As inflation hit a 32-year high, signalling a rise in interest rates in February, bank shares rose on the ASX. Besides the prospect of fatter profit margins though, they are coining $102m a week from an obscure Pandemic stimulus measure. Callum Foote investigates.
Inflation has just hit its highest annual rate in Australia in 32 years. “Extreme price pressure remains” said Treasurer Jim Chalmers, noting there was cause for optimism as inflation had now probably peaked. Food and housing up almost 10%, very bad news. The good news is, that the rate of rising prices is plateauing.
As inflation is about sellers putting up prices though, and bank shares also rose today, it is reasonable to speculate that Chalmers may have a quiet word with the money sellers – the banks – about putting up their prices.
For, besides the opportunity to fatten their profits margins as rates rise, they are still on a big winner with profits from Covid stimulus measures. It’s called the TFF and it’s something Jim Chalmers would be unlikely to canvass in the public domain; nice little earner that it is for the banks – better make that big earner
A 2020 Reserve Bank pandemic response measure is now providing banks operating in Australia $102 million per week in risk-free profit, with the Big Four banks claiming approximately 70% of the loot.
Covid stimulus
In March 2020, the Reserve Bank of Australia announced the Term Funding Facility (TFF) “as part of a comprehensive policy package to support the Australian economy in response to the COVID-19 pandemic” according to the RBA’s August 2021 statement on monetary policy.
The TFF provided billions of dollars in cheap 3-year loans to banks operating in Australia.
The aim of the TFF was to provide the banking sector with enough cash to continue to lend to households and businesses at lower borrowing rates and to stimulate the economy through the Covid lockdowns.
Ultimately, $188 billion was borrowed by an unknown number of the 130 Authorised Deposit-Taking institutions (ADIs) that were permitted to draw down funds from the TFF.
Big Four dive in, big
As is to be expected, the big four banks drew down the most funds from the TFF at approximately 70% of the total amount.
The CBA took $51.14 billion, NAB $31.87, Westpac $29.78, and ANZ $20.09 billion. Together, the top 10 borrowers claimed 90% of the total amount provided under the stimulus program.
The TFF was offered in two phases, the first which offered loans at 0.25% interest and the second, following an interest rate drop, which offered loans at 0.1% interest.
The total interest rate for each bank depended on how much the banks drew down in each phase. CBA was the smartest of the big four, with an effective interest rate on their TFF loans of just 0.16%.
Printing then shredding
These amounts are repayable throughout 2023 and 2024, with $3.6 billion due for repayment in April this year.
The money that these banks were loaned through the TFF was essentially printed by the RBA for this purpose, it did not come from government revenues such as taxes.
When the loans are repaid, the RBA will ‘shred’ the funds.
What won’t be shredded, however, is the interest that the banks are earning on this money, this risk-free money.
How do we know this?
As reported here previously, when the banks took loans from the TFF the amount in each bank’s ESA accounts kept growing.
The RBA’s exchange settlement accounts were originally and still are, used to cover overnight interbank payments. In other words, these accounts are what Australian banks use to settle transfers between each other, with the RBA acting as a clearing house.
As such, banks traditionally only required a small amount of funds in their ESAs, approximately $2 billion before the pandemic.
The interest paid on the exchange settlement accounts is also the vehicle that the RBA uses to control interest rates.
When the RBA raises the interest rate target to counter inflation it also raises the interest it will pay on money held in its ESAs at the same time.
Risk free nice
The interest rate target is just that, a target, however, the interest paid on money held in the ESAs is the real mechanism of interest rate change.
In his Shann Memorial Lecture in May 2021, ex-RBA deputy governor Guy Debelle made the point that the amount payable on these accounts was effectively the risk-free interest rate.
By raising the interest rate paid on these accounts the RBA has increased the floor for economy-wide lending, meaning higher interest rates will be passed onto everyday Australians.
ESAs start to grow
However, in March 2020 banks’ ESAs began to grow even though no interest was paid on these accounts.
The cash stored in ESAs is counted as high-quality liquid assets. Under the Basel III accord, financial institutions require a certain proportion of high-quality liquid assets to lower the risk of their lending activities. The more high-quality liquid assets a financial institution has, the more it can lend out.
As such, the larger the ESAs grew, the more freedom Australia’s banks had to lend money.
The interest that the RBA pays on the funds held in its ESAs is tied to the cash rate target and as such was 0% until the RBA decided to raise interest rates in May last year.
Since then, the interest rate target has steadily crept up bringing with it the interest paid on funds held in the ESAs which is now being paid at 3%.
Currently, there is $426 billion held in the RBAs exchange settlement accounts, paying out approximately $13 billion a year in risk-free interest to banks operating in Australia.
TFF/ESA program: how the banks made free money
Back when the banks took their $188 billion in cheap loans from the TFF, they almost immediately deposited it back with the RBA in their ESAs – rather than lending it as had been intended in order to stimulate the economy.
Initially, the lack of interest paid on these funds cost the banks a cumulative $6 million per week. Although, as previously discussed, this was a fine trade-off for the banks for a variety of reasons.
Now that interest rates have risen, the profits on the borrowed $188 billion are up to $102 million per week, approximately 70% of which is going to the big four. The interest paid by the RBA on the banks’ ESA deposits exceeds the interest charged on the initial TFF loans by around 2.84% if we calculate the weighted average interest rate for the TFF loans.
The TFF loans are repayable between April 2023 and June 2024. Let’s watch and see how those ESA balances shrink after the TFF is repaid.
Is there anything wrong with the TFF?
The TFF delivered much-needed liquidity to the banking sector, lessening the impacts of the Covid recession.
What the RBA couldn’t predict was inflation spiking because of the Russian invasion of Ukraine, ensuing rampant energy prices and the subsequent necessity, from the RBAs point of view, of increasing interest rates.
The mistake was locking in a 0.16% borrowing rate for the funds loaned in the TFF, fixed out to 2024.
If the TFF was a variable rate tied to the cash rate, we wouldn’t be in a position where the RBA was printing the big four roughly $70 million a week for nothing.
Hindsight is everything.
Callum Foote was a reporter for Michael West Media for four years.