Question

In: Finance

“The rate of interest represents the compensation to the lender for the administrative cost incurred, such...

“The rate of interest represents the compensation to the lender for the administrative cost incurred, such as rent, salaries, air conditioner, and other costs. Also a compensation for the risk of not recovering the cash flow that was lent, and for an additional profit.”
Why do you think in the Puerto Rico Bank and Financial sector, the interest rate that is paid to the clients in the savings accounts is so low? Few years ago the interest rates were much higher.

Solutions

Expert Solution

A bank earns Interest by lending money to borrowers. Where does this money come from?
It comes from the money deposited by customers in their savings accounts and term deposit accounts. It also takes money from Central Bank of the country at a rate known as Repo Rate.

A bank's profit is the difference between interest earned through loans given to borrowers and interest paid to savings & term deposit account holder. This is also known as spread or margin.

If the lending rates go down, the gap between lending rates & deposit rates will narrow, affecting profitability of the bank.
Example - If Puerto Rico Bank lends at 8% and pays 4% to savings account holders, the margin is 4%.
Now, if Puerto Rico Bank has to reduce the lending rate to 6%, and keeps the savings account rate at 4%, the margin would reduce to 2%.


The higher the lending rate in a country , the higher the inflation. The central bank of the country lowers the Repo rate so that bank's take money from the central bank at a lower rate. Because of this the Puerto Rico Bank will have to lower the rates of lending.
And in order to maintain their spread (margin), they will have to reduce the savings account rates.


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