Spike in borrowing costs: Another margin risk
Shorter term funding costs have spiked at the worst possible time for the banks especially if their ability to reprice mortgages is limited due to the royal commission.
Wholesale funding pressures are intensifying with a 25-basis point rise in the spread between the BBSW and the OIS in the past six weeks to 55 basis points.
The spread between the 3 month bank bill swap rate and the overnight index swap rate is at its widest since the eurozone crisis in early 2012 when the spread peaked at 50 basis points.
Bank margins could be hit hard if the wider spreads persist for a year, according to Morgan Stanley’s Richard Wiles who reckons as much as 2.5 per cent could be shaved off bank earnings if that happened.
“Assuming no benefit from hedging or other management actions, if wholesale funding costs rise by a persistent 25 basis points for a 12 months period, we estimate a 4-basis point margin impact, or 2.5 per cent, for a major bank.”
As Wiles sees it, there will be a little more impact at National Australia Bank and a little less at ANZ.
However, he thinks the impact of the wider spreads will be small for the 2018 first half.
"The average BBSW-OIS spread in the 2018 first half was 28 basis points - versus 23 basis points in the 2017 second half and 28 basis points in the first half - so the margin impact is unlikely to be material in the 2018 first half," Wiles said in a client note.
According to JP Morgan banking analyst, Andrew Triggs, the spike in the BBSW-OIS spread - mirroring a widening of the US Libor-OIS - was the most noticeable feature of funding markets in March.
Like Wiles, Triggs also expects a negligible impact on the major banks 2018 first half results.
"However, should spreads stay at these levels longer term it may require loan repricing to offset the impact," he said.
“This will ultimately put pressure on banks’ margins, at a time when loan repricing may be difficult due to the royal commission.”
Over the past several years, US Libor-OIS spread has been relatively stable, averaging 30 basis points.
“At 55 basis points, this measure of US borrowing costs has hit its highest level since December 2011.
According to Triggs, in the past a spike has typically been an indicator of market stress. But JP Morgan economists think the current rise has principally been driven by US monetary policy - namely an increase in short-term Treasury bill supply.
"These effects are, however, only expected to be transitory, which should see spreads slowly begin to normalise," they argued.
"These pressures have been transmitted to Australian markets, contributing to a similar rise in the BBSW-OIS spread."
However, US reports indicate that the widening spread may indicate a structural change - that recent US tax reforms might have a permanent effect on the way companies manage their portfolios.
These reports say tax reforms incentivise US corporations to bring money back to the US that they had previously kept overseas.
This has reduced offshore cash at US multinationals as a source of funding, forcing these companies to increase their borrowing in the short-term markets, leading to higher rates in the commercial paper market.
Yet to Triggs, wholesale term funding markets remain open and healthy with Commonwealth Bank, National Australia Bank and Westpac all issuing benchmark deals at reasonably attractive spreads in March.
“These deals were done in covered and senior unsecured. The majors are also well progressed on funding targets, which should help to limit impacts from instability, should it persist.”
Deposit pricing risk
On Wiles’ analysis of the BBSW spread, deposit pricing is not impacted, and his current margin forecasts assume a small tailwind from lower term deposit pricing.
However, the banks are not quite out of the woods yet.
Higher short-term wholesale costs can affect the pricing decisions for term deposits with a similar duration.
“All else equal, 25 basis point higher term deposit pricing impacts margins by 6 basis points and profits by 4 per cent,” he said.