Over the last couple of years, we’ve seen a lot of debate around the need for greater levels of competition in New Zealand’s banking sector—including lots of noise coming out of the Reserve Bank (RBNZ) and Commerce Commission.
But, in my mind, much of the discussion that’s taking place fails to really get at the heart of what’s needed to address the problem.
So, here’s my take on the things regulators might want to be thinking about, based on data and trends in the banking industry over the last 30 years.
What is competition in banking really about?
At its core, the push for greater competition in banking is about ensuring bank customers are getting a fair deal.
In simple terms, banks have two main sources of income—their Net Interest Margin and “Other” revenue. That “Other” category is mostly made up of bank fees, but also includes things like foreign exchange and trading revenue.
Here’s how the split between the two has changed over time:
As you can clearly see, Net Interest Margin has soared in the last 30 years, while ‘Other’ income has dropped off significantly, at least in a relative sense. In fact, as of March 2024, “Other” income contributes just 12% of total bank revenue.
To date, efforts to foster greater competition in banking have largely focused on all the stuff that falls into that “Other” category, or in other words, the transactional stuff.
But in my opinion, we’re missing a key part of the solution—targeted at that big portion of bank revenue known as the Net Interest Margin. This is the hard bit, hence why it hasn’t been addressed to date. And it’s not about reducing the cost to the customer, but rather making sure the banks are paying a fair price.
So, what’s needed from here to support more price competition over time? Here’s my thoughts.
In terms of that “Other Income”, competition is already here
Back in the early 1990s a.k.a. the “bad old days”, 38% of bank income was generated through ‘Other’ sources.
The bulk of that was fees paid by consumers and businesses, including transaction fees, monthly account fees, eye-wateringly expensive FX fees, and truly abhorrent honour fees (I shudder just thinking about them).
Now, in my view, the launch of Kiwibank in 2002 marked the start of greater levels of competition in the transaction account space.
Ongoing developments in banking technology since then have seen transaction costs fall significantly—while also paving the way for new players (like Wise) to come in and shake things up.
In the last few years alone, competition in the transaction space has ramped up further, with three new companies now jostling to become banks and a few fund managers (including Squirrel) delivering a range of banking products.
The net result of all of this is that, today, bank fees represent pretty fair value for money—at least in my opinion. I mean, if you think about it—how much do you actually pay in monthly bank fees these days? And if you had to put a price on the convenience of being able to do most of your banking through your mobile banking app, what would it be?
As a result, in the year to March 2024 banks’ “Other” income fell to its lowest level since March 2002. While there might be some volatility in these results, due trading gains, etc., broadly speaking “Other” revenue has been pretty flat for about 20 years now, despite a growing population.
And what’s more, there’s more competition on the way at both a price and feature level.
The Net Interest Margin is where the real problem lies for competition across the NZ banking sector
So, what exactly is “Net Interest Margin"?
To put it simply, it’s the difference between what a bank pays for funding (like the interest you earn on money held in transaction and savings accounts) and what it lends money out at (i.e. the interest rate it charges on loans).
To illustrate, let’s look at a hypothetical and very simplified example, using The Bank of Dave.
Let’s say you’re The Bank of Dave’s only customer. You have $50,000 in deposits across a range of accounts and a total of $50,000 left on your home loan.
Here’s what that means for The Bank of Dave:
In this (simplified) example, the bank earns $3,500 from the money lent out as your mortgage and pays $2,375 in interest to the deposit side. The Net Interest Margin is the difference—$1,125—and that’s The Bank of Dave’s revenue. The Bank of Dave needs to pay its costs out of this money before it gets to declaring a profit (or loss).
Often, you’ll see the net interest margin declared as a percentage, in this case, 7.00% - 4.75% = 2.25%.
If you look back at the graphs in the first section, you’ll see our banks’ Net Interest Margin income has hit stratospheric levels in recent years.
The big reason for this is the low interest rates we saw during Covid—which caused NZ housing debt (i.e. mortgage borrowing) to “explode”, and also meant banks were able to access funds (i.e. deposits) at relatively low cost, including from the RBNZ.
It’s the second part of that equation—how much banks pay to access deposits—which is where I think the problem exists for NZ banking competition
What determines banks’ underlying funding costs?
Bank funding costs depend on where they’re getting that funding from.
In New Zealand, the bulk of bank deposits come from people’s savings (from NZ residents and businesses, as well as non-residents) with a little bit of wholesale funding thrown into the mix.
