News | Sunday, 07 December 2008

Another cut in interest rates. So where’s the cash?

Banking profits are often the reason why banks don’t cut interest rates immediately

Good news for you if you’re a mortgage-paying homeowner, or if anything close to 90% of your life is financed on credit loaned to you by the bank. The European Central Bank has cut interest rates by 0.75%, the third cut in months.
For those still untouched by the ravages of credit crunching, global crises, and subprime housing crashes, the third drop in interest rates will mean more money in people’s hands. Or will it?
There is always a feeling that banks often take their time in passing on the cuts in interest rates. When the ECB cut the rates for the second time in October, HSBC Malta only informed clients it would be effecting the cut in January 2009. But wouldn’t it be better to have more money in people’s pockets now at this time of global slowdown?
As countries like the UK and Sweden go through the bold steps of aggressively slashing interest rates – in layman’s terms, the cost of borrowing money – people like financial advisor and MaltaToday columnist Mark Lamb note how it was only in July, when the global financial crisis was rearing its head, that the ECB actually raised the interest rates by 0.25%, taking them up to 4.25%.
“In September, I highlighted the desperate calls by many for the need of a sizeable reduction in interest rates to re-stimulate the Eurozone’s investment markets, house prices and economic growth. Now that it has finally happened, hopefully it hasn’t come too late.”
In Sweden, the central bank on Thursday cut interest rates by an unprecedented 1.75 percentage points to 2%. As in the UK, Swedish employers are laying off workers in their masses, and consumer confidence has plummeted. In response, the Swedish premier Fredrik Reinfeldt is using tax cuts and increased infrastructure spending to revive the economy.
Sweden’s rate cut is bold when compared with the 0.75 point reduction by the ECB. In the UK, Gordon Brown even effected a 2.5% cut in VAT to 15% ahead of Christmas, with department stores like John Lewis implementing the cut three days before the VAT cut was officially introduced.
But Lamb says that without the banks actually passing on the reductions to borrowers and businesses, the latest ECB cut will have little effect on consumer spending. The reason is banking profits.
“Obviously banks make their profits on the difference between the mortgage and savings rates. These margins are now becoming smaller and while the banks in Malta should be congratulated for largely side-stepping the sub-prime, mortgage-backed securities fiasco, they will not be thanked for making the lives of their customers more costly than is absolutely necessary in these tough times.”
Certified Public Accountant Stephen Muscat seems to concur: “Banks are using the rate cuts from the ECB for their own lending, which they could then lend to customers at higher rates, to turn a profit after having lost their foreign exchange income with the adoption of the Euro.”
As Lamb explains, banks are being slow to pass on the rate cuts because they want to hold on to the money, and because it makes their accounts looks good.
“Firstly, they want to hold on to the cash rather than lend it out, because their balance sheets are absorbing losses on bonds in failed banks, or on credit default swaps in which they were in effect insuring someone else against a default on these bonds.”
The second explanation is that banks want to make their balance sheets look good for the 31st December accounting year-end.
“But until banks pass the benefits of low interest rates onto their customers, credit markets will remain blocked and a sustained recovery in the real economy is unlikely,” Lamb warns.
That very warning was sounded only last Friday at the annual dinner of the Institute of Financial Services by Central Bank governor Michael Bonello. Addressing banks directly, Bonello, a member of the ECB, said banks were expected to make their contribution in restoring confidence.
“With bank lending rates in Malta being generally set with reference to official policy rates, I would, therefore, expect bank customers, particularly those whose borrowings promise most to support domestic economic activity, to benefit fully from the recent ECB rate cuts, which have totalled 175 basis points.”
Now while the UK and Sweden fight hard to curb the recession that has taken hold of its market, the Maltese may still be looking at things differently. In an island that considers itself ‘sheltered’ from the worst the world can throw at humanity, it is no surprise that the fear of recession has not yet crept down to a wide section of the population. That depends on which part of the population you form part of. If you’re one of the employees at the Trelleborg, Methode, or Packprint and Multipackaging firms, you have probably had a taste of the global crisis with a reduced, 30-hour week.
But as Bonello warned, it would be “naïve, indeed dangerous” to think the crisis will leave us untouched. The reasons are simple, Bonello explained: a small economy, Malta is highly dependent on trade, and the recession will affect Malta’s exporters (consider tourism from UK, for example). With less income from exports, domestic demand will also be affected, in turn affecting the banking system as asset quality deteriorates.
Even more ominous are the banks’ high dependence on property as a driver of credit growth, Bonello said. Construction and property comprise some 50% of total loans. If property prices increase because of a rapid growth in credit, faster than incomes, “housing simply becomes unaffordable.”
Now, with property prices already having fallen moderately in the September quarter, the continued high dependence on property for credit growth and as collateral for other lending, “remains a source of risk,” Bonello said.
Stephen Muscat is clear about what direction to take: “Banks should be pressured to comply with the cut in rates. Give it to customers and start the money cycle. With cheaper commitments on loans, consumers will proceed to spend on credit… I would urge banks to lower rates on all credit lines, including credit cards. We need customers spending more now. And it generates a feel-good factor, especially during Christmas when consumers pay later in the New Year.”
And what about replicating a cut in VAT like Gordon Brown’s, the kind which this week was refused by European financial ministers?
“The reason the EU did not agree on lower VAT is because they have huge deficits to service,” Muscat says. “Remember that VAT contributions are the general income for government and for the common EU budget. Gordon Brown was right in reducing VAT, and with lower interests rates, banks will loan out more money. The only pitfall is if people start saving, rather than spending, that reduction in VAT. Highly unlikely, but definitely undesirable.”


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