Interest Rate Spread

The interest rate spread is the difference between the cost of liabilities and the earnings on assets by a bank. It measures the financial sector efficiency in intermediation. A narrow spread means low transaction costs, which indeed reduces the cost of funds for investment, crucial to economic growth.

Both banking and financial institution enhance growth and contribute towards  poverty reduction. At low-level of economic developments, commercial banks tend to dominate the financial system while at higher levels domestic stock markets tend to become more active and efficient. The size and the mobility of international capital flow makes it increasingly important to monitor the strength of financial systems. Robust financial systems can increase economic activity and impose wide-spread costs on the economy.

The interest rate spread is China has shot up from 0.7 percent to 3.0 percent in the past 30 years. S As a nation progresses, the interest rate spread tend to fall. For example the interest rate spread of Kenya has declined from 15.2 % to 8.7 % over the past 20 years. Taking the data of developed countries like Canada, we find that the interest rate spread has remained within a close range of 4.5 to 2.1 % as they constitute matured economies.The highest interest rate spread is seen with Brazil in double figures. Interest rate spread cannot be calculated for USA as the interest rate offered there on loans and deposits is negligible.

At individual financial institution level, Banks and NBFCs  are able to earn higher interest rates than they pay by using a common strategy that is  to take advantage of differences between long-term interest rates and short-term interest rates. Long-term interest rates are typically higher than short term rates to compensate for the inaccessability of money lent out for long periods of time .

Many financial services companies borrow money at short-term rates (for example, paying low savings-account interest rates to their depositors), and lend at long-term rates (for example, through mortgages). When the interest rate spread is large, this can be a source of significant profit for banks, since they collect interest at high rates but only pay low short-term rates. As the spread shrinks (or even becomes negative), this source of profit disappears.

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