journal of Banking and Finance 32, 501 – 511.

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Liu, M.-H., Margaritis, D., Tourani-Rad, T., 2011, Asymmetric information and price competition in small business lending, Journal of Banking and Finance 35, 2189 – 2196. Neumark, D., Sharpe, S.A., 1992, Market structure and the nature of pricing rigidity: Evidence from the market for consumer deposits”, The Quarterly Journal of Economics 107, 657-680. Payne, J.E., 2007, More on the monetary transmission mechanism: mortgage rates and the federal funds rate”, Journal of Post Keynesian Economics 29, 247-257. Pilloff, S. J., Rhoades, S. A., 2002. Structure and profitability in banking markets, Review of Industrial Organization 20, 81–98. RBA (Reserve Bank of Australia), 2010. Senate Economics references committee inquiry into competition within the Australian banking sector. RBA (Reserve Bank of Australia), 2011. Parliamentary joint committee on corporations and financial services inquiry into access for small and medium business to finance. Rousseas, S., 1985. A markup theory of bank loan rates. Journal of Post Keynesian Economics 8, 135-144. Saikkonen, P., Lütkepohl, H., 2000. Testing for the cointegrating rank of a VAR process with structural shifts, Journal of Business and Economic Statistics 18, 451-464. Saikkonen, P., Lütkepohl, H., 2002. Testing for a unit root in a time series with a level shift at unknown time, Econometric Theory 18, 313-348. Sander, H., Kleimeier, S., 2004, Convergence in Eurozone retial banking? What interest rate pass-through tells us about monetary policy transmission, competition and integration, Journal of International Money and Finance 23, 461-492.

Scholnick, B., 1996. Asymmetric adjustment of commercial bank interest rates: Evidence from Malaysia and Singapore. Journal of International Money and Finance 15, 485-496.

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31

Table 1 Composition of Australian banks funding (% of funding liabilities)

Major banks Regional banks

Foreign-owned banks

Jun-07 Oct-10 Jun-07 Oct-10 Jun-07 Oct-10 Domestic deposits 44 50 39 48 26 27 Short-term capital market debt 23 15 22 13 60 53 Long-term capital market debt 21 26 10 16 11 17 Equity 7 7 12 13 2 3 Securitization 5 1 17 10 1 0

Source: Reserve Bank of Australia (2010).

32

Table 2 Descriptive statistics (whole sample)

Term deposit

rate

Term deposit special

rate

Six-month

swap fate

Floating-rate

mortgage rate

Secured small

business loans

Non-secured small

business loans

Personalloans

Mean 3.997 5.458 5.085 7.307 7.914 8.566 13.164 Median 3.925 5.250 4.940 7.300 7.800 8.400 12.925 Maximum 5.250 7.950 7.500 9.600 10.100 10.700 15.250 Minimum 2.600 3.700 2.410 5.750 6.250 6.850 11.000 Std. Dev. 0.527 0.846 1.172 0.865 0.936 0.952 1.388 Skewness -0.050 0.725 -0.058 0.562 0.373 0.290 0.136 Kurtosis 3.324 3.792 2.694 3.421 2.338 2.189 1.485 Observations 126 126 126 126 126 126 126

33

Figure 1 Interest rates of Australian banks

Notes:

SB-secured = Residentially secured small business lending rate

SB-non-secured = Non-secured small business lending rate

Mortgage = Floating-rate mortgage lending rate

Personal = Personal loan lending rate

Swap rate = six-month fixed swap rate

Term-deposit rate = average term-deposit rate of all terms

Sepcial rate = average term-deposit special rate of all terms

34

Table 3 Correlation coefficients 2002-2012

Term-deposit

rate

Term deposit special

rate

Six-month swap rate

Floating- rate

mortgage rate

Secured small

business loans rate

Non-secured small

business loans rate

Personal loans rate

Term-deposit rate 1

Term-deposit special rate 0.91 1

Swap rate 0.73 0.65 1

Floating-rate mortgage rate 0.93 0.86 0.76 1

Secured small business loans

rate 0.79 0.82 0.34 0.86 1

Non-Secured-small business

loans rate 0.76 0.80 0.28 0.82 1.00 1

Personal loans rate 0.44 0.56 -0.18 0.44 0.83 0.87 1

35

Table 4 Long-term relationship between lending rates and funding costs

tttttt xDDxy *3210

Panel A: Six-Month Swap Rate as the cost of funds

Mortgages


Non-secured small business loans

Personal loans

Coefficient

t-Statistic

Coefficientt-

StatisticCoefficient

t-Statistic

Coefficientt-

StatisticConstant 1.447 5.463 1.263 4.505 1.863 6.875 6.010 19.775 Swap rate 1.046 22.854 1.120 23.127 1.120 23.930 1.107 21.082 Dummy 2.551 6.752 4.260 10.650 4.532 11.723 6.062 13.983 Dummy *Swap -0.269 -3.320 -0.416 -4.854 -0.448 -5.414 -0.476 -5.123

