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FINANCIAL LAW SEMINAR FOR JUDGES. HOW BANKS CALCULATE INTEREST RATES. 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.
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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 jnketsiah/01/12/11
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 jnketsiah/01/12/11
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