What is driving the interest rate rises? BDO explores how inflation, bank funding costs and bank regulations are contributing to the continual rate rises, and what you can do to avoid some of the pain.
Many borrowers would have seen the announcement by the Reserve Bank of Australia (RBA) on 4 October, where the Cash Rate only rose 0.25%, as a welcome sign that the worst of the interest rate rises are behind us. Unfortunately, several worrying signs point to more pain to come.
So, what is driving the interest rate rises?
The RBA has cited rising costs of living and wage rise pressures as the primary drivers of its decisions since May to raise rates from their COVID-low point of 0.10% to the present 2.60%.In its latest announcement, the RBA stated that it “expects to increase interest rates further over the period ahead” and presently there is some consensus that there might be around 1.0% of further interest rate rises to come in the Cash Rate by the middle of next year. With mooted electricity price increases next year and other costs of living items also on the rise, there is some risk 1.0% may not be enough to manage inflation and the Cash Rate could rise further.
2. Bank Funding Costs
It’s been largely forgotten that the banks in Australia were the beneficiary of $188 billion of ultra-cheap funding from the RBA through the COVID period. The banks borrowed these funds from the RBA as a three-year loan, with the last round of funding in June 2021. As a result, the banks must start repaying the RBA and have it fully repaid by June 2024.
To maintain their lending, the banks will have to find alternative capital – and unfortunately, the financial conditions around the globe aren’t presently supportive of cheap and easy finance – even for our well-rated banks. Bank funding costs are already much higher as they replace the cheap funding from the RBA. The more they need to borrow, the more expensive it will be. If bank funding gets too expensive, banks might reduce the pace of their growth and moderate their lending.
There is growing evidence that banks have started to slow their lending as they manage their balance sheets. There are two ways where we see this evidence emerge.
Firstly, banks become more picky lending to new borrowers, tightening their credit terms and conditions - making loans more difficult to secure.
In early October we saw a BDO client apply to a major Australian Bank for a large new loan. Despite a solid track record, low gearing, and growing profitability, the bank response was that they had no appetite to lend to this borrower as they were “conserving their capital for other existing borrowers.
Secondly, the banks will start to increase the margins on their loans to make them slightly less attractive in the hope some borrowers will go elsewhere. Home loan borrowers are likely to see out-of-cycle interest rate rises separate from the RBA Cash Rate changes, and business borrowers will find banks repricing loans at their next review.
One borrower has been advised their interest rate margin will rise by 0.37% to secure an extension to their loan, even though their business has improved since the last review.
At BDO we’re seeing margin increases for many of our clients across a range of industries, on top of the cash rate rises already occurring. I expect this alone could add a further 0.50% to the interest rate on a typical loan – but the risk is it could be even more for some borrowers.
3. Bank Regulation
Australian Banks are very safe and well-regulated. There are rules regarding how much capital Australian banks must hold as a safety net. Changes to these rules were scheduled to commence in 2020 but were delayed until January 2023 due to the COVID pandemic.
These rule changes will make it easier for banks to lend to those borrowers with good equity and lots of security, but it will make it harder to lend to those that have fewer assets as security. I think banks will use this as a reason to raise interest rates or margins for those businesses with less security.
The interest rate pain will be most severe for borrowers without bricks and mortar security.
How do we avoid the rate rises?
Unfortunately, these impacts are going to be hard to avoid. If you think you can move to a non-bank financier to side-step the margin pain – I don’t think it will help, as we’ll see these impacts wash through the entire financial system and affect all lenders. Even though the non-bank lenders generally don’t have to follow the same rules set by the regulators, many of them will still have bank debt facilities themselves and will face their own funding costs rising – which they will pass on to their borrowers.
To help avoid some of the pain, my advice from my article in April (The era of cheap loans is ending) still stands:
- If your financial position has improved, negotiate with your bank. You can make a case for a lower margin or at least for why it shouldn’t increase.
- Simplify your arrangements if you are paying for loan features that you aren’t using - removal of these could reduce your interest rate
- Reduce your loan (or your loan limit) if you can. The better your security cover for your loan, the better you can shield yourself from rising margins
- Renegotiate your loan now before the situation worsens
- If you are looking to borrow more money for your next purchase or expansion, think about the structure of your loan arrangements and how to access the cheapest form of funding available efficiently.