Cash rate, loan rate, equity funding - Essay Example

This can be attributed to the increased cost of debt funding for the major banks in Australia. Study of major banks’ fund composition shows that the banks are shifting their focus towards deposits and long term borrowings more and there has been a decline in share of short term debt in banks funding. Amongst others, higher deposit rates have contributed significantly towards increase in debt funding costs for banks. Although the share of equity has also increased in the banks’ funding composition but it has not contributed much towards changes in housing loan rates, since they are less risky.

Until recently, in 2011, the spread between standard housing loan rate and cash rate has reduced by about 10 basis points due to the increase in discounts offered by the banks on new mortgages, but it’s only a small reduction compared to the overall spread. Table of Contents Table of Contents 3 Widening of the spread between the major-banks standard variable housing loan rate and the RBA’s cash rate since 2007 4 RBA’s Cash Rate 4 Variable Housing Loan Rate and Cash Rate 4 Composition of Banks’ Funding 5 Cost of Debt and Equity Funding 5 Pricing for Risk and Banks’ Housing Loan Rates 6 Conclusion 6 List of Graphs 7 References 10 Bibliography 12 Widening of the spread between the major-banks standard variable housing loan rate and the RBA’s cash rate since 2007 RBA’s Cash Rate The key objective of RBA’s monetary policy is to lower the inflation rate, targeting around 2 to 3%.

Other objectives of RBA’s monetary policy include low unemployment rate and maintaining a stable growth of Australian economy. Cash rate is the primary tool which is used by RBA to regulate the monetary policy in the country. It increases target cash rate when the inflation pressure is in excess of the RBA’s target and it decreases the target cash rate when the economy can grow at a faster rate without creating any inflation problem (Lowe, 1995, p. 3-15). If we look at the history of RBA’s cash rate, it can be inferred that there has been a steady increase in cash rate from 2007 till mid 2008, which was the beginning of Global Financial Crisis (GFC).

Then there was a sharp decline in cash rate during the period of mid 2008 till April, 2009. The cash rate was as low as 3% and continued to be so till September, 2009. Since October, 2009, there had been a steady increase in cash rate (Graph 1). Until recently there had been minor cuts in cash rate and is at 4.25%, as of today (RBA, n.d.). Variable Housing Loan Rate and Cash Rate The trend of standard variable housing loan rates is believed to follow the trend of cash rate. It is so because the household cost of funds are driven by the cash rate.

If we compare the standard variable housing loan rate with cash rate, we find an overall strong correlation between these two rates over the years but with some anomalies in between (Graph 2). If we watch closely, it can be found that there has been an increasing spread between the major bank’s standard variable housing loan rate and the cash rate since 2007. This increase in variable housing loan rate by major banks relative to the cash rate can be attributed to the increase in bank’s cost of debt funding.

In addition to this, higher equity funding costs and increase in expected losses have also attributed to this widening of spread between the two rates. Until recently, in 2011, the spread has reduced by about 10