RDP 2019-09: Australian Money Market Divergence: Arbitrage Opportunity or Illusion? 6. Opportunity Cost of Money Market Lending

A final consideration is whether there are more profitable uses for bank funding. We compare returns on money market trades with residential mortgages, the core business activity of major banks, to assess the opportunity cost of deploying their balance sheet to arbitrage differences in money market rates. Applying the same methodology, we find margins on residential mortgages have been significantly wider than those on money market trades during the sample period (Figure 13).[13] This suggests there is a significant opportunity cost associated with deploying equity funding away from mortgages and towards low-margin activities such as money market trading. Note, however, that there are fixed and variable costs – such as branches, personnel, information technology and other costs (including fees and commissions) – that banks face in writing mortgages which are not explicitly accounted for in our framework.[14] Some sources of revenue are also omitted, such as fees, charges and the revenue earned from market-making activities.

Different constraints apply to foreign banks operating in Australia. This affects their trading activities and is reflected in their balance sheets. Foreign banks (either through their branches or subsidiaries) tend to have smaller mortgage books and so might face a lower opportunity cost of arbitraging price differences in money markets. However, research suggests that the ability of large global banks to arbitrage across money markets may be constrained by various regulatory rules (see Boyarchenko et al (2018) for US banks and Aldasoro, Ehlers and Eren (2018) for European and, indirectly, Japanese banks). This may be an even more binding constraint than for the major Australian banks.

Figure 13: Return on Assets
Figure 13: Return on Assets

Note: (a) Average of estimates for bank bills, repos and swaps into JPY and USD

Sources: APRA; Authors' calculations; Bloomberg; RBA

More broadly, a reassessment of how banks optimise both capital and liquidity has meant that banks must utilise an internal liquidity transfer pricing model which fully reflects the cost of obtaining equivalent liquidity externally. A transfer pricing model which appropriately reflects funding costs will affect profit allocation and disincentivise activity of less profitable business units, such as money market trading desks. In the United Kingdom, banks surveyed by the Prudential Regulation Authority have revealed a more prominent role for capital efficiency in determining how banks assess business unit performance against other strategies (Bajaj et al 2018).


Banks report the cost of funding new mortgages to APRA every month, which we use to evaluate our estimate of TCit for mortgages. Our calculated measure follows the same trends as the reported series but is consistently lower. This suggests that TCit is a conservatively low estimate of the actual total cost of funding mortgages. While it is difficult to draw conclusions on the bias, this gives us confidence that our approach does not over-inflate the cost of funding. [13]

For further discussion on the cost-to-income ratios of Australian banks, see RBA (2014). [14]