RDP 2022-08: The Consequences of Low Interest Rates for the Australian Banking Sector 6. Conclusions, Policy Implications and Future Research

In the face of low rates, the profitability of Australian banks has likely been less adversely affected than what the international literature would predict. The flip side to this is that the pass-through of cash rate changes to lending rates may have been more muted than what the literature would predict.

That said, the pass-through of Australian monetary policy has remained high. And pass-through would likely remain at similar levels were the cash rate reduced to the small negative interest rates implemented in some other jurisdictions. Moreover, a reversal rate is highly unlikely to exist in Australia.

As noted in Section 5, even if Australia faced an extreme scenario in which banks remained below their target capital ratio for an extended period of time and they remained excluded from external equity markets for this entire period, government/regulatory policies could be used to alleviate the problem and prevent a reversal rate from emerging. For example, in jurisdictions that have a positive countercyclical capital buffer (CCyB), this tool could be used by the regulator to temporarily reduce the capital ratio buffer they require banks to hold. This allows banks to reduce the speed at which they increase their capital ratios following a crisis, thereby permitting smaller reductions in credit supply and stronger pass-through of monetary policy. Future research could use BA-MARTIN to explore how different CCyB calibrations could change how the Australian banking sector, and therefore the economy, weather large downturns. Given that BA-MARTIN is a large macro model, this research could also be used to assess the potential complementarities or trade-offs between the RBA's inflation and full employment objectives and its financial stability objective.

Even without a reversal rate, the question remains as to whether central banks should lower policy rates by more or less as the pass-through to lending rates falls. The answer depends on the central bank's objectives, the costs of policy rate reductions (e.g. the increased risk of crises (Schularick and Taylor 2012)), and how it weights the trade-offs.

The international literature makes clear that maintaining adequate prudential supervision is key to ensuring banks do not ‘search for yield’ as interest rates fall, thereby reducing the extent to which low rates make large downturns more likely. And preventative macroprudential policies, such as floor rates for assessing loan serviceability, can also mitigate any increased risk that may emerge at low rates. Even without these prudential policies, there is some evidence from recent research that suggests interest rates have too small an effect on the probability of a crisis for this benefit to be worth the higher unemployment that would result from not ‘doing more’ as pass-through falls (see Saunders and Tulip (2019) and references therein).

It would also be beneficial to research the overall welfare implications of the Australian banking system's structure relative to the structure in other jurisdictions. The apparent ability of Australia's major banks to maintain their lending spreads as rates have fallen has ensured these banks remained profitable and resilient to further shocks, thereby improving financial stability. But this has likely come at the cost of lower pass-through to lending rates.

That said, the high share of variable-rate loans in Australia means that even muted pass-through feeds through to the interest rates households pay much faster than in jurisdictions with long-term fixed-rate loans, thereby enhancing the effectiveness of policy via the cash flow channel (La Cava, Hughson and Kaplan 2016). But this also means that Australian households bear more interest rate risk than in other jurisdictions. Over time, many of these households respond to this risk by building up substantial buffers of excess repayments, so financial stability need not be lower as a result of households bearing this risk. But new borrowers and those unable to build buffers remain vulnerable to this risk.