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FINANCIAL LAW SEMINAR FOR JUDGES HOW BANKS CALCULATE INTEREST RATES jnketsiah/01/12/11 INTEREST RATES • Interest is the price paid by a borrower for the use of money that is borrowed from a lender. • It is expressed as a percentage of the amount borrowed; hence the term interest rate. • Interest rate is the amount of interest expressed as a percentage of the amount borrowed jnketsiah/01/12/11 NOMINAL VERSUS REAL • Nominal interest rate is the actual interest paid expressed as a percentage of the amount borrowed. • If a borrower pays interest of GHC10 on GHC100 borrowed for one year the nominal interest rate is 10% • Real interest rate is a measure of the purchasing power of interest receipt jnketsiah/01/12/11 NOMINAL VERSUS REAL • Real interest rate is calculated by adjusting the nominal interest rate by inflation. • If a borrower pays interest of GHC10 on GHC100 borrowed for one year when annual inflation rate is 8%, the real interest rate is 2%; i.e 10% minus 8% jnketsiah/01/12/11 DETERMINATION OF LENDING RATES • • • • The key drivers of a bank’s lending rates are: The bank’s base rate; The industry of the borrower The borrower’s specific risk jnketsiah/01/12/11 BASE RATE • It is the rate that banks lend to their prime (first class) customers; • The main variables in a bank’s base rate are: • Cost of funds • Operating expenses • Loan loss provision • Profit margin/shareholders return jnketsiah/01/12/11 COST OF FUNDS Deposit Demand Savings Fixed Borrowing Total Amount Weight (%) 500 400 1,000 100 2,000 Cost (%) 25 20 50 5 100 *Primary reserve of 9%, cash ratio of 6% jnketsiah/01/12/11 Adjusted* WACF 0 0.00 4 4.71 12 14.12 10 10.00 0.00 0.94 7.06 0.50 8.50 OPERATING EXPENSES • • • • • The operating expenses of a bank consist of: Personnel cost Occupancy cost Technology cost Administration cost jnketsiah/01/12/11 OVERHEADS ABSORPTION RATE • Example: • A bank’s total asset is GHC2100 million Operational expenses is GHC80 million. Earning Assets ratio is 70% • Overheads absorption rate is 80/(2100X70%) multiply by 100 • (80/1470) X 100 = 5.44% jnketsiah/01/12/11 LOAN LOSS PROVISION • The Regulator requires Banks to make provision for loan losses according to the classification and formula below: • Current 1% • OLEM 10% • Sub standard 25% • Doubtful 50% • Loss 10% jnketsiah/01/12/11 LOAN LOSS PROVISION CLASSIFICATION BALANCE REQUIRED PREVIOUS Current 1,000 10 OLEM 120 12 Sub standard 200 50 Doudtful 100 50 Loss 50 50 Total 1,470 172 Loan Loss Provision rate = (62/1,470) X100 4.22% jnketsiah/01/12/11 CHARGE 10 0 30 70 0 110 0 12 20 (20) 50 62 BASE RATE • Granted that a bank’s profit margin on loans is 2.5% the base rate of the bank becomes • Cost of Funds 8.50% • Operational expenses 5.44% • Loan loss provision 4.22% • Profit margin 2.50% • Base Rate 20.66% jnketsiah/01/12/11