Domestic Interest Rate Decisions still very much influenced by the Reserve Bank of Australia

In light of the forthcoming interest rate decision on Tuesday May 1st, there has been much media bank bashing and misconceptions on the question as to who sets the level of interest rates in Australia. Ideas have also been perpetuated, by various commentators, that the RBA’s credibility is diminished because lending interest rates, set by authorised deposit taking institutions (ADIs) especially banks, had moved independently of the official cash rate.  The idea that the RBA sets all interests is incorrect and this misconception is largely due to an inadequate understanding of the nature of banks and the RBA within money markets.

Money markets are arcane places – operations are very much in-house and closed to outsiders adding to their complexity and fascination. However, oversimplification as to their operations can add to the misconceptions.

The RBA operates in a money market of its own making – yes you may call this a synthetic market whereby the RBA does not restrict liquidity, known as exchange settlement funds, but rather sets the price or interest rates at which banks can obtain liquidity. In Australia this money market is known as the cash market.

As banks trade and transact throughout the day, they will mostly likely accumulate funds or require funds to square with the RBA. Banks with surplus funds on-lend to banks in deficit – the exchange occurs in the overnight interbank cash market and the target interest rate is the RBA’s official cash rate. There are incentives to trade. The RBA pays 25 basis points either side of the official cash rate target – those with surpluses can receive a quarter of 1 per cent below the cash rate target while those in deficit approach the RBA for funding at a quarter of 1 per cent above the cash rate target. The 50 basis point differential assists banks to fund daily positions between themselves as opposed to accumulating and borrowing excess funds with the RBA.

A closer examination shows that the interbank cash market is a residual market in which banks fund daily positions resulting from changes in broader movements in the flow of funds. This is an important concept because it implies that the official market is not the basis for bank funding. In fact the amount of borrowing/lending in the overnight market is just some several billion dollars representing a small fraction of total bank funding. The mainstays of bank funding are the broader domestic and international short-term and longer-term money markets, the deposit market, and the equity capital market – and this is why unofficial interest rates deviate from their official rates.

Banks compete aggressively and make portfolio decisions as to the composition of their  funding in unofficial markets. Depending on how valuable the sources of funds are to banks, interest rates may rise above the rate at which a bank could fund their lending book in the overnight cash market. Why is this? The name of the game is funding diversification to support lending books while price can become a secondary consideration, particularly in times of heightened risk, as seen by the GFC. In many respects, higher borrowing costs are simply passed on in their lending interest rates to maintain the net interest margins required to generate the return necessary to service their capital.

Banks cannot be satisfied with a narrow source of funding; the GFC taught banks that the analogy of the game of musical chairs can develop quickly resulting in an illiquid although solvent bank. In addition, Banks have increasingly relied on international funding swapped back into Australian dollars. The cost of international borrowings is independent of the RBA official cash rate. Accordingly, to maintain diversified positions, banks must pay the going international market rates particularly when the optimal funding mix is continually shifting.

And of course other factors come into play when determining interest rates including expectations of the expected cash rate, and risk and term premia. But as Guy Debelle, Assistant Governor (Financial Markets) notes:  the RBA provides the front end of the risk free yield curve, a critical benchmark rate for pricing – for if a bank cannot fund itself in other markets they will be forced to fund themselves in the official cash market. And as others have noted including Steven Münchenberg, the Chief Executive of the Australian Bankers Association, the RBA is still very much in the driver’s seat in setting interest rates.

Liam O’Hara is Senior Economist for a Government Agency, Sydney, and Director of Reality Economics. He is co-author of Fundamentals of Financial Markets and Institutions in Australia (2010).

Tom Valentine is a Senior Economist and Visiting Professor (MGSM), Sydney. He is co-author of Fundamentals of Financial Markets and Institutions in Australia (2010).

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