Nothing excites Australians like house prices and mortgage rates. It is no surprise, therefore, that the recent decision by major banks to increase interest rates 'outside the cycle' - that is independently of the Reserve Bank of Australia (RBA) - has led to hyperventilation among consumers and politicians.

The major driver is the rising of the banks' own funding costs, which have increasingly become decoupled from the RBA-set official cash rate.

According to the RBA, the cost of senior unsecured bank debt has risen by around 1.85% per annum over inter-bank money market rates, up from an average of 1.27% per annum in June 2011. The cost has eased somewhat from its recent high of 2.23% per annum in late December 2011 and early January 2012. The banks' cost of secured borrowings, such as covered bonds (collateralised by residential mortgages) is also high; between 1.70% and 2.20% per annum over the relevant money market rates, depending on whether it is issued in the domestic or international market.

Current borrowing rates compare to average margins of around 0.15-0.25 % per annum paid by the banks prior to the commencement of the global financial crisis (GFC) in 2007.

The higher rates reflect tighter global liquidity conditions, a structural change likely to persist.

High borrowing costs reflect general risk aversion where investors demand and receive higher compensation for bank risk. It also reflects the higher costs of hedging foreign currency borrowing into Australian dollars. These factors may also persist for some time.

Bank borrowing costs are also affected by regulations introduced in the aftermath of the GFC to improve the solvency of the banking system.

New liquidity controls, being phased in by global banking regulators, including the Australian Prudential Regulatory Authority, require banks to hold more liquid assets such as government bonds to minimise liquidity risk - an inability to raise money to meet sudden withdrawals or repay maturing borrowings. In addition, the new regulations favour banks with a higher level of retail deposits as a proportion of their funding.

This has led to aggressive competition among Australian banks for retail deposits, forcing up the cost. The average term deposit rate for major Australian banks has not fallen in line with decreases in the official cash rate and remains above that for equivalent wholesale funding.

The new regulations also require banks to hold higher levels of shareholder's funds, further increasing their costs. Compliance costs, under new regulations, will also increase.

Given that the cost of funding has gone up as a result of largely uncontrollable external factors, the real question is how these additional input costs are to be allocated. Increasing borrowing rates to pass on the higher cost of funding, penalises borrowers but rewards depositors and shareholders. Absorbing the higher cost of funding by maintaining or reducing lending rates rewards borrowers but punishes depositors and shareholders.

As many Australians are simultaneously borrowers, depositors and bank shareholders (either directly or indirectly through their superannuation savings), the appropriate allocation is unclear.

Australian banks could maintain mortgage rates but increase business lending rates to preserve profits. They could ration mortgage lending to minimise the effect of lower margins on their profitability. These actions may decrease business profitability and investment or reduce the supply of housing finance. In turn, this may reduce economic growth and employment opportunities, indirectly leading to lower house prices.

Critics point to the profitability of Australian banks. Absolute profitability levels are misleading as banks require substantial amounts of capital to operate. Measured using a more appropriate metric such as return on capital invested, Australian banks earn around 15% per annum. This is among the highest in the developed world, although down from the peak levels above 20% prior to the GFC.

Martin Wolf of the Financial Times described banking as 'a risk-loving industry guaranteed as a public utility'. As evidenced by government support during the GFC, this is as true of Australian banks as their overseas peers. If society and governments wish to control banks and limit profitability, then it requires a different debate and extensive re-regulation of the banking system rather than arbitrary interference in the process of setting rates.

The high level of angst is disproportionate to the modest nature of the increases. It highlights a different problem - high levels of consumer debt and their vulnerability.

Between 1991 and 2011, Australian household debt rose from around 49% to 156% of disposable income. In 1989, when mortgage rates were 17%, the ratio of interest payments to disposable income was 9%. Currently, despite the fact that mortgage rates are around 7.5%, the ratio has increased to around 12%, making borrowers sensitive to small changes in borrowing costs.

Australian housing is already heavily subsidised, through direct transfers (the first home buyers schemes), stamp duty exemptions, preferential taxation treatment of capital gains and favourable banking regulations which encourage mortgage lending via lower capital charges. Further assistance by artificially manipulating mortgage rates is difficult to justify.

Regards,

Satyajit Das
for The Daily Reckoning Australia