Bank differential – What it is, definition and concept | 2022

In other words, a commercial bank has to capitalize first. For this reason, he is willing to pay the passive interest rate. After capitalizing, it is already in the capacity to grant loans. Therefore, when it grants loans, it charges the active interest rate.

In effect, the bank differential is a benefit that the commercial bank obtains for participating in the financial market. To get this benefit, the commercial bank has to pay a lower deposit rate and charge a higher lending interest rate. The exchange differential is also known as the bank spread.

What is the importance of the bank spread?

Of course, the bank spread is a determining factor for bank profitability. Since, it represents the difference between the active interest rate charged by the bank and the passive interest rate paid by the bank in its regular operations.

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In other words, if the rate charged were less than the rate paid, the bank would not be able to continue operating within the financial system. Of course, this is true taking strictly this definition. Although, banks make other types of operating expenses to be able to function.

For example, if a commercial bank pays a passive interest rate of 8% to capture savings deposits. While, when giving loans to finance companies, it is 15%. The bank differential would be 7%. This 7% is the benefit or profitability that the financial institution would be obtaining.

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However, we cannot consider that the only cost of a bank is the passive interest rate. Certainly, the bank incurs other operating costs such as administrative expenses, payment of insurance against defaults and the payment of taxes, among a few that can be mentioned. Naturally, this means that this 7% is not a net percentage that the bank receives for operating within the financial system.

Additionally, the exchange differential will depend on the competitive situation within the financial market. The more competitive the market is, the smaller the gap between the lending and deposit rates will be. The less competitive the market is, the larger the gap between the lending and deposit rates will be.

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How do you get the bank spread?

Importance of the active and passive interest rate in the bank differential

It is important to mention that both the passive and active rate are very important aspects in the bank differential.

1. The passive interest rate

First, the passive interest rate is the percentage rate that a bank pays to depositors. So, this rate represents a cost for the bank. Since, only if you pay this rate can it be capitalized to be able to operate in the market. It is called passive because it is a disbursement that the banker has to make.

However, if a bank wants to attract more depositors, it has to be willing to pay a higher deposit rate compared to other banks that compete in the market. Of course, the higher the deposit rates, the greater the incentive that people will have to save and keep their money.

2. The active interest rate

Secondly, the active rate is the percentage rate that a bank charges for all the credits or loans that it grants to its clients. Therefore, it is called active because it represents an income for the banker.

On the contrary, in this case, the lower the lending rates, the greater the incentive to borrow. In financial market competition, the bank that wants to make the most loans has to be willing to charge the lowest rate.

3. The passive rate, the active rate and the bank differential?

Finally, the only way for commercial banks to obtain profit or profitability with the bank differential is for the active rate to be higher than the passive rate. This implies that, if the bank differential is higher, the higher the profitability that the bank obtains.

How are interest rate prices set and how is the exchange differential produced?

When operating under free market conditions, it is the forces of supply and demand that set interest rate prices. Therefore, the bank differential also results from the conditions in which competition operates within the financial system.

On the other hand, when the government intervenes in the financial market. Interest rate prices are established through the policies applied by the Central Bank. As a consequence, the bank spread also results as a product of government control.

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What other costs can affect bank profitability?

What other costs can affect bank profitability?

In addition to the passive interest rate, the commercial bank has other costs that may affect its profitability. Among these costs we find:

  • Cost of credit: Here it refers specifically to the cost of the passive rate that the bank must pay to have deposits.
  • Cost to manage accounts: This cost refers to the bank’s administrative and management tasks. Tasks that must be carried out to recover the loans and safeguard the deposits.
  • Cost of reserve requirements: The legal reserve is the mandatory percentage that each bank must save on the deposits it receives. This percentage is established by the Central Bank and determines the amount that the bank can lend on said deposits.
  • Government cost: It includes paying taxes and complying with government policies.
  • Operational risk premium: It is the risk premium that is paid for non-compliance in the repayment of the loans granted.
  • Exchange risk premium: Risk premium paid in anticipation of a currency devaluation.

In conclusion, it can be said that the bank spread is the difference between the passive rate that a bank pays and the passive rate that it charges. The passive rate is the rate that the bank pays to obtain deposit funds. Whereas, the lending rate is the rate charged for lending those funds. A bank is profitable when the active rate is greater than the passive rate.

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