Banks and cost of funding

This week ANZ and Westpac increased interest rates on variable rate loans. ANZ also reduced intereste rates on three year fixed mortgages. The banks have been telling us for some time that they have increased funding costs so the rate rise was no surprise. However, given their level of profitability, I think the interest increases are indicative of an industry lacking sufficient competition. In a competitive environment a business is limited in its ability to pass cost increases on to its customers. In many cases it will need to accept a lower level of profit instead.

Jessica Irvine addresses this issue in High returns, little competition - life is still sweet for the big banks. She argues that Australia's big four banks have an excessive return on equity (average 15%) given their low risk level.

Banking, by contrast, ain't exactly rocket science. It's a very simple process of buying low and selling high. Borrowing at a certain rate, lending at something higher and sitting back to collect the interest. The potential for innovation is low, on par with, say, a utility. Banks are a low-risk investment. Why, then, should they offer shareholders average or above rates of return? They shouldn't.

She argues that we have a failure of competition in the banking industry:

So how do the big banks get away with it? When faced with higher costs, businesses in a competitive market have only three options: cut costs, raise prices or accept lower profits. Most businesses have only a limited capacity to raise prices - because they would be undercut by a competitor. If a business can pass on higher costs entirely to customers, it is a clear sign that there is a failure of competition in the market. Which, of course, is the bottom line with the Australian banking system. Has been for a long time.

I agree with her conclusion:

Customers have every right to feel ripped off if they're slugged with higher rates. Australian banks just don't take enough risks or add enough value to justify their high rates of return.

Disclaimer: I own shares in ANZ bank.