Why Banks pay different Interest Rates for deposits

We often get confused with different interest rates paid by various banks to their customers. All banks don’t pay the same interest for the deposit of same maturity and each Bank also offers different interest rates to deposits with different maturity dates. A customer depositing his money for 1 year may get a 8.00% p.a. whereas somebody who is depositing for more than 2 years may get 7.50% p.a. Underlying all these fluctuations in interest rates is Bank’s job to rotate the money i.e., movement of money from those who have excess to those who are in need and earn a spread in- between called as Net Interest Margin (NIM).

The difference interest rates are due to Asset – Liability Management (ALM). In other words, each bank has broadly three streams of sources of funds (i.e., fixed deposits, savings account/current account and money raised from market). Out of these funds, banks lend to different individuals and entities who are in need of money. Banks put a spread between the two to earn some profit i.e, banks may raise funds from individuals at 7~8% and lend it to others at 10% making the difference 2~3% as its profit margin.

Now each banks divides its sources of funds and lending into different buckets:

Interest Rate buckets

From the above, let us say that a bank raises funds for 30 days then typically it lends this amount to someone for 30 days so that by the end of 30 th day bank gets the principal and interest from its customer which can be paid back to the depositor. The difference between these two is the profit margin. The sum of the sources of funds in each bucket determines the overall cost of funds i.e., If banks have large amount of savings and salary accounts from customers whose cost of funds is low (4% for savings account and 0% for current account) then its cost of funds ideally comes down resulting in offering very unattractive rates for its fixed depositors. In addition, market also determines the interest rate differential to various buckets.

Let us assume a bank is offering loans at an attractive rate of 10.00% p.a. to its customers for a period of 90 days then other banks also try to offer at same or competitive rates. Eventually the interest rate lowers down due to demand supply mismatch. In addition, if a bank is having large amount of loans getting matured/repaid in 90 days bracket resulting in large inflow of funds to the bank. As a result, bank may price interest rate lower for its depositors in 90 day bucket as it is already anticipating large inflow of funds. In this way, the bank tries to maximize its returns. Contrary if there is a scarcity of funds in 90 day bucket then banks may price it attractively to get the deposits thereby lending at a reduced net interest margin.

ALM is also the main reason why banks insist on paying a prepayment penalty if you try to close your loan before actual maturity.