Malcolm Edey: Competition in the deposit market
Speech by Mr Malcolm Edey, Assistant Governor (Financial System) of the Reserve Bank of
Australia, at the Australian Retail Deposits Conference 2010, Sydney, 19 May 2010.
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Introduction
The theme for this session is Pricing and Competition in the Deposit Market. It's a highly
topical subject, because we have been seeing some very strong competition in this area in
the recent period. To give one summary indicator: the average interest rate banks have been
offering on their term-deposit "specials" recently have been around 6 per cent, or about
100 basis points above the bill rate. A few years ago they were typically about 50 points
below the bill rate - so there's been a price movement, in relative terms, of around 150 basis
points.
That's a significant shift although, to keep it in perspective, we have to remember that this is
not the whole market - it's just the part where competition has been most intense. Other
rates are not as high. Nonetheless, across the board, spreads between deposit rates and
wholesale rates have generally shifted in the same direction over the past couple of years.
Obviously this is good news for depositors. It means that, if you have funds to invest, and
you're prepared to shop around, now is a very good time to find a favourable rate. Of course,
from the point of view of deposit-takers1 and the people they lend to, it mightn't seem
particularly good news, because this is one of the factors that have been adding to the
relative cost of funds, and therefore adding to the cost of lending.
I've been asked to talk today about what's driving this competition in the deposit market, and
how it might develop from here. I'm going to stick to that brief, but I also want to place it in a
broader context by looking at how competition has evolved over a longer period.
Evolution of competition in the post-deregulation period
I'll take as a starting point a snapshot of the aggregate balance sheet of the banking system
in 1980 - just before the main sweep of financial deregulation got under way (Table 1).
Banks' balance sheets back then looked rather different from the way they do now. Roughly
speaking, the liabilities side of the balance sheet consisted of close to 90 per cent deposits.
On the asset side, loans were around 60 per cent of the total, and much of the rest consisted
of government securities, which were held under the "captive market" arrangements that
were then in place.
In simplified terms, we can think of the banks' core business in that environment as being a
mix of three main elements - namely, deposit-taking, lending, and providing transactional
services. Banks' net interest margins were quite a bit wider than they are now. That was
partly because their (non-interest) costs were higher. But in a deeper sense, it's also a
reflection of the way competition has evolved in the meantime.
In the regulated environment, banks generally faced a situation of excess demand for their
loans. As a result, competition within the banking sector was not very strong, and banks
faced relatively weak pressure to contain costs.
These conditions affected not just the intensity of competition, but also its focal point. In the
regulated environment, competition within banking tended to take place at the whole-of-bank
level, rather than at the level of the individual product. There was no point competing to offer
lower lending rates when the market was in structural excess demand. Instead, the banks
competed to offer their full mix of services on terms that would be attractive as a package.
Typically the pricing structure that this type of competition generated involved significant
elements of cross-subsidy. In particular, the net interest margin tended to cross-subsidise
transaction services and other activities (such as the maintenance of branch networks) to a
much greater extent than is the case today. This is the business model that used to be
referred to, only half jokingly, as 3-6-3 banking - borrow at 3 per cent, lend at 6 per cent and
be on the golf course by 3 o'clock - although even then the joke was probably well past its
use-by date.
Obviously, a great deal has changed in the banking industry since then. Banks have become
much more diversified, both in their funding sources and in the range of businesses they
engage in.
But for the purpose of today's subject, the thing I particularly want to focus on is the change
in the way they compete. Post-deregulation, competition has been both more intense, and
increasingly directed at the level of the individual product. That's been true of both the
competition between banks, and the competition provided by specialist institutions that
targeted the banks' most profitable product lines.
One early example of that, on the deposit side, was the introduction of cash management
trusts, which came in as providers of what were effectively stand-alone deposit-taking
services. The effect was to put upward pressure on deposit interest rates relative to
wholesale rates - in other words, to give depositors a better deal. Specialist mortgage
originators later did a similar thing on the lending side. Over time, these sorts of
developments had the side-effect of reducing the amount of net interest margin available for
banks to cross-subsidise their other activities. In addition, technological improvements like
internet banking have contributed to the intensity of product-level competition, by making it
easier for customers to shop around on a product-by-product basis.
The results of all this can be seen in some summary indicators of the banking sectors'
aggregate performance.
