Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 51

How bank transfer pricing affects everyone

At least once a week, in every bank and non-bank across the country, pricing committees have their regular meetings. These discussions determine the rates and fees on every financial product in the market. Each meeting is presented with enough data to make Edward Snowden jealous. Market rates, competitor rates, product profitability, capital costs, liquidity costs, changes in regulations … it can go for hours. I have sat on the pricing committees of four banks and numerous non-banks, and while each has a different emphasis, they all have common elements. This article is a simple explanation of how they affect all borrowers and depositors.

Many bank executives spend their entire multi-decade careers specialising in product pricing, and over the years, it has become extremely complicated. Entire consultancy firms have built their fortunes on advising banks, and the complexity of capital allocation and liquidity management plays beautifully into their hands.

At the heart of the pricing process is a Funds Transfer Pricing System (FTPS). The FTPS is usually controlled in a central unit such as the bank’s Treasury. Every asset writing or deposit raising unit in the bank must negotiate its own relationship with the FTPS and Treasury. The basic rules are:

  • all lending units borrow from the FTPS (or Treasury)
  • all fund raising units deposit with the FTPS (or Treasury)
  • Treasury manages the resulting interest rate mismatch and liquidity requirements centrally.

The FTPS allows the bank to isolate the performance of every business unit by measuring the margin between the FTPS rate and the customer rate. For example, on a five-year fixed rate loan:

GH snip1 Ed51

GH snip1 Ed51

By locking in the 1.5% margin, the lending business unit does not have to worry about interest rate mismatch or how to fund the loan. The transaction is combined with millions of others in the bank and the mismatch and funding is managed as one centralised risk position.

That’s the easy bit. Behind the scenes in the FTPS rate calculation, Treasury will ensure any capital or liquidity charges are passed to the relevant business unit. If a regulation changes, such as a requirement to hold more capital against a certain type of loan, the cost of business and the rate charged to the borrower rises.

Maturity transformation and pricing signals

One of the roles of banks is ‘maturity transformation’. Most borrowers want money for long terms (housing, plant and equipment, buildings) while depositors want access to money at short notice. Banks facilitate this by borrowing short and lending long, but it introduces risk into their balance sheet which events such as the GFC expose.

Regulators impose rules which control the extent of maturity mismatch or supporting capital required, and those rules have costs. Treasury will tweak the FTPS rates to recover the costs. For example, the new Basel III liquidity rules mean a deposit that may mature within 31 days must have high quality liquidity (essentially, government debt) held against it. Such liquidity usually carries an opportunity cost and as the table below shows, it is the lowest-yielding investment in the market.

GH snip2 Ed51

Asset writers are generally charged for the capital they use. Each bank will estimate a different cost of capital, based on a variety of factors such as its view on how much capital it needs to hold to retain its credit rating, and the Prudential Standards for Capital Adequacy. The Australian Prudential Regulation Authority (APRA) grants approval for the more sophisticated banks, such as the Big Four, to use an internal ratings-based approach, using estimates of defaults and loss-given-default.

Every asset on- and off-balance sheet is given a risk weighting, and the lower the risk weight, the less the capital charge. It’s one reason why banks love residential mortgages: the risk weighting is low, and even in the simple models, a standard eligible mortgage with a Loan To Valuation ratio less than 60% is risk weighted at only 35% of its actual balance. Corporate loans can be rated 150%.

In response to changing regulations, banks adjust their pricing signals to encourage or discourage certain activities. For example, a product developed in response to pricing signals is the growth of Notice Accounts on deposits, where a higher rate is paid if the depositor agrees to a 32-day notice period. This avoids the Liquidity Coverage Ratio (LCR) charges imposed on short term deposits.

Obtaining the best rates from the bank

Although most customers are price takers, a knowledge of how FTPS works may give some negotiating edge in certain circumstances:

1.     The less capital used on a loan, the lower the lending margin.

Housing loan rates are the lowest, and whatever the purpose, an offer of housing security can reduce costs. For example, borrowing on a margin loan to buy shares, even with the security of BHP and CBA shares and an LVR of 50%, will cost about 7%. A line of credit against the home is less than 6%, while mortgage rates are around 5%. Similarly, a small business that offers a residential property as security will achieve a lower rate, as shown below by the difference between the orange and blue/grey lines.

GH snip3 Ed51

2.     The classification of a deposit as ‘retail’, and therefore long-term and ‘sticky’, should achieve a higher deposit rate.

This issue has been discussed in Cuffelinks at length. A practical application is that a direct deposit with a bank into a retail deposit account will usually achieve a higher rate than a deposit with a super fund, as the fund itself is not considered ‘retail’.

