How Banks Make Money With Interest Rate Spread

Banking and Spreads: How Commercial Banks Utilize Spreads to Maintain Profitability

Commercial banks are institutions that provide services to their customers, including accepting deposits, cashing checks, lending money for various purposes, and providing investment products. Commercial banks are for-profit institutions, and while they rely on various sources of profit, including fees, their main source of profit is the interest rate spread (Investopedia, 2016). Interest rate spread refers to the difference between the interest rate charged by banks on loans to the private sector and the interest rate paid on various savings accounts. A simple numerical equation to describe the interest rate spread is Spread = Interest charged -- Interest paid. The interest rate paid by the bank is lower than the amount it charges to customers who have loans, and the difference between these two rates is how commercial banks derive the bulk of their income.

While a bank may derive the bulk of its income from the difference between interest rates, it is incorrect to assume that the bank's income can be determined solely by examining the rates and comparing the amounts on deposit with the amount of money lent by the bank. First, while banks may change the interest amount paid on regular accounts with some regularity, banks also provide their customers with traditional investment vehicles, such as certificates of deposit, which have the possibility of long-term payments at a higher rate than the bank's interest rate to customers, if there is a dramatic change in the economy during the life of the investment product. Furthermore, interest on loans that once reflected an optimal and profitable rate of spread can become less profitable when the economy changes, which might be reflected by a bank lowering the interest it pays on traditional savings accounts and simple investment products.

Furthermore, it is important to realize that, even if commercial banks were non-profit entities, there would still need to be a spread between interest paid and interest charged. There are costs associated with running a bank, which must be paid through earnings. However, more importantly, it is critical to realize that some percentage of money that banks lend to customers will not be repaid. Not only will the bank not receive interest on that money, but will actually lose the principal. Therefore, it is important that a bank's spread be sufficiently large to cover those anticipated losses. To understand how important this factor is, one need only revisit the savings and loan mortgage scandals. Because unqualified borrowers received loans that they had no ability to repay, the default rate on mortgages was much higher than anticipated, resulting in banks experiencing losses that were in excess of what would be covered by the spread. This was exacerbated by the fact that high-risk borrowers were often able to access the same interest rates as customers who were a good risk.