Let's start by looking at the relativities between deposit and loan rates and interest rates in
the wholesale market (Graph 1). For much of the 1980s, the 90-day bill rate was actually
higher than the average rate that banks charged on loans, a result of regulations that held
lending rates much lower than they would otherwise have been.2 Of course, that didn't mean
that borrowers were on average getting a favourable deal. It just meant they were being
rationed for funds and may have had to go outside the regulated sector where rates were
much higher.
Graph 1
In the post-deregulation environment, from the 1990s onwards, the whole interest rate
structure was much lower because of the fall in inflation that occurred at that time, but
wholesale rates fell significantly further than both deposit and lending rates. This restored the
structure to a more logical configuration where average lending rates were usually above the
wholesale rate and deposit rates below it.
An important driver of the fall in banks' intermediation margins on the liabilities side has been
the declining share of deposits bearing either zero or very low interest (Graph 2). That was
partly a regulatory effect, since before 1984 banks were prohibited from paying interest on
current accounts. But it was also a consequence of stronger competition. In 1980, around a
third of bank deposits were either in interest-free current accounts or in low-interest
passbook accounts. Twenty years later, that proportion was down to around 5 per cent. Not
only did this proportion decline, but the relative benefit to banks from any given amount of
low-interest deposits has fallen substantially, as the overall interest-rate structure has come
down.
Graph 2
Another important development on the liabilities side, which I alluded to earlier, was that an
increasing proportion of banks' funding was coming from wholesale sources. That was a
partly a consequence of the growth of the superannuation system as a recipient of household
funds, some of which were then channelled into bank securities; it was also partly a result of
the banks' diversification into offshore funding sources.
We see, then, that a combination of structural factors, regulatory changes and increased
competition has been working to narrow average margins on the liabilities side for quite
some time. A similar thing happened on the lending side: after the initial reconfiguration of
interest rates that occurred in the early 1990s, competition over the subsequent decade put
substantial downward pressure on most lending rates relative to wholesale funding costs.
The result of all this is that the major banks' net interest margins in the period since
deregulation have been trending downwards (Graph 3). They roughly halved, from an
average of around 41⁄2 per cent in 1980 to a bit over 2 per cent in the latest period.
Notwithstanding its most recent uptick, the average margin now is well below where it was a
few years ago.
Graph 3
To complete the story, the downward trend in net interest margins hasn't resulted in any
structural decline in banks' overall profitability (Graph 4). In broad terms it has been offset by
two factors - namely, reduced non-interest costs, and increased non-interest income as
banks diversified their business models and reduced cross-subsidies. The net effect is that
banks' combined income from all sources has been declining in relation to assets, but this
has been broadly matched by a downward trend in the cost-to-assets ratio.
Graph 4
Probably much of this is familiar territory. My reason for going through it is to make the point
that a trend towards increased competition in the deposit market, and an increased relative
cost of deposits, is not something new. It has been an ongoing consequence of the way
market forces have evolved in a deregulated environment.
Effects of the crisis on the deposit market
Having made that point, it's also clear that the trend has been amplified by factors flowing
specifically from the financial crisis. Let me turn to that part of the story now.
For some time, banks have tended to operate with a two-tier pricing structure on their term
deposits, offering significantly higher-than-average rates at certain points on the maturity
spectrum. Often these are at non-standard terms like four or seven months. These "specials"
have been the part of the market where banks competed most vigorously for price-sensitive
customers.
The average rates on these specials are shown in the accompanying chart (Graph 5). In the
years just prior to the crisis, the pricing of these term-deposit specials was fairly stable. They
were typically priced at about 50 basis points below the bill rate. As I noted at the outset, that
margin has now shifted to around 100 points above.
Graph 5
Another indication of more intense competition is that institutions have become more active
in offering special rates at terms of longer than a year, and often out to as much as five
years. They have also begun to offer higher rates in other parts of the market. Rates on
"nonspecial" term deposits have tended to move up closer to the specials, and margins on at-call
deposits have moved in the same direction, though by a lesser amount.
So, clearly the intensity of competition has stepped up.
This has been a consequence of two factors associated broadly with the crisis and with the
post-crisis environment.
