Why The Banks Did The Right Thing With Interest Rates

Whether we like it or not, the banks simply could not afford to pass on all of this week’s interest rate cut by the Reserve Bank of Australia. The RBA cut interest rates by 25 basis points but the banks only passed on about 13 of those points.

As usual, most within the commentariate went off like Saturn rockets because they think the banks have ripped us off. They haven’t. In fact, the banks have done the right thing.

To help explain my point, think of interest rates as meat pies. And let’s suppose the pie market is made up of four pie shops (the banks) and one wholesaler (the Reserve Bank).

Everything is going along swimmingly until the wholesaler becomes very nervous about foreign wholesalers entering the Aussie pie market. Therefore, to remain competitive the wholesaler drops the price of his pies (interest rates) from $3 to $2 so the pie shops can drop their prices and remain loyal to him.

Things get desperate so the wholesaler drops his prices even further to $1.50. (Sauce is extra)

But the four big pie shops have a problem. When pies were $3 each, they could afford to pass on any discounts. But now pies are $1.50 and there’s no margin left in the pies, meaning, there is less room for the pie shops to move and pass on any discounts. If they do, they begin to sell the pies at a loss and eventually they have to close the doors.

This is exactly the situation our banks are in. Let’s say they ‘buy’ money at 1.5%, it doesn’t matter how much the Reserve Bank cuts rates by, the banks can no longer pass on all the cuts because of the very thin margins left available to work with. If they pass on all the cuts, eventually they operate a loss.

If you don’t understand the importance of margins, just ask any business owner. Margins are everything! It’s not about revenue or sales, it’s about margin, the difference between income and expenses. Good investors understand this as well.

And yes, I’m well aware of bank profits but on this occasion you need to pick a better argument than that one. In the scheme of things their profits are small change compared to the risks of not being prudent managers of ‘our’ money.

Why the rate cut?
The RBA rate cut was supposed to drive down the Aussie dollar to make our exports more competitive. Instead the A$ has gone up because a heap of other countries have dropped their rates as well.

In the meantime, Bill Shorten has gone off on another one of his rants calling for a Royal Commission (RC). So let’s be very clear on one thing here, the banks have not broken the law by not passing on the rate cuts. Nor do they have a moral obligation to do so.

Shorten also wants the banks to open their books. Hello! They’re publicly listed companies Bill which means anyone can get access to whatever information they need anytime they like.

But Shorten loves a scare campaign so expect more.

Meanwhile, Prime Minister Turnbull wants to call the bank CEO’s before a parliamentary enquiry. Who’s he kidding? Where was he before the election when he had the chance to say something about the banks and rack up some major brownie points with the electorate? Heaven knows, he needed it!

And if you think I’m here to stick up for the banks, I’m not. They can fight their own battles.

I’m making a stand for every depositor who entrusts the banks to be custodians of their money so it’s on call whenever they need it.

And if you want to know what it looks like when a bank ignores their fiduciary duties, which includes maintaining minimum capital requirements, just have a look at what happened to Lehman Brothers in 2008 – they filed for bankruptcy and sparked an entire GFC. The knock-on effects were enough to almost collapse the world’s entire financial system. It was that close.

Similar fears surfaced this time last year in Greece. Remember that? And their economy is smaller than Queensland’s.

I appreciate everyone wants more, we all do, after all, that’s what got our ancestors out of the caves. But interest rates are already close to zero, so let’s be greedy for something else with less severe knock on effects…like more pies with sauce!

Have a great weekend!

Adam

Back paddock – Speaking of pies and getting access to information, how’s this. I was doing some research on Aldi recently and learnt that once they reach the critical mass they aim for in every country, they then approach all their suppliers with specific recipes on how they want their food supplied.

E.g. let’s say Aldi’s research reveals Aussie’s want their Tomato sauce to be a certain thickness and flavor, Aldi then issue their suppliers with a specific recipe on how they want their sauce made. This then strengthens the loyalty with both their buyers and suppliers at discount rates. How’s that for a yummy deal!