Rising mortgage rates - is it time to refinance your home loan?

Last week, Westpac hoisted its lending rate by 20 basis points in a bid to recover the costs of recent capital raisings. There is speculation other banks will follow. Australia’s non-bank lenders could be winners from such a scenario - but the choice may not be as simple as the lowest interest rate.

The outcome of the Financial Systems Inquiry

The background to Westpac’s move lies in recommendations by the Financial System Inquiry that the capital base of Australian banks should be increased to an “unquestionably strong” level and that there should be a narrower gap in different mortgage lending requirements between institutions.

As a result Australian banks have considerably increased capital levels this year by approximately $16 billion.

However, higher capital levels and bank stability may come at additional costs, even if trade-off theory suggests greater bank and system resilience would normally equal lower funding costs. That’s because bank investors have high dividend expectations, so this means the costs of boosting capital may be passed onto borrowers.

Capital levels are likely to increase further as regulators seek to narrow the gap between the practices of the big banks and smaller lenders, and amid their increasing concern at Australia’s house prices. In particular, large banks are expected to increase capital required under their internal risk weighting models for mortgages.

Will non-bank lenders grow their mortgage books?

Non-bank lenders provide mortgage loans with comparable features but unlike banks are exclusively funded from wholesale markets and not from consumer deposits.

As a result, banks face minimum capital requirements enforced by the Australian Prudential and Regulation Authority to protect depositors, while non-bank lenders are unregulated and may more freely choose their funding mix and hence have lower funding costs.

This often implies lower capital ratios for non-banks than banks. Raising capital levels for banks only may have an impact on the balance between bank and non-bank competitors.

The following chart shows the counts and total assets of banks and non-bank lenders in Australia over time:

Total assets of non-bank and bank lendersprovided by Australian Prudential Regulation Authority, http://www.apra.gov.au

The size of non-bank lenders ($120 billion) is much smaller than the size for bank lenders ($3.8 trillion) and has shrunk in relative terms over the past years. This may suggest that Australians fail to really consider this sector to finance their homes despite competitive mortgage rates from non-bank lenders.

There are many reasons for this – convenience may be one of them as banks are able to offer a larger product range and cover most financial needs of consumers, and consumers prefer to bank with a single institution.

The small size is a great disadvantage as relative fixed costs are higher for small firms than for the major banks.

Should you choose a bank or non-bank to finance your home?

Consumers seeking mortgage finance for a property – either a new borrowing or refinancing of an existing loan – can choose between a large number of banks and non-bank lenders, along with hundreds of loan products.

Comparison websites generally rank lenders and products according to the most obvious criterion – the interest rate. Non-bank lender often provide the cheapest terms. But the lowest rate loan is not necessarily the best loan.

The choice between bank and non-bank lender can be important if you want to use an offset facility. Offset facilities are not always included and they can expose borrowers to lender risk.

Having savings in an offset facility means that in effect the lender owes you money. Banks are much less risky in this regard because they benefit from government guarantees as well as greater scrutiny that are tied to the bank status.

Non-bank lenders are excluded from such guarantees and furthermore may have a greater exposure to market instability.

During the global financial crisis non-bank lenders (especially overseas firms) that were funded through capital markets, rather than customer deposits, were challenged as wholesale funding markets dried up. Some failed and total volumes shrank between 2009 and 2013 (see chart above).

Still, it is likely that more Australians change to non-bank lenders in the future. Changing a lender is easy as mortgage brokers often provide the legwork, plus exit fees have been considerably reduced since new laws came into effect on 1 July 2010 limiting mortgage exit fees to the lender’s losses directly connected to the borrower exiting the loan early.

Are non-bank lenders dangerous to our system?

Low volumes mean non-bank lenders are currently of no systemic concern to the economy and regulators. However this may change in the future as volumes shift and grow for non-bank lenders.

New market participants enter as new non-bank loan platforms are developed. One example is internet-based peer-to-peer lending.

Australians may adapt to this new regime and take on new technologies offered and seek the lenders providing the cheapest funding. Consumers generally do not care about the lenders’ own funding and may arbitrage the differences in mortgage rates by shifting the business from regulated banks to unregulated non-banks.

A concern may arise if non-bank lending is successful and to become a large player that is systemically important. In such a scenario the government would be well advised to consider regulating the industry.

Such regulations may include minimum lending and funding standards with the mission to protect de facto consumer deposits via offset accounts and to ensure the credit supply in economic downturns when wholesale funding markets are constrained.

We may be some time away from such a scenario in light of the increasing dominance of bank lenders.

Harry Scheule receives funding from Centre for International FInance and Regulation (CIFR). CIFR is funded by the Commonwealth and NSW Governments and supported by other consortium members (see www.cifr.edu.au).