Even in such an unpredictable market as this, the chain of events around the interest rate cut by the Bank of England’s monetary policy committee earlier this month was unprecedented. On 3 November, the Treasury published arrangements for managing its shareholding in banks through a new “arms-length” company. Three days later, the Bank announced its historic 1.5% cut in rates.
Virtually no-one had predicted a cut in rates of that size, although there had been widespread anticipation of a cut by the Bank of at least 0.5%. In a note to journalists the day before the decision, we anticipated the obvious follow-up question: “Will lenders pass on any Bank rate cut to mortgages?”
As we said in our advance media note, the wording of the question in itself implies that lenders automatically benefit from any cut in Bank rate. They don’t, of course. As a number of commentators – but not the headline writers – acknowledged in their coverage following the rate announcement, the cost of funds to lenders depends not on Bank rate, but on a range of other factors, including what they have to pay savers to attract deposits, how much it costs them to borrow in money markets, and the costs of holding capital and sufficient liquidity.
The Bank rate and libor
Far more important than the Bank rate in determining lenders’ funding costs is the three-month London inter-bank offered rate (libor). Before the onset of the credit crunch, libor had typically fluctuated in a narrow range of between 0.15% and 0.2% above Bank rate. But since the autumn of last year, it has been consistently much higher than Bank rate. It has also been much more volatile – and this volatility, in itself, has a cost that lenders have to factor into mortgage pricing decisions.
The day before the monetary policy committee’s decision, libor remained at the sort of stubbornly high level that had persisted since mid-September. At 5.68%, it was 1.18% above Bank rate. On November 7, the day on which a number of large lenders – under pressure from the government – decided to reduce borrowing costs by 1.5%, the gap between libor and Bank rate had actually widened, to 1.5%.
The reality was therefore that, in response to the Bank rate cut, libor had indeed fallen – but not by as much as the Bank rate. In other words, lenders, being pressurised to “pass on” the full benefit of the Bank rate cut, had not seen the full benefit of it themselves. So, politicians were expecting them to take a financial risk.
This point was acknowledged by The Times’ business editor David Wighton the day after the Bank rate decision. “Lenders are under intense pressure to pass through the cut in full as soon as possible,” he wrote. “However, as the CML pointed out again yesterday, the key is how the rate cut feeds through into lenders’ own costs…Money markets remain extremely thin. Meanwhile, the competition for retail deposits remains fierce, which will limit lenders’ scope to cut savings rates.”
In current market conditions, however, lenders’ decisions about mortgage pricing are constrained by much more than the cost of funds. In the aftermath of the credit crunch, the government, regulators and financial markets now expect firms to re-build capital and to reduce exposure to risk.
In these circumstances, the gap between the price of mortgages and benchmark rates simply cannot return to the very narrow margins existing before the credit crunch. The pressure to price more cautiously for risk has been further exacerbated by an anticipated rise in arrears and possessions in the coming months.
So, what do ministers want?
This point was developed by Jeremy Warner in The Independent, who asked the question: What do ministers really want out of banks? “Is it for them to engage in unsustainable pricing of mortgage and small business products? That is surely what helped create the bubble in the first place, but now that some sanity has returned to the pricing of risk, the government doesn’t much like it. The free and easy credit of the old days seemed far preferable.”
Since the credit crunch began, lenders have been adjusting to higher funding costs, the need to re-capitalise and the likelihood of higher mortgage arrears. But for those receiving an injection of capital from the government, there are further costs and constraints.
As the BBC’s business editor Robert Peston put it in his blog: “The chancellor understandably took the view that if taxpayers are in a sense insuring the money being borrowed by banks, we should be paid for that insurance.
“But the cost of that insurance isn’t cheap. It’s working out at between 1.2% and 1.7% per annum of the amounts being borrowed for most banks. That’s 1.7% that has to be added to the 4% or so interest-rate cost of the funds being raised. In other words, the price of money for banks under the government’s own sponsored scheme is somewhere over 5%.
“It’s therefore very difficult to see how the banks can charge us less than the 5% that the Treasury is demanding they pay for the vital taxpayer-backed funds they need. Unless, that is, the chancellor were to decide that the banks should be transformed into loss-making public utilities.”
An unmitigated outrage?
A similar point was made by Dominic Lawson in The Independent, who referred to a “concerted attack on the banks’ lending policies from across the political spectrum.” He continued: “It is, they all agree, an unmitigated outrage that our bankers are not passing on in full the recent cuts in the official Bank of England rate.”
But he went on to explain that, given the large numbers of borrowers on either fixed-rate or tracker mortgages, lenders could only make decisions affecting the monthly mortgage payments of a tiny proportion of customers.
“About half of all mortgages are fixed-rate: borrowers will pay the same until their term comes to an end. They don’t suffer when the official rate moves rapidly upwards, so they can’t expect to gain when it moves in the other direction.
“A further 40% of mortgages are tracker deals, under which both lenders and borrowers have contracted to follow the movements up and down in the official lending rate: in these cases, it’s not a question of ‘urging’ the banks to ‘do the decent thing’ – it just happens automatically.”
Like other commentators, Dominic Lawson also argued that managing the spread between mortgage rates and the cost of funds was important for lenders under pressure to re-build capital on significantly lower volumes of business.
“I can see this is politically embarrassing for the government,” he said, “which seems to think that it has a deal with the banks who have taken the Treasury shilling that they would continue to ‘make credit available at 2007 levels’. Since neither the Treasury nor the banks have seen fit to tell us exactly what those conditions are, we are little the wiser.”
Confusion about the relationship between the government and re-capitalised banks was a common theme among commentators. Jeremy Warner offered his own concise version of the historic meeting the day after the Bank rate cut between the chief executives of large lenders and the chancellor.
“Look, (the chancellor) said, brandishing a copy of the Daily Mail, we’ve done you a favour by bailing you out. Now it’s time to reciprocate. Hours later, they had virtually all moved into line. Is this evidence of the new world order, where banks that have accepted public money can also be subjected to public control?
“(The government) insists it wants an arms-length relationship with the banks it controls so that it can maximise returns and eventually sell the shares back to private investors for a profit, yet already the calls of the ballot box are leading it to meddle not just in pay and credit allocation, but now the pricing of credit too.”
In the Financial Times, Andrew Hill has his own perspective on the relationship between the government and lenders. “Politicians, lashed to an electoral timetable, are in a more delicate position. Gordon Brown and Alistair Darling have promised ‘arms-length’ oversight of the banks in which the government will have stakes. Each face-to-face harangue of big lenders in Downing Street demonstrates just how short their arms really are.”
At the start of his piece, he put it even more succinctly: “When The Sun leads with the headline ‘Now pass it on, you bankers!’, the chancellor of the exchequer has to listen.”
But he warned against any temptation for the government to sidestep its frustration at lenders’ “failure to pass on” any future rate cuts by pumping out loans through wholly-owned state banks.
“That could backfire badly if it encourages reckless spending, expansion or house-buying while the market is still in free-fall, the economy weakening and unemployment rising.
“And who will The Sun blame then?”
The difficult market conditions and political environment are creating a series of conflicting pressures for lenders. Managing them requires a serious, co-ordinated and long-term approach, not a series of knee-jerk reactions to media headlines.
We will continue to set out the facts and our expectations of how the market will evolve, as we have done since the onset of the credit crunch and before. We will also continue to work for the right outcomes for the tripartite authorities, the industry, consumers and the UK economy more generally.
Press Release – Council of Mortgage Lenders – 18 Nov 2008