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Navigating the dark waters of interest rates — what does it all really mean?

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Be it in good economic times or bad, interest rates dictate how we spend our lives. Or more importantly, how we spend. Period. For many of us, how they are determined and interpreted seems to be the work of economics wizards and the faceless gods at the top of banking towers.

Generally we just accept that what we’re told in news reports, or over the counter at the local high street bank, because attempting to understand, or calculate, the interest rate mire appears far too complicated or beyond us.

Michael Ryan, a  specialist in boat finance, is regularly quizzed as to the intricacies of fixed interest rates, among other options, and has decided to put pen to paper [fingers to keyboard] to shed some light on this little understood economic tool, using purchasing equipment as an example.

Interest rates and your business

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 unfortunately it’s not a reality.

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 of 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 are calculated. 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.

So, it’s all about the cash rate

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. 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 (ABS) revealed, as at September 2009, that the Australian banks have 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 on all of 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 it’s 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.

The purpose/effect of the Government Guarantee

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 to gain access to funding in the marketplace and was voluntary, but it came at a cost for the bank, which is 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 four 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 of 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% as at 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 bank’s 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, three- and five-year money, we start to look at what is called the ‘Swap Rate’ as a guide to what a bank’s cost of funds are doing.

What about equipment finance

When it comes to equipment finance we are still very fortunate in the way in that 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 a 20-30% deposit before the bank will lend the money, plus 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 while a deposit is required on property finance, and property is considered an appreciating asset while 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, as a result of 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 and 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%.”

Where are equipment finance rates heading

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.

Michael Ryan is a Senior Broker of Finlease, a specialist plant and equipment finance broker to small and medium sized business at Finlease. Michael is a Professional member of the National Institute of Accountants.

Photo: kevinzhengli

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