Funding cost pass-through to mortgage rates

Prior to the global financial crisis (GFC), there was a relatively stable relationship between the Official Cash Rate (OCR) and retail mortgage rates. Changes in the OCR were typically accompanied by a proportional change in floating mortgage rates. However, this relationship has deteriorated since the GFC and the OCR on its own has not been a good proxy for bank funding costs. This paper examines the change in the transmission of the OCR, and the role of other funding costs for retail mortgage rates since the GFC. Banks now place greater reliance on more stable (but more costly) sources of funding. They rely on domestic deposits and long-term wholesale funding more, and less on short-term wholesale funding. This has resulted in a wider and more volatile spread between mortgage rates and the OCR. Not all changes in the OCR have passed through one-for-one into floating mortgage rates, as funding costs from other sources have sometimes been offsetting. We construct a comprehensive estimate of bank funding costs using a weighted average of the cost of domestic deposits, short-term wholesale funding and long-term wholesale funding. This weighted-average measure is further decomposed into a monetary policy rate component and a funding spread component. We use an error correction framework to measure the relative contributions of the policy rate and funding spreads to the level of mortgage rates in New Zealand, and estimate the speed of pass-through to mortgage rates from changes in funding costs. Our results suggest that funding spreads have been larger post-GFC, and have had a larger impact on the level of fixed-rate mortgages than on floating rates. There has also been a significant slowdown in the pass-through from policy and funding spreads to the floating mortgage rate. The speed of pass-through to fixed-rate mortgages has slowed only slightly.