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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...
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,…
References
Investopedia. (2016). How do commercial banks make money? Retrieved February 8, 2016
from: http://www.investopedia.com/ask/answers/040215/how-do-commercial-banks-make-money.asp
Were, M. & Wambua, J. (2014, December). What factors drive interest rate spread of commercial banks? Empirical evidence from Kenya. Review of Development Finance, 4(2), 73-82.
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