With all the news about interest rates at the moment, you’re probably wondering how banks set their interest rates? In this blog, I’ll explain the key terms and numbers to help you understand why interest rates change.

Understanding the numbers

The 2 most important numbers are the:

• Official Cash Rate – set by the Reserve Bank of Australia (RBA)
• Bank Bill Swap Rate (BBSW) – set by the market

Every day, banks have transactions to execute, including retail and business purchases, credit card payments, payroll. There’s no reliable way of predicting how much those transactions will be. Inevitably, some days, banks will have more money going out than coming in.

So, they need to borrow cash. Where do they go? The bank.

The cheapest way is an overnight loan based on the Official Cash Rate (currently 1.35%). The next cheapest way is through short-term loans (1 – 6 months). These are loans between banks in the wholesale markets based on the BBSW (currently 1.55% for one month or 2.98% for 6 months).

The BBSW is higher than the cash rate, so banks are paying more to cover their cost of funding.

Connected to this is the Bank Bill Swap Yield (BBSY). This is the reference rate when setting customer funding costs in the business lending market, equivalent to BBSW + 0.05%. If you have a market rate loan, you’ll see this referred to in your letter of offer when the bank quotes your interest rate. Put simply, this means that if BBSY goes up, you pay more interest.

Banks, like every other business, want to make a profit. They set their lending rates to maximise their profitability of lending. But they also need to manage the risk that some borrowers won’t repay their loans.

As lending rates increase, demand for borrowing could decrease, which could reduce the bank’s profits. It’s a balancing act.

So, What Can You Do?

Well, banks still need to lend money. That’s how they make their profits.

As rates increase, it’s important to manage your debt proactively. You need to work on the parts of your debt strategy that you can control. If you haven’t paid attention to managing your debt risk (loan terms, interest rates, covenants, and your lender), you’re probably paying too much for your debt.

You should always review and manage your debt strategy regardless of the market conditions. But in the current uncertain market, it’s more important than ever.

So, don’t blame the banks.

It’s up to you to manage your debt and get the best rate for your circumstances.

You need to ensure your debt strategy is appropriate and flexible to see you and your business through the variabilities of agriculture.

Let’s chat. I’d love to work with you to achieve this. And if you know someone else who’d be interested in learning how banks set their interest rates, please share this article.

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