Takes Two To Tango To Step Up Competition In Rates

Sydney Morning Herald

Saturday February 18, 2006

ROSS GITTINS Ross Gittins is the Herald's Economics Editor.

THE Reserve Bank hasn't changed the official interest rate in almost a year but the rates we're paying have fallen a little. Why? The customer's friend - competition.

In other words, the banks or other financial institutions have been obliged by competitive pressure to cut the margin between the interest rates they charge to borrowers and the interest rate they pay to lenders.

It's a sign that the process of financial deregulation begun 20 years ago is still delivering additional benefits to borrowers. The Reserve proudly recounts the details of the latest benefits in the Statement on Monetary Policy it issued this week.

Starting with home mortgages, there have been some small reductions in the indicator rates charged on variable-rate loans, mainly by the non-bank mortgage originators.

The Reserve thinks the main explanation for this is the decline in demand for home loans following the end of the housing boom. Weak demand puts downward pressure on prices.

But most of the recent competition in the home loan market has shown itself in the greater generosity and wider availability of discounts offered on the list-price "indicator rates" supposedly charged by the banks.

More than 90 per cent of borrowers taking out variable-rate home loans in the first half of last year (the latest period for which figures are available) were charged a rate lower than the average of the major banks' indicator rates.

The average size of this discount has risen from about 0.4 percentage points in early 2004 to 0.55 percentage points.

While this increase may partly reflect borrowers choosing cheaper loan products (which itself may reflect people getting cannier about paying extra for bells and whistles they rarely use), it also reflects the banks increasing the size of the discounts they offer and easing the requirements for borrowers to get access to those discounts.

The consequence was that, in mid last year, the average rate that borrowers actually paid on new variable-rate home loans was about 0.3 percentage points below the average rate for the previous 10 years of 7.1 per cent. And this was true whether you looked at nominal interest rates or real rates (that is, the interest rate in excess of the expected inflation rate).

While the interest rate on home loans is the rate dearest to most families' hearts, there's actually been more action on the interest rate on credit cards.

Credit card rates have long been far higher than they should be - way out of line with mortgage rates - and very "sticky downwards", as economists say. That's because competition has been weak.

The past few years have seen a proliferation of "no-frills" credit cards, which have relatively low interest rates and annual membership fees but generally no loyalty rewards programs.

Interest rates on the new no-frills cards range from 9 to 13 per cent, compared with rates of 17 per cent or more on most standard rewards-based cards.

(The benefits of rewards - taken, say, as shopping vouchers - are worth the equivalent of 1 percentage point at best. So it's obvious people who pay interest on their credit cards balances are much better off with no-frills cards.)

Competition has also seen some lenders offer significantly discounted introductory interest rates on balances transferred from other credit cards and on new purchases, in some cases as low as zero per cent for six months.

(Someone who wanted finally to get on top of their credit card balance would be well advised to switch to one of the zero for six months deals and put no new purchases on the card, so that every monthly payment they made came 100 per cent off the principal.)

Turning to borrowing by businesses, banks have been competing more for business loans because of the moderation in lending to households. While indicator rates on variable-rate business loans have mostly been unchanged, the overall rate actually being paid on these loans (after adding in the premiums charged to riskier borrowers less the discounts offered) has declined by 0.1 to 0.15 percentage points.

The recent decrease in the banks' interest margin on business loans is consistent with other signs of competitive pressure in the business loan market, including the discounting of loan fees and indications that banks have eased their standards for approving loans, particularly larger loans.

So far we've been looking at variable-rate loans, but now let's look at loans where the rate stays fixed over the life of the loan. Three years is the most popular term for a fixed-rate home loan.

The major banks' average rate for such a loan is now 6.7 per cent. This is about its level at the beginning of 2005 and close to the average rate that new borrowers would pay on those banks' variable-rate housing loans (once you allow for the discounting of the latter).

Demand for fixed-rate housing loans remains fairly low, with only about 10 per cent of new loans to owner-occupiers being fixed-rate on average.

It remains for me to make two points. First, people tend to think that what you need to get vigorous competition in a market is a large number of businesses contesting with each other for our business.

But that's only half true. In markets it takes two to tango. The other ingredient needed for vigorous competition is customers willing to work for a better deal: willing to haggle over the rate they're being offered and willing to get off their backsides and shift their business to a bank offering a better deal.

Ideally, the customers should avoid being bamboozled by folderol, such as features that look nice but aren't worth the extra you're being asked to pay for them.

The second point is to remind you that as competition has narrowed the interest-rate margin the banks charge, they've looked for other ways to preserve and improve their overall profitability.

They've done so by cutting costs (including closing branches) but also by introducing and increasing fees and charges for account keeping and transactions.

In pre-deregulation days, the banks covered these administrative costs by overcharging their borrowers - that is, by making them cross-subsidise depositors and transactors.

Deregulation has gradually brought about an "unbundling" process where borrowers and transactors now pay prices that better reflect the cost of the services they're receiving.

The result is lower prices for borrowers (abstracting from the ups and downs in the official interest rate) but higher prices for transactors.

© 2006 Sydney Morning Herald

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