Money and its price (interest)
Banks play a central role in economies as they manage the flow of money. The take in deposits from people who want to save money (money supply) and grant loans to people who need more money than they currently have (money demand). Banks charge interest for money they lend to borrowers and they pay interest for money savers deposit with them.
Read on to learn more about the role of deposit and loan interest in the banking business and how central bank policies can influence interest rates.
The role of banks in the economic cycle
Sometimes people need more money than they currently earn, and sometimes they earn more than they currently need. In the latter case, they can save money for later. Saving can make sense for many different reasons. It helps you build up a financial cushion for unexpected expenses, like when you have to replace a broken household appliance or need to have your car repaired. It can help you reach specific savings goals or make general provisions for the future and your retirement.
But your savings might not always be enough to finance necessary investments or get things you currently wish to buy. Especially for major expenditures like buying a home or starting a business, you might sometimes need more money than what you have been able to save. In cases like that, a loan can help raise the missing funds and finance your expenses early on. The following brief examples show how people in different situations and at different stages of their lives can have different needs for financing.
Example: Julia and Simon Selic, aged 31 and 35, two children
The Selics live in a rented apartment. They dream of owning a house in the country. Although both parents earn well, they do not have enough money to buy a house. They need a loan of EUR 200,000 in addition to their own funds.
Example: Bernhard Feldbacher, aged 18, single
Bernhard Feldbacher is a newly trained office administrator and has a regular income. He is planning a trip to China in three years' time. Each month, he sets aside EUR 100 from his pay for this trip.
Example: Barbara Bernecker, aged 45, married
Barbara Bernecker has been working in an electrical installation company for 20 years. Now she and her husband plan to start their own business. She needs EUR 30,500 from the bank for initial funding.
If there were no banks, the Selics or Barbara Bernecker would have to try and find private individuals or businesses that would lend them the money they need for a certain time. Bernhard Feldbacher, on the other hand, would have to store his savings at home. Moreover, the money would lose its value because of inflation. It would be worth less in three years' time.
Banks fulfill two important tasks in the economy: taking in deposits and granting loans. In general, borrowers need large amounts of money, while savers tend to regularly deposit smaller amounts with their bank. Banks normally have many customers that have smaller amounts in their savings deposits (usually short-term savings). The banks can use these deposits to grant larger loans to borrowers (usually long-term loans). By doing so, banks create a temporal balance between the different maturities of deposits and loans. Because of their size, banks also spread the risk among their customers.
The tasks banks fulfill in the economic cycle
Banks manage amounts of money
Banks take in small amounts of savings deposits from many savers and combine them to extend larger loans to borrowers.
Banks manage maturities
Savings deposits with banks and loans banks extend have very different maturities. Banks work to balance these differences.
Banks manage risk
Banks spread risk by extending large numbers of loans to different individuals and businesses.
Deposit and loan interest
Banks pay and charge interest to their customers as part of their business activities. Interest is the price you pay for using someone else’s financial resources.
Savers who deposit their money at the bank receive interest from the bank for making their money available to the bank. In this case, the bank is the debtor. Interest you receive for a deposit at a bank is called deposit interest or savings interest. Borrowers who borrow money from a bank must pay interest to the bank. In this case, the bank is the creditor. Interest you have to pay for a loan from the bank is called loan interest.
The interest rates banks charge for granting loans (lending rates) are usually higher than those they pay for customer deposits (deposit rates). This way, banks earn money from the difference between deposit and loan interest. Banks' customers include all types of economic agents: households, businesses and government agencies.
Banks obtain their financial resources not only from their customers’ deposits but also by borrowing from central banks. In the euro area, the European System of Central Banks (ESCB) grants loans to commercial banks and charges them interest. Commercial banks are banks that directly serve households or businesses. The ESCB consists of the European Central Bank (ECB) and the national central banks of the European Union. The interest rates charged to commercial banks are based on the key interest rate set by the ECB.
The following figure shows the flow of money between commercial banks, lenders (money suppliers), borrowers (money consumers) and the central bank.
The central bank’s monetary policy and the key interest rate
Lending and deposit rates are influenced by central bank policy. The European Central Bank (ECB) aims to ensure price stability in the euro area (Money and its value (inflation)). The ECB influences prices in the euro area by raising or lowering its key interest rate.
Commercial banks need central bank money to cover their refinancing needs. They need central bank liquidity for three reasons:
· to have sufficient cash available for their customers
· to be able to process cashless payments
· to meet the legal requirement that commercial banks keep a certain amount of their deposits as a minimum reserve with the central bank
Usually, commercial banks obtain central bank money by borrowing from the central bank (in our case, the ECB). They have to pay a price for this money, however, as the ECB charges them interest for the money they borrow. This interest is based on the key interest rate that is set regularly by the ECB. The commercial banks, in turn, use the money they borrow to grant loans to their customers (borrowers). From these borrowers, they demand interest and collateral.
