Increase capital requirement due to increasing regulation of Australian banks by the Australian Prudential Regulation Association (APRA) and their need to comply with international rules governing capital management has over the past 18 months required most banks to raise more capital to further strengthen their financial position.

The banks are therefore faced with the need to be more profitable (and therefore charge their clients more interest and fees) so as to maintain their desired ‘return on capital’ which is a key measure of their financial performance.

Increased funding costs

In order to lend money, banks needs to borrow money as cheaply as possible. The difference between a banks borrowing cost and lending return (net interest margin) is the cash flow required to meet its operating costs and produce a profit.

All banks cannot fund their lending entirely from cash deposits. As such the banks need to borrow money from international financial markets.

In recent months (for example at the time of the Brexit result) financial markets were disturbed and as a consequence of higher perceived global financial risk the interest rate cost to Australian banks borrowing from these markets jumped significantly.

The flow on effect is therefore for banks to recover this higher business cost by charging its customers higher interest rates and fees.

What is bizarre about the government’s recent criticism of the bank’s not passing on the recent 25 bp interest rate cut to borrowers when it was in fact the government sanctioned increases in regulation and capital requirements that led to increases in Bank operating costs, which in turn prevented the banks from passing on the benefit to their customers.

Balance of loan portfolio

Bank management teams need to constantly ensure they have appropriate spread of investment risk between their various loan asset classes. For banks, their assets are represented by the loans that they write. These loans are broadly categorized between owner occupied residential home loans, residential investment loans, personal loans, credit cards, commercial property loans, business loans (SME), corporate loans and inter-bank loans.

Banks will constantly adjust their desired loan weightings between these classes based on many factors such as: expected growth in asset values, the return from those assets, the costs associated with generating the assets, the default rates from each loan class and sectors within and the availability of funding to generate these assets.