If Interest rates just mean the bank are making more profit back doesn’t that mean they want them to be as high as possible? What incentivises them to reduce rates and make less money?
In: Economics
One way to think of it … the interest rate on a loan is the price for borrowing the money. And if you believe in demand curves … the higher the price for something, the lower the demand. So while any one loan might be more profitable for the bank, far fewer people will be seeking to “buy” one.
Banks make money *on the difference* between the rate they borrow at (cost-of-funds) — from savings accounts, CDs, other banks — and the rate they charge. When their cost-of-funds rate goes down it does so for *all* of the other lenders out there. It’s a competitive market so they have to lower their lending rate.
> What incentivises them to reduce rates and make less money?
the same thing as every other store, if you set the price too high people will buy from someone else
Banks are basically like those drug dealers in 1980s anti-drug commercials handing out free samples.
They get new customers when rates are lower, then screw the rates up and slowly bleed people on variable rates.
So think of those low rate periods as, “hey kid, you wanna try some *compounded interest*?”
Mostly, yes, they’ll make more from investing.
However, if the rate is too high, people won’t borrow.
Generally the cycle is driven by rates set by central banks and because central bank is „bank for banks”, those rates are passed on to individual and company clients.
When rates are increased, this is contractionary monetary action (basically everything on credit is more expensive, so for mere mortals key thing is mortgage rates. If it’s more expensive, you expect less activity). High rate environments are usually considered to have less liquidity in the market.
On the other hand, you have expansionary monetary policy, primarily linked to decreasing interest rates. Stuff is cheaper on credit, so people are more keen to buy.
Above is very simplified, but gives you a bit background.
The interest rate you pay is always going to be a little higher than the interest rate the bank pays to borrow money, they need to make money to cover costs and defaults. The bank borrows money from depositors and other banks and has to pay them interest. In general a bank will maintain the same profit margin between loans they give out and the rate they borrow at.
If you get really into the details banks do tend to make more money when interest rates are higher, either through paying less interest to depositors or charging slightly higher rates on loans.
You run a lemonade stand. Your supplies cost 5 cents a glass, so you charge 50 cents, making a 45 cent profit.
Your supply costs double. You now charge 55 cents. The price has gone up, but you aren’t making any more money than you were before.
Interest rates are set by the central bank, which is an independent entity, not for profit, and also separate from the government. For example the bank of England in the UK for the British pound and the federal reserve for the dollar.
It slowly exists to ensure that the currency it issues holds it’s value and tame inflation/recessions.
‘retail’ i.e. for profit banks get their money because it is on loan from the central bank and have to pay interest to the central bank.
The interest paid is called seniorage, and gets paid to the government, but it’s pretty small fry compared to taxes, and also, the government doesn’t have control over hoq much seniorage it gets because the central bank SHOULD BE independent. The point is not to make money, but to encourage/discourage debt.
Banks are in the business of transforming risk – usually by transforming short term deposits into long term loans. For this they charge a margin between the costs of borrowing and the interest on deposits.
Retail banks generally avoid taking a significant position on interest rates, which means that they don’t make more or less money either way – they trade off risk into the interbank market until they are basically immune to most interest rate movement.
Investment banks and hedge funds are able to take a limited position and make more money if rates move, but they will position themselves according to what they think will happen, rather than always getting more money for higher rates.
Regarding when they would reduce variable rates (on borrowing like mortgages), there is the typical competitive pressure to reduce rates, and regulators have rules and guidelines about changing the SVR.
Latest Answers