Cash Rate and Bank funding - Essay Example

Long term debt funding is a relatively expensive source of funding than equity finding. This resulted in the rise in funding costs for major banks and consequently they were forced to increase their housing loan interest rates relatively more than the rise in cash. RBA have also accepted this fact and considers the existing spread as new normal standard spread. Table of Contents Table of Contents 3 Cash Rate – An Overview 4 Major Banks’ Funding and Costs of Funding 5 Pricing for Risk and Variable Housing Loan Rates set by Banks 6 Standard Variable Housing Lending Rates and Spreads 8 Conclusion 10 References 11 Bibliography 12 Cash Rate – An Overview Reserve Bank of Australia (RBA) uses cash rate as a tool to control the pressure of inflation in Australia.

RBA targets to keep the inflation rate in and around 2% to 3%. This refers to the monetary policy followed by RBA. RBA’s monetary policy also includes curbing unemployment rate and assuring a stable economic growth of the country as its other objectives. When the inflation rate goes beyond the target of RBA, the cash rate is enhanced. Otherwise RBA tries to reduce the cash rate when it feels that inflation is not posing a great threat and Australia can have a faster economic growth. Since 2007, there has been a steady growth or hike in cash rate till the beginning of Global Financial Crisis (GFC) during mid 2008, when the cash rate was 7.25%. Starting from September 2008 to September 2009, in one year the cash rate fell drastically to 3% figure.

This was done by RBA to help Australian economy recover from the effects of GFC. Next from October 2009 onwards, the cash rate shows a steady increasing trend (Graph 1). Present cash rate is 4.25%, which is constant for the last 5 months (Reserve Bank of Australia, n.d.). Graph 1 Source: (RBA, 2012, p.18) Major Banks’ Funding and Costs of Funding The funding bases of Australian banks are diverse. The primary sources of funding for the major banks in Australia are: a) Deposits, b) Short term wholesale debt, c) Long term debt and d) securitization.

Prior to GFC, the major banks had a stable funding mix. However, GFC had an adverse effect on the costs of funding of the banks derived from different sources. Since 2007, the major banks have shifted their focus away from short term debt and securitization. The funding mix now is composed of greater percentage of deposits and long term debt (Graph 2). It is so because they are considered to be relatively safer sources of funds. However, these being relatively expensive sources of funds, the cost of funding have increased considerably relative to the cash rate and money market rates relevant to it (Brown, et al., 2010). Graph 2 Source: (RBA, 2012, p.30) Pricing for Risk and Variable Housing Loan Rates set by Banks Risks involved in lending housing loans to the borrowers are an important consideration for banks in determining the variable housing loan rate.

Since 2007, the spread of banks’ lending rates on all the loan products offered by them relative to the cash rate have increased (Graph 3). The increase in these interest rates varied across different types of loans depending on the banks’ perception about the credit risk of the borrowers and the pace with which each type of loan can be re-priced