September 21st, 2017 8:35 AM by Jackie A. Graves, President
On the face of it, figuring out how a bank makes money is a pretty
straightforward affair. A bank earns a spread on the money it lends out from the money it takes
in as a deposit. The net interest margin (NIM),
which most banks report quarterly, represents this spread, which is simply the
difference between what it earns on loans versus what it pays out as interest
on deposits. This, of course, gets much more complicated given the dizzying
array of credit products and interest rates used to determine the rate
eventually charged for loans.
is an overview of how a bank determines the interest rate for consumers and
are generally free to determine the interest rate they will pay for deposits
and charge for loans, but they must take the competition into account, as well
as the market levels for numerous interest rates and Fed policies. The United
States Federal Reserve influences interest rates by setting certain rates,
stipulating bank reserve requirements, and
buying and selling “risk-free” (a term used to indicate that these are among
the safest bonds in existence) U.S. Treasury and agency securities to affect
the deposits that banks hold at the Fed. This is referred to as monetary policy and is intended to
influence economic activity, as well as the health and safety of the overall
banking system. Most market-based countries employ a similar type of monetary
policy in their economies.
A primary vehicle the U.S. Fed uses to influence monetary policy is setting the Federal funds rate, which
is simply the rate at which banks trade balances (borrow and lend) with the
Fed. Many other interest rates, including the prime rate, which is a rate that banks use for the ideal
customer with a solid credit rating and payment history, are based off Fed
rates such as the Fed funds. Other considerations that banks may take into
account are expectations for inflation levels, the demand and velocity for
money throughout the United States and, internationally, stock market levels
and other factors discussed below.
again to the NIM, banks look to maximize it by determining the steepness in
yield curves. The yield curve basically shows in graphic format the
difference between short-term and long-term interest rates. Generally, a bank
looks to borrow, or pay short-term rates to depositors, and lend, through
making loans, at the longer-term part of the yield curve. If a bank can do this
successfully, it will make money and please shareholders. An inverted yield curve,
which means that interest rates on the left, or short-term spectrum, are higher
than long-term rates, makes it quite difficult for a bank to lend profitably.
Fortunately, inverted yield curves occur
infrequently and generally don’t last very long.
One academic study, appropriately entitled “How Do Banks Set Interest Rates,”
estimates that banks base the rates they charge on economic factors including
the level and growth in Gross Domestic Product (GDP) and inflation. It also cites interest rate volatility – the ups
and downs in market rates – as an important factor banks look at. These factors
all affect the demand for loans, which can help push rates higher or lower.
When demand is low, such as during an economic recession, banks can increase deposit rates to encourage
customers to lend, or lower loan rates to incentivize customers to take on debt.
Local market considerations are also important. Smaller markets may have higher
rates due to less competition, as well as the fact that loan markets are less
liquid and have lower overall loan volume.
mentioned above, a bank’s prime rate – the rate banks charge to their most
credit-worthy customers – is the best rate they offer and assumes a very high
likelihood of the loan being paid back in full and on time. But as any consumer
who has tried to take out a loan knows, a number of other factors come into
play. For instance, how much a customer borrows, what his or her credit rating is, and the overall relationship with the
bank (e.g. the number of products the client uses, how long he or she has been
a customer, what credit score he or she has) all come into play.
amount of money put down as a down payment – be it none, 5%, 10% or 20% – is also
important. Studies have demonstrated that when a customer puts down a large
initial down payment, he or she has sufficient “skin in the game” to not walk
away from a loan during tough times. The fact that consumers put little money
down (and even had loans with negative amortization schedules,
meaning the loan balance increased over time) to buy homes during the Housing
Bubble is seen as a huge factor in helping to fan the flames of the Credit Crisis and ensuing Great Recession.
Collateral, or putting one’s other assets (home, car, other
real estate) into the loan terms, also influences skin in the game. The loan
duration, or how long to maturity, is also important. With a longer duration comes a
higher risk that the loan will not be repaid. This is generally why long-term
rates are higher than short-term ones. Banks also look at the overall capacity
for customers to take on debt. For instance, the debt service ratio attempts to fit this discussion into
one convenient formula that a bank uses to set the interest rate it will charge
for a loan, or that it is able to pay on a deposit.
covered the Fed funds rate, prime rate and related interest rates above. There
are many other types of interest rates and loan products. When it comes to
setting loan rates, certain loans, such as residential home mortgage loans, may
not be based on the prime rate but rather trade off the Treasury Bill rate (a
short-term U.S. government rate), the London Interbank Offered Rate (LIBOR) and longer-term
U.S. Treasury bonds.
rates on these market rates rise, so do the rates that banks charge. Other
loans and rates include government-backed loans such as mortgage-backed securities (MBS), student loans and small
business loan rates (SBA loans),
the last of which are partially backed by the government. When the government
has your back, loan rates tend to be lower and are used as the basis for other
loans made to consumers and businesses. Of course, this can lead to reckless
lending and moral hazards when
borrowers assume the government will bail them out when a loan goes bad.
use an array of factors to set interest rates. The truth is, they are looking
to maximize profits, through the NIM, for their shareholders. On the flip side,
consumers and businesses seek the lowest rate possible. A commonsense approach
for getting a good rate would be to turn the above discussion on its head, or
look at the opposite factors from what a bank might be looking for.
easiest way to start is from client inputs, such as having the highest credit score
possible, putting up collateral or a large down payment for a loan,
and using many services (checking, savings, brokerage, mortgage) from the same
bank to get a discount. In addition, borrowing during a down economy or when
uncertainty is high (about factors such as inflation and a volatile interest
rate environment) could be a good strategy for achieving a favorable rate –
choose a time when a bank may be especially motivated to make a deal or give
you the best rate possible. Finally, seeking a loan or rate with government
backing can also help you secure the lowest rate possible.
By Ryan C. Fuhrmann, CFA - To view the original article click here