The following figure shows how the ECB influences commercial banks' lending by granting loans.
Let's take a closer look at how key interest rates work. Case 1 shows what happens when the ECB raises its key interest rates, and case 2 shows what happens when it lowers them.
Case 1: The ECB raises its key interest rates
If inflation is above the target value of 2% and forecasts indicate further price increases, the ECB would typically raise its key interest rate. This makes it more expensive for commercial banks to borrow money from the ECB. They have to pay higher interest to the ECB, and they compensate their higher expenses by charging their customers higher interest for borrowing money, too. This means they pass on higher interest rates to their customers. At the same time, they are prepared to pay higher interest on savers' deposits. As a result, both banks’ lending and deposit rates rise. With interest expenses going up, demand for loans from commercial banks goes down. At the same time, higher deposit rates make investing money with commercial banks more attractive again. There is less money in circulation. In addition, demand for consumer and capital goods declines as borrowing costs rise. As a result, prices fall and inflation decreases.
The following figure shows what happens when the ECB raises its key interest rate.
Case 2: The ECB lowers its key interest rates
If the ECB lowers its key interest rate, it becomes cheaper for commercial banks to borrow money from the ECB. Commercial banks can then afford to pass these favorable conditions on to their customers by charging lower interest rates on loans. This means it becomes cheaper for borrowers to take out loans from commercial banks. At the same time, however, deposit rates go down as well, which means that depositing money at a bank becomes less attractive for savers. This means households and businesses begin to spend more, taking out loans or using money that they would otherwise have saved to finance their investments or purchases. As a result, prices rise and inflation increases.
The following figure shows what happens when the ECB lowers its key interest rate.
Interest rates in banking transactions
Banks and their customers agree on interest rates for both savings deposits and loans. Interest rates can be either fixed or variable (see Saving and investing and Debt and credit).
A fixed interest rate remains unchanged for an agreed period of time even if the ECB raises or lowers its key interest rate. For instance, a fixed interest rate of 3% per year on a loan will remain unchanged no matter what happens to key interest rates. The fixed interest rate is only based on the interest rate level that prevailed at the time the loan contract was concluded.
A variable interest rate, e.g. for savings deposit or for a loan, is linked to the ECB's key interest rate and, because of that, may fluctuate over time.
Most loan contracts with variable interest rates refer to the Euro Interbank Offered Rate (Euribor). For instance, the annual variable interest rate for such a loan might be the three-month Euribor plus 1.5%. The Euribor is the interest rate at which banks are willing to lend money to other banks. It is based on the ECB's key interest rate and calculated for different periods.
Tip
- In times when the ECB's key interest rate is low, it can be advantageous for borrowers to have a variable-rate loan. In a so-called low interest rate environment, variable interest rates are somewhat more favorable than fixed interest rates. However, there is always the risk that variable rates might rise significantly in times of high inflation. In general, a fixed-rate loan is therefore easier to calculate in the longer term.
A brief recap
What role do banks play in the economic cycle?
The two most important tasks banks fulfill in the economy are taking in deposits and granting loans. In general, borrowers need large amounts of money, while savers tend to regularly deposit smaller amounts with their bank. Because of their size, banks spread the risk among their customers.
What is deposit and loan interest?
Deposit interest is the interest savers receive on their savings deposits. Loan interest is the interest that borrowers pay on their loans.
What is the key interest rate?
The key interest rate is an interest rate set by a central bank, for example the ECB. There can be more than one key interest rate. If key interest rates rise, it becomes more expensive for commercial banks to borrow money from central banks. These higher borrowing costs also have an impact on the lending and deposit rates banks apply when doing business with their customers.
How does the key interest rate influence lending and deposit rates and inflation?
If key interest rates rise, lending and deposit rates usually rise, too. This means that saving becomes more attractive because it earns higher interest, and loans become less attractive because they cost more. If people save more and spend less (because they borrow less), demand for goods and services goes down. Subsequently, inflation will go down.
What is the difference between fixed and variable interest rates?
Fixed interest rates remain unchanged for a fixed period of time even if key interest rates change. Variable interest rates fluctuate in line with key interest rates. This means they change when key interest rates change.
What are the pros and cons of fixed and variable interest rates?
When interest rates are low, fixed interest rates for loans may be higher than variable rates. This means borrowers pay more for fixed-rate loans when interest rates are low. On the other hand, they know the exact amount of interest they have to pay and need not worry about rising interest rates. When interest rates rise, variable-rate loans become more expensive.