First, the crisis has focused the attention of investors, regulators, rating agencies and, not
least, the banks themselves, on the need for stable sources of funding. What constitutes
stable funding is, of course, a good question. There is some tendency for analysis in this
area to be overly simplistic, and in particular to assume that deposits are unambiguously
more sticky than various forms of wholesale funding. That might not always be the case.
Within short-term wholesale funding, for example, holdings of bank paper by domestic super
funds are actually likely to be quite stable. Conversely, those types of deposits designed
specifically to appeal to price-sensitive customers will be less stable than others. So in
analysing funding stability, it is important to focus on the specific characteristics of each
instrument, and not just to rely on broad summary measures like aggregate deposit ratios.
That said, markets have clearly been taking a general view that banks should source more of
their funding from deposits rather than from short-term wholesale liabilities, and there is no
doubt that this has been a factor in market pricing in the post-crisis environment. It's also
clear that prospective regulatory developments are going to put more emphasis on stable
deposit funding, although there are many details of this still to be worked out.
A second factor is that the crisis made non-deposit sources of funding more expensive, or in
some cases more difficult for lending institutions to obtain, than was previously the case. In
this environment, it is to be expected that deposit rates would be bid up. One element of the
change in funding conditions was the drying up of the RMBS market early in the crisis period.
That was a factor that disproportionately affected the smaller lenders and induced them to
compete more vigorously for deposits as an alternative source of funding.
These factors are of course not unique to Australia. There are, however, some arguments
that it may be more difficult for banks to attract deposit funding in Australia than elsewhere,
because a structurally higher share of their funding comes from non-deposit sources -
particularly from international markets and from domestic super funds. These funding
patterns may be hard to change quickly, although we certainly shouldn't think of them as
being immutable.
How far these Australia-specific factors might be adding to competitive pressure on deposit
markets is hard to judge. But it's notable that significant shifts in deposit margins have been
occurring in a number of other economies besides Australia (Graph 6). Although strictly
comparable data are hard to come by, term deposit margins in the UK look to have risen by
more than those in Australia. In the euro area, average margins rose initially by a similar
amount to those in the UK, though they have since retraced some of that. So, on the face of
it, it seems likely that a good deal of the recent pressure on deposit rates has reflected
common international forces, not just conditions specific to Australia.
Graph 6
Assessment and outlook
Let me conclude with a few more general remarks about what all this means and how things
might develop from here.
My first remark is that we shouldn't talk as though competition in this market is a bad thing in
itself. The point of financial deregulation was to deliver efficiency gains through increased
competition. Among other things, that should mean a better deal for banks' customers. The
particular customer we've been talking about today is the depositor, someone who is often
neglected in these sorts of discussions. As I said at the outset, if you're a depositor who is
prepared to shop around, now is a very good time to find favourable rates.
It's also important to put these things in a longer-term context. The tendency for competition
to put downward pressure on banks' net interest margins is not new - it's been going on for a
couple of decades, to the benefit of both borrowers and depositors.
Having said all that, there's a legitimate question as to how far the most recent step-up in
competition for deposits will prove to be sustainable. There do seem to have been some
instances of anomalously high deposit rates being offered on occasion. It seems likely that,
over time, banks and other deposit-takers will get better at managing these more competitive
conditions and avoiding paying rates that are unnecessarily high relative to the market.
There are other reasons to think that the factors giving rise to the current wave of competitive
pressure might prove to be partly transitory. In particular, conditions in alternative funding
markets have been improving. A further recovery in securitisation markets, for example,
would help lenders to diversify their funding sources and probably help to take some
pressure off the deposit market. Similarly, any further narrowing of risk spreads in other
wholesale funding markets would work in the same direction. Possibly reflecting some of
these factors, there does seem to have been some easing in deposit margins recently.
On the other hand, we should expect the increased emphasis on stable funding sources to
continue. It is also possible that the recent wave of competition has itself helped to make
depositors more price-sensitive. With the availability of special rates being more widely
advertised, households may be learning to be more active, and more sophisticated, in
seeking out the most favourable rates. If so, then we would expect this to have an ongoing
impact on the dynamics of the market.
In a nutshell then, a good deal of what is happening in deposit markets is not new, but is
actually a continuation of existing trends. Some of what is new might prove to be temporary,
but some of it is likely to persist. To me, that sounds like an environment where competitive
pressure in the deposit market is going to remain strong, even if some of the recent intensity
has been somewhat overdone.