Who hasn’t been startled when they received their account statement when they saw the debit interest rate on a three-day “small overdraft” or when they read a preliminary offer for a 15-year home loan preceding the purchase of a principal residence?
How to explain 7 to 14% in one case, 1 to 1.5% in the other?
Take a quick look in the banker’s laboratory to see how he measures the ingredients of his cost price and cooks up his “customer rate” expressed by the APR (Annual Effective Annual Rate) .
The lender’s resources
The money he lends is not his. He gets it from:
- depositors to whom he can pay interest ( the deposit can come from credits granted ),
- of its colleagues with cash surpluses,
- institutionals and companies also in surplus, via the interbank market ,
- the equity it has (money contributed by shareholders and reinvested profits),
- loans it issues on the financial markets,
- the European Central Bank (which lends money – sometimes at zero interest – or which exchanges its money for assets of the lender).
It thus has resources , the amounts, origin, rate of remuneration and maturity of which are very different. It lends them in accordance with rigorous criteria set by the supervisory authorities of the banking sector.
Overall, there is a balance between the bank’s resources and uses. But when a bank grants a loan, it does not verify that it has the money in its accounts. Each time it grants credit, it creates money ex nihilo , but in doing so it automatically creates a deposit, which makes it possible to say that “credits make deposits”.
Risk management center
It acts as a real risk management center since it exposes itself to:
- having to return the money of depositors , institutions and various investors, before having been reimbursed by their borrowing client (who sometimes even never reimburse it)
- be surprised by the divergent evolution of the interest rate he pays to the depositor compared to that which he receives from the borrower: the latter willingly returns to renegotiate the rate of his mortgage loan downwards, never upwards…
- matching the amounts and maturities of deposits with those of loans, anticipating the respective evolution of long rates and short rates, finding resources in the same currency as that of the loans, etc. is the role of “asset liability management ” .
The mysteries of the Chef’s recipe
Unlike an industrial or commercial enterprise, whose profitability on sales is quickly known, that of a bank is not certain until much later, after the expiry of the credits previously granted.
The talent of the “chef” lies in the right mix of fast sugars (overdrafts and other cash loans) with slow sugars which finance, for example, the acquisition of main residences. He ensures that each customer does not suffer from inanition (overly rationed credit) or indigestion (credit too easily granted to those who do not transform it well into wealth-creating energy).
Any dosage error would sooner or later lead to regrettable health accidents which would also affect the bank’s health.
In this delicate preparation, he must quantify all the elements, often qualitative , so as to propose a rate acceptable to the client while generating a margin after covering all known or foreseeable risks.
Based on past experience and forecasts by economists, each business sector, each form of credit is assigned a margin to cover the risk , which is greater when the credit is unsecured. This margin is modulated client by client and then added to the cost of financing to obtain the proposed rate.
Financial companies specializing in consumer credit do not receive deposits. They are mainly financed on the markets (monetary and financial). The credit files are of a low unit amount, which increases the management costs. In addition, they are granted without guarantee to customers who are already in debt elsewhere, hence the numerous “litigations”. The percentage of unreimbursed credits is higher there than in banks.
The case of real estate loans
In the case of real estate loans for the acquisition of a main residence (often 10 to 20 years), the bank calculates its cost of financing in relation to a cocktail of medium-term resources (5/7 years), for example the housing savings and long-term plans whose reference is currently that of the rate of long-term government loans, which have been very low for two years.
It adds its margin and estimates the cost of risk , ie the percentage of loans that will not be repaid on time due to the default of the borrower. That said :
- the unit amounts are high (a low percentage on large amounts can yield more than a high percentage on small amounts)
- the competition is very strong
- reimbursement incidents are infrequent because the initial agreement is studied with care, even with severity
- the final losses are much lower (than for consumer loans and business loans) because the bank has a guarantee on the financed property (mortgage) or a guarantee provided by a mutual guarantee company
- death and disability insurance is almost systematic: it reinforces the security of the lender and offers him an additional margin.
