Posts Tagged ‘‘shadow’ banking system’

Can falling interest rates and rising mortgage rate come together?

Monday, July 21st, 2008

Yesterday, in Too eager for an interest rate cut?, we said that

Fourth, an interest rate cut by the RBA need not necessary mean a cut in the mortgage rate. In fact, the opposite can occur.

Today, we will elaborate on that.

A large fraction of Australia’s borrowed money is sourced from overseas through the ‘shadow’ banking system. In other words, there are not enough domestic deposits to fund all the needed credit (e.g. home loans) in this country. As we explained before in Rising price of money through the demise of ?shadow? banking system, with the fall of the ‘shadow’ banking system, the supply of credit shrinks. This resulted in a rise in the price of money.

That is why non-bank mortgage lenders (e.g. RAMS) found their business in trouble. Because they are not banks, they do not have access to deposits to fund their lending. Their only source of funding is through the ‘shadow’ banking system. When money from that system dried up (i.e. credit crisis), they could no longer lend money as cheaply as before.

The banks, on the other hand, are not left off the hook. Because of their deposit base, they are in a better to weather the credit crisis storm. But overall, there is still a shortfall of deposits to provide for all the demand for lending. As the de-leveraging of the global financial system continues, the price of money will continue to increase. This left the banks with two choices:

  1. Increase the cost of loans (e.g. mortgage rate).
  2. Attract more deposits with higher interest rates- that’s where all the attractive term deposit interest rates from the banks come from.

For Australia to be completely free from the ‘shadow’ banking system, two things must happen:

  1. Borrowing must decrease.
  2. Savings must increase.

This is the only way to bridge the gap left by the credit crisis in the absence of any central bank intervention. We believe that the credit crisis will worsen (see Is the credit crisis the end of the beginning?), which means the gap will widen, which in turn implies even higher lending rate. Since the Australian economy is very much addicted to credit to keep going, any dramatic fall in its supply will have serious repercussions. What to do if such a day eventuate?

Not to worry, because Australia has a central bank (note: sarcasm here)! Since the Reserve Bank of Australia (RBA) is the only institution that can create credit out of thin air, we can be sure they will cut interest rates and be the lender of last resort when the day of reckoning comes. But that does not necessarily mean that mortgage rate will come down too, as reported in this news article, RBA rate cuts may fail to ease mortgage pain,

National Australia Bank chief economist Alan Oster, just back from a month in Europe, said a reprise of the British experience, where banks failed to ease the burden on borrowers despite official rates falling 75 basis points over six months, was not out of the question.