3.     The longer the maturity of a deposit, the more a bank is willing to pay above the swap rate.

Banks prefer the funding security of long term liabilities, and will generally pay higher margins above swap for longer maturities. In addition to the LCR mentioned above, APRA will be introducing a Net Stable Funding Ratio (NSFR) calculation that will gradually influence FTPS rates. It is the equivalent of the 31 day LCR at the one year maturity. Banks will want to avoid maturities of deposits of less than one year and this will feed into better long term deposit rates.

4.     Watch for early repayment interest costs.

Anyone borrowing for a fixed rate over a long term must understand how the bank may charge for early repayments. It’s far riskier than repaying a variable rate loan, and can easily be lost in the fine print. In my past life, I have briefed QCs and appeared as an expert witness in court disputes over the costs of prepayments of fixed rate loans. It can be a very messy business if market rates have fallen significantly since the loan was written.

As far as a bank’s Treasury is concerned on a fixed rate loan, the business unit has entered a long term contract to borrow money to lend to the client. If the loan is repaid early, Treasury will charge the business unit an interest adjustment if rates have fallen, and this will be passed on to the client.

How much? An easy way to estimate the possible cost is to multiply the estimated rate change by the number of years remaining on the loan. After one year on a five-year loan, if interest rates have fallen by 1%, the interest charge will be a little less than 4%. On a loan of $500,000, that’s $20,000. Many people think the simple act of repaying a loan early will result in some fees, but that’s not the main problem. I have seen early termination fees on large loans following the rapid rate falls in the 1990s run into millions of dollars.

The other tip is to make sure the documentation works both ways. That is, on a loan, if interest rates rise, then the payment should come to the borrower. It must be symmetric to be fair.

And the reverse of all this should apply for deposits.

Think about what is happening in the bank’s FTPS when you borrow or lend, and you may be able to improve your deal by taking advantage of each bank’s approach to pricing.

 


 

Leave a Comment:

     

RELATED ARTICLES

Is it time for an Australian 30-year fixed rate mortgage?

Rising interest rates and the impact on banks

Australia’s pending refinancing revolution

banner

Most viewed in recent weeks

How to enjoy your retirement

Amid thousands of comments, tips include developing interests to keep occupied, planning in advance to have enough money, staying connected with friends and communities ... should you defer retirement or just do it?

Results from our retirement experiences survey

Retirement is a good experience if you plan for it and manage your time, but freedom from money worries is key. Many retirees enjoy managing their money but SMSFs are not for everyone. Each retirement is different.

A tonic for turbulent times: my nine tips for investing

Investing is often portrayed as unapproachably complex. Can it be distilled into nine tips? An economist with 35 years of experience through numerous market cycles and events has given it a shot.

Rival standard for savings and incomes in retirement

A new standard argues the majority of Australians will never achieve the ASFA 'comfortable' level of retirement savings and it amounts to 'fearmongering' by vested interests. If comfortable is aspirational, so be it.

Dalio v Marks is common sense v uncommon sense

Billionaire fund manager standoff: Ray Dalio thinks investing is common sense and markets are simple, while Howard Marks says complex and convoluted 'second-level' thinking is needed for superior returns.

Fear is good if you are not part of the herd

If you feel fear when the market loses its head, you become part of the herd. Develop habits to embrace the fear. Identify the cause, decide if you need to take action and own the result without looking back. 

Latest Updates

Economy

The paradox of investment cycles

Now we're captivated by inflation and higher rates but only a year ago, investors were certain of the supremacy of US companies, the benign nature of inflation and the remoteness of tighter monetary policy.

Shares

Reporting Season will show cost control and pricing power

Companies have been slow to update guidance and we have yet to see the impact of inflation expectations in earnings and outlooks. Companies need to insulate costs from inflation while enjoying an uptick in revenue.

Shares

The early signals for August company earnings

Weaker share prices may have already discounted some bad news, but cost inflation is creating wide divergences inside and across sectors. Early results show some companies are strong enough to resist sector falls.

Property

The compelling 20-year flight of SYD into private hands

In 2002, the share price of the company that became Sydney Airport (SYD) hit 80 cents from the $2 IPO price. After 20 years of astute investment driving revenue increases, it sold to private hands for $8.75 in 2022.

Investment strategies

Ethical investing responding to some short-term challenges

There are significant differences in the sector weightings of an ethical fund versus an index, and while this has caused some short-term headwinds recently, the tailwinds are expected to blow over the long term.

Investment strategies

If you are new to investing, avoid these 10 common mistakes

Many new investors make common mistakes while learning about markets. Losses are inevitable. Newbies should read more and develop a long-term focus while avoiding big mistakes and not aiming to be brilliant.

Investment strategies

RMBS today: rising rate-linked income with capital preservation

Lenders use Residential Mortgage-Backed Securities to finance mortgages and RMBS are available to retail investors through fund structures. They come with many layers of protection beyond movements in house prices. 

Sponsors

Alliances

© 2022 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. Any general advice or ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.