The Interest Rate differential or banking differential is the difference between the interest rate that a commercial bank pays to attract savings and the rate that it charges for loan accreditation. In other words, a commercial bank first has to become capitalized. That’s why it is willing to pay the passive interest rate. After becoming capitalized, it is now capable of granting loans. That’s why it charges an active interest rate when it grants loans.
In effect, the banking differential is a margin that a commercial bank obtains by participating in the financial market. To obtain this margin, the commercial bank has to pay a lower passive rate and charge a higher active interest rate. The banking differential is also known as the banking spread.
What is the importance of the Interest Rate differential?
Certainly, the banking differential is a determining element for banking 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.
That is, if the rate charged were lower than the rate paid, the bank could not remain operating within the financial system. Of course, this is true strictly taking this definition. Although, banks make other types of operational expenditures to be able to operate.
For example, if a commercial bank pays a passive interest rate of 8% to attract savings deposits. While, when giving loans to finance companies is 15%. The banking differential would be 7%. This 7% is the margin or the profitability that the financial entity would be obtaining.
However, we cannot consider that the only cost of a bank is the passive interest rate. Certainly, the bank incurs other operational costs such as administrative expenses, payment for breach of insurance and payment of taxes, among some that can be mentioned. Naturally, this means that that 7% is not a net percentage that the bank receives for operating within the financial system.
Additionally, the Interest Rate differential will depend on the competitive situation within the financial market. The more competitive the market is, the smaller the gap between the active and passive rate will be. The less competitive the market is, the larger the gap between the active and passive rate will be.
How is the Interest Rate differential obtained?
It is important to mention that both the passive and active rates are very important aspects in the banking differential.
- The passive interest rate:
First of all, the passive interest rate is the percentage rate that a bank pays to depositors. So, this rate represents a cost for the bank. Since, it can only operate in the market if it pays this rate. It is called passive because it is a disbursement that the banker has to make.
Now, if a bank wants to attract more depositors, it has to be willing to pay a higher passive rate compared to other banks competing in the market. Of course, the higher the passive rates are, the greater the incentive will be for people to save and keep their money.
- The active interest rate:
The active interest rate, on the other hand, is the rate that a bank charges to borrowers. Therefore, this rate represents a revenue for the bank. Given that, this rate is a return on investment for the bank because it has invested capital in the loan.
In conclusion, the banking differential is a critical component for the financial market and a determining factor for banking profitability. By paying a lower passive interest rate and charging a higher active interest rate, banks can earn a margin that allows them to remain operational in the financial system. Additionally, the banking differential will depend on the competitive situation within the market, the costs incurred by the bank and the incentives offered to depositors.
