Bank tells inquiry higher interest rates on farm loans only partially explained by extra capital requirements.

The Reserve Bank has played down its contribution to high interest rates on farm loans in its submission to Parliament’s banking inquiry.

The deadline for submissions to the joint inquiry into banking competition by the Finance and Expenditure and Primary Production select committees was this week.

Heading into the inquiry both Federated Farmers and the major banks have claimed the amount of capital the Reserve Bank requires the banks to hold against farm loans is over the top.

Federated Farmers believes increased capital requirements due to be fully implemented by 2028 will cost farmers between $310 million and $472m in higher interest charges each year.

But in its submission released this week, the Reserve Bank said higher interest rates on farm loans are only partially explained by the extra capital it says must be held against them.

It notes the average interest rate on a farm loan was 8.71% in June, compared to the average rate on a residential mortgage of 6.93%.

Of the 170 extra basis points in interest charged on farm loans, it calculated only 60 basis points were due to regulatory capital requirements.

To further emphasise its point, the Reserve Bank compared lending rates and capital requirements for farm loans with those for loans secured against commercial buildings.

While the interest rate charged on commercial property loans is only marginally higher (8.7% versus 8.6%) the risk weighting used to calculate the capital required to back commercial property loans is significantly more (107% for commercial property loans compared to 71% for farm loans).

“These examples show that capital requirements are only one part of the variation in lending rates, alongside operating costs, provisioning and other factors,” the submission says.

Other factors include a bank’s profit margins, which could fluctuate according to its “strategic goals” such as whether it wants to increase its share of lending to a particular sector.

Where a bank wants to expand its market share it could decide to decrease its profit margins and vice versa.

It notes the Australian-owned banks’ share of the rural lending market has declined in recent years while rural specialist Rabobank’s market share has increased.

Addressing the higher capital requirements for rural lending, the submission notes these are benchmarked against standards set by international banking regulators.

Volatile farm earnings and the close relationship between commodity prices and farm values mean banks need higher capital as a buffer against losses than they would for residential lending which does not face the same risks.

Interestingly, the Reserve Bank says two years ago it asked the major banks to model expected losses for their lending books under extreme economic downturn scenarios.

The exercise revealed the banks were holding more capital against farm loans than was justified by the risks posed to the lenders’ balance sheets, although the amounts involved were minor and unlikely to have had a major impact on either the supply of credit to the sector or interest rates charged to farmers. The same exercise found the banks were also holding more capital against residential loans than was justified.

The submission explores the possibility of lowering capital minimums to encourage increased lending to favoured sectors.

However, it says overseas experience suggests the impact on lending rates would be both limited and temporary.

Reducing the amount of capital banks are required to hold as a buffer against losses also increases the risk of bank insolvencies and a run on the banking system as a whole.

The Finance and Expenditure and Primary Production select committees expect to report their findings back to Parliament before the end of the year.

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