How Bank Interest Rates Are Determined

Purpose

Customers often ask why the rate on a loan is higher than the rate paid on deposits, why rates differ between banks and between borrowers, and why they change over time. This paper explains, in general terms, the main factors that determine bank interest rates. It does not describe the pricing of any particular bank and is not a statement of current rates. Banks set their prices independently, and the Association does not discuss or coordinate pricing among its members.

Monetary policy and the policy rate

The Central Bank of The Gambia is responsible for monetary policy under the Central Bank of The Gambia Act 2018. A principal instrument is the policy rate, which signals the stance of monetary policy and influences the rates at which banks lend to and borrow from one another and the Central Bank.

When the Central Bank raises its policy rate, typically to contain inflation, short-term market rates tend to rise and, over time, so do the rates banks pay on deposits and charge on loans. When it lowers the rate, the reverse tends to occur. The speed and extent of this transmission depend on market conditions, the structure of bank balance sheets and how quickly existing loans and deposits reprice. Monetary policy decisions are published by the Central Bank at https://www.cbg.gm.

The building blocks of a lending rate

A lending rate can be understood as the sum of several components. The weight of each varies by product, borrower and market conditions.

Cost of funds

What the bank pays for money. Banks fund loans mainly from customer deposits, supplemented by interbank borrowing and capital. The cost of funds reflects the interest paid on these sources, the mix between lower-cost current accounts and higher-cost term deposits, and the return available on alternative uses of funds, such as government securities.

Credit risk premium

The risk that the loan is not repaid. Lenders charge more where the probability of default is higher or where recovery would be difficult. The premium reflects the borrower's repayment record, financial position and collateral, and the sector in which they operate. Weak credit information and slow enforcement of security raise risk premiums for all borrowers.

Operating costs

The cost of providing the service. Assessing applications, monitoring loans, operating branches and digital channels, and meeting compliance obligations all carry a cost. Smaller loans tend to carry higher costs relative to their size, which is one reason why micro and small loans are often priced higher.

Capital and liquidity costs

Holding capital and liquid assets. Banks must hold capital against their loans and maintain liquid assets, in line with the Central Bank's prudential requirements. Shareholders expect a return on that capital, and liquid assets typically earn less than loans. These costs are reflected in pricing.

Term and interest-rate risk

The length of the commitment. Longer-term lending exposes the bank to greater uncertainty about future rates, inflation and the borrower's circumstances. A fixed rate places interest-rate risk on the lender, while a variable rate places it on the borrower, and pricing reflects which party bears it.

Competition and margin

Market conditions. Competition among banks and with other providers constrains pricing. Each bank's margin also reflects its strategy, its efficiency and the return its shareholders require.

Deposit rates

The rates banks pay on deposits are influenced by the policy rate, returns on alternatives such as government securities, each bank's funding needs and competition for deposits. Term deposits usually pay more than savings accounts, which in turn usually pay more than current accounts, because the bank can rely on term funds for longer, while current accounts carry higher servicing costs. Rates on larger deposits may be negotiated.

The spread between deposit and lending rates

The difference between lending and deposit rates, known as the interest spread, covers the risk premium, operating costs, the cost of holding capital and liquid assets, and the bank's margin. Spreads tend to narrow where credit information is better, contracts are enforced predictably, operating costs fall and competition increases. For this reason, improvements in credit infrastructure and payment systems can support lower borrowing costs over time.

A hypothetical illustration

Purely to illustrate how the components combine, consider an invented loan priced from a cost of funds of 6 per cent, to which the lender adds 3 per cent for credit risk, 2 per cent for operating costs and 1 per cent for capital costs and margin, giving a lending rate of 12 per cent. These figures are hypothetical and do not represent actual rates in any market.

A note on Islamic finance

Where banks offer Islamic financing products, the return is not structured as interest. Common forms include:

• Murabaha (cost-plus sale): the bank buys an asset and sells it to the customer at an agreed mark-up, payable in instalments.
• Ijarah (leasing): the bank owns an asset and leases it to the customer for an agreed rental.
• Mudarabah and musharakah (partnership arrangements): profits are shared according to agreed ratios, and losses are borne in accordance with the principles governing each contract.

Although the structure differs, the pricing of these products is influenced by many of the same economic factors: the cost and availability of funds, the risk associated with the customer and the asset, operating costs and competition. Products are reviewed for consistency with Islamic principles through each institution's sharia governance arrangements.

What customers can do

• Compare the total cost of a loan, including fees and charges, not only the headline rate.
• Ask whether a rate is fixed or variable, and how and when it may change.
• Maintain a good repayment record and accurate financial records, which can support better terms.
• Ask the bank to explain, in general terms, how the rate offered was arrived at.