Adj. R-sq 84.6% 85.3% 86.7% 92.1%

Panel B: Average Special Term-Deposit Rate (Dep_Spec) as the cost of funds

Mortgages



Personal loans

Coefficient

t-Statistic

Coefficientt-


t-Statistic

Coefficientt-

StatisticConstant 2.280 8.233 2.089 7.551 2.689 10.138 6.565 28.529

Dep_Spec 0.944 18.880 1.023 20.487 1.023 21.371 1.059 25.495 Dummy 1.090 2.020 2.977 5.520 3.232 6.252 4.784 10.668 Dummy

*Dep_Spec -0.262 -2.674 -0.426 -4.346 -0.447 -4.752 -0.466 -5.718

Adj. R-sq 77.9% 81.1% 83.3% 94.1%

Panel C: Swap Rate and Average Special Term-Deposit Rate (Dep_Spec) as cost of funds

Mortgages



Personal loans

Coefficient

t-Statistic

Coefficientt-


t-Statistic

Coefficientt-

StatisticConstant 1.368 5.621 1.210 4.874 1.847 7.759 6.139 25.492 Swap rate 0.839 8.602 0.810 8.139 0.776 8.131 0.392 4.062 Dep_Spec 0.231 2.515 0.336 3.584 0.364 4.059 0.726 7.990 Dummy 3.153 6.439 4.967 9.948 5.139 10.732 5.748 11.863

Dummy* Dep_Spec -0.372 -4.735 -0.532 -6.637 -0.548 -7.130 -0.517 -6.650

Adj. R-sq 86.2% 87.7% 89.1% 94.7%

36

Table 5 Deposit rates versus cash rate in Australia Dec-07 Dec-08 Dec-09 Dec-10Current accounts 0 0 0 0Savings accounts Bonus savings 4.90 3.20 2.95 4.75 Online Savings 6.55 4.60 3.85 4.70 Cash Management 5.35 3.10 2.75 3.70Term Deposits Average for regular rates 4.75 3.35 3.75 4.45 Average for "specials" 6.75 4.85 6.15 6.15 Cash rate 6.75 4.25 3.75 4.75 Spread to cash rate Savings (Bonus saver) -1.85 -1.05 -0.80 0.00 Term deposits (Specials) 0.00 0.60 2.40 1.40

Source: Reserve Bank of Australia

37

Table 6 Symmetric adjustment model

ttttttttt DDxxxy 1514232211

Mortgages



Personal loans

Coefficient

t-Statistic

Coefficientt-


t-Statistic

Coefficient t-

Statisticd(swap) 0.486 6.406 0.367 4.805 0.375 5.015 0.177 3.056

d(dep_spec) -0.011 -0.123 0.069 0.783 0.068 0.787 0.303 3.575 d(dep_spec)*

dummy -0.033 -0.305 -0.268 -2.538 -0.252 -2.441 -0.292 -2.700

ec(-1) -0.243 -3.019 -0.188 -2.615 -0.190 -2.679 -0.184 -3.005

ec(-1)* dummy 0.046 0.484 -0.075 -0.845 -0.052 -0.583 0.062 0.744

Adj. R-sq 60.9% 50.3% 51.0% 28.6%

Notes: d(swap) = change in the six-month fixed swap rate d(dep_spec) = change in the term-deposit special rate ec(-1) = lagged error correction variable

38

Table 7 Asymmetric adjustment model

1 1 2 1 2 1 3 3(1 )t t t t t t t t t ty x x x D x D

Mortgages



Personal loans

Coefficient

t-Statistic

Coefficientt-


t-Statistic

Coefficientt-

Statisticd(funding)+ 0.524 3.944 0.535 3.937 0.530 3.989 0.510 4.717 d(funding)- 0.056 0.340 0.010 0.059 0.039 0.236 0.052 0.394

ec(-1)+ -0.156 -2.454 -0.157 -2.387 -0.127 -1.928 -0.269 -4.135

ec(-1)- -0.274 -4.546 -0.298 -5.008 -0.301 -4.921 -0.120 -2.050 dummy*

d(funding)+ -0.436 -2.209 -0.516 -2.560 -0.495 -2.510 -0.459 -2.463

dummy* d(funding)- 0.489 2.955 0.317 1.863 0.304 1.823 0.077 0.516

Chi-sq_1a (p-value)

4.654 (0.031)

5.444 (0.020)

4.979 (0.026)

7.053 (0.008)

Chi-sq_1b (p-value)

6.053 (0.014)

2.747 (0.097)

2.818 (0.093)

0.230 (0.631)

Chi-sq_2 (p-value)

1.601 (0.206)

2.282 (0.131)

3.353 (0.067)

2.769 (0.096)

Adj. R-sq 65.0% 52.2% 51.8% 27.1% Notes: Funding (cost) is measured by the six-month swap rate in the regressions for mortgages and business loans and by the special term-deposit rate for the regression for personal loans. Ch-sq_1a denotes the Chi-square statistic for testing the equality of the funding coefficients, 1

= 1 , for the period prior to the crisis

Ch-sq_1b is the Chi-square statistic for testing the equality of the funding coefficients,

1 3 1 3 , for the period prior to the crisis

Ch-sq_2 is the Chi-square statistic for testing the equality of the error correction (ec) adjustment coefficients, 2

= 2 .