FINANCIAL LAW SEMINAR FOR
JUDGES
HOW BANKS CALCULATE INTEREST
RATES
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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
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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
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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%
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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
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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
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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%
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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
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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%
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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%
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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%
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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%
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