Now, the cost of wholesale funding is dictated by the market—priced relative to wholesale interest rates. It’s often the most expensive source of bank funding, but again, only makes up a relatively small proportion of NZ banks’ funding overall.
Non-banks, meanwhile, are often totally reliant on wholesale funding—which means it costs them a lot more to get than the banks, who can access ‘cheap’ deposits via their depositor base.
Therein lies the competition problem. For the majority of banks’ funding—a.k.a. our savings—the banks currently get away with paying less than what they could
Although the Official Cash Rate does broadly influence what’s happening with deposit rates, the banks have significant freedom to determine what they pay us on our savings.
And because New Zealand’s banking sector is an oligopoly—dominated by a handful of relatively large players with significant levels of control over pricing in the market, and who all tend to move together—it means there’s very little room for competition in this space.
While you might not think it, given where mortgage rates are at right now, the relatively low rate the banks pay for customer deposits does get passed onto New Zealand borrowers—meaning they actually get a pretty good deal.
It’s depositors who are getting the sharp end of the stick.
Why does the state of the funding market spell bad news for competition in banking?
Essentially, it makes it extremely difficult for new players (like non-bank lenders) to enter the funding space.
As I mentioned earlier, most non-bank lenders are heavily—if not totally—reliant on wholesale funding, which means they have relatively little control over their funding costs. Meanwhile, the banks (being far less reliant on wholesale funding) are less at the mercy of wholesale interest rates, and instead far more influenced by what they pay their retail depositors.
So, my hypothesis is that until competition forces banks to ‘pay up’ on retail deposits, we’ll continue to see banks get away with a very wide competitive moat on the lending side, stifling competition.
At the very highest level of analysis, retail deposit pricing in NZ needs to move upwards by somewhere between 0.50% and 0.75% (relative to current rates) in order to close the gap with the cost of wholesale funding—and thereby enable greater competition on the lending side from non-bank lenders.
How do we change the competitive landscape when it comes to Net interest Margin?
There are no quick fixes here, but just as we’ve seen in that “Other Income” revenue space, change is possible.
If I was the Commerce Commission, here are the things I’d be thinking about:
1. Making it a requirement for banks to remove ‘grandfathered’ deposit products.
This is a pet hate of mine.
By my estimate, Kiwi have hundreds of millions of dollars (possibly billions) on deposit in crappy, old savings products that are no longer available to new customers, and which pay terrible interest rates.
Most banks (not all) are guilty of this in some way. I’ve written about ASB’s practices in this space before, you can read about it here.
2. We need to address the inherent conflict that exists inside banks between enabling competition from fintechs, and protecting their retail franchise.
Separation of ‘wholesale’ from ‘retail’ has occurred in other industries with some success—so why not in banking? New Zealand’s telecommunications market is one example, where improved competition has come about off the back of a similar separation.
I’ll acknowledge this is no panacea. It’s failed in the electricity market as the separation was (in my view) incomplete.
So, getting the approach right is important in order to be successful.
3. Mandate that interest must be paid on ALL bank deposits.
When I say this, I’m looking at transaction accounts in particular.
The Commerce Commission could dictate an arbitrary rate—perhaps something like ‘half the OCR’—as the minimum banks must pay on all deposited funds, and which would also then become the base rate for what would be paid on savings accounts.
Radical, it may be…yes. But if the end goal is meaningful change in Net Interest Margin competition—why not?
4. Encourage bank customers to shop around.
New Zealand’s Deposit Compensation Scheme is set to come into effect in the coming months, and while I’m no fan of the scheme itself*, it does create an opportunity.
Now’s the perfect time for people to be thinking about how they might split up and move their deposits around to take advantage of the scheme’s benefits. And why not hunt out the best rates while they’re at it (and punish banks who are underpaying)?
At Squirrel, we put our money where our mouth is when it comes to encouraging greater competition in the savings market
Squirrel’s On-Call Account currently pays a variable rate of 5.25% p.a. (meaning it’s subject to change), which is one of the best rates you’ll find across any equivalent savings product in New Zealand.
The funds deposited in this account are held on trust with AA- rated banks, and we don’t charge transaction or account fees.
In the interests of full transparency, Squirrel currently makes a Net Interest Margin of 0.25% p.a. on these funds, which begs the question: if Squirrel can operate on a margin of that size for a savings product, why can’t the banks?
(*The moral hazard introduced by the Deposit Compensation Scheme is bonkers, particularly given the way it is priced. Did we learn nothing from the finance company implosion during the GFC? Squirrel submitted our views on this to the RBNZ earlier this year. But that’s enough on that.)