Why would one bank charge more interest than the others? And what actually happens to your money when you give it to a bank?
Money Mysteries is a column by Ryan Ong that explores the odd world of money. Where does it all go when you give it to a bank? Why does a potato sometimes cost S$200, or shipping a sofa sometimes cost S$1.99? Why is art so expensive, and how do people (legally) rip off casinos? Every week we unveil a new Money Mystery.
One of the great money mysteries is why banks have different interest rates. Why would one bank charge more money for a home loan than another, and why do some banks pay more for fixed deposits than others? The answer lies in the nature of various banks, and how they work.
First, We Need to Understand How Banks Make Money
This will only make sense if you understand how banks make money, so let’s start from there.
The banking system in use today (called fractional reserve banking) more or less began in 17th century England. At the time, people in England realised that goldsmiths had the most secure storage facilities; because, you know, it’s not like you can just leave heaps of gold in your back yard.
So people began to pay the goldsmiths to store their money and valuables in their super-safe vaults (homes were not very secure back then). Over time, the goldsmiths realised that these people seldom withdrew what they deposited. They would leave their money and valuables in storage for years, and every month only a small fraction of the valuables and money (say 5%) would actually be reclaimed by the owners.
The goldsmiths knew opportunity when they saw it, and began to loan out the money in their care. They also charged interest on it. Hey, it’s not as if the owners were doing anything with that money, right?
While this meant the goldsmiths couldn’t repay everyone at once, it didn’t matter - people seldom withdrew the money, so they only needed to maintain a certain amount in the vault at all times (say 5% of the total deposited amount, which they call the reserves).
This was the origin of the banking system today, which remains more or less the same. This process of lending out money, and balancing between deposits and collecting interest, is what leads to the constantly changing interest rates
Some of the key factors are:
- The interest rate changes based on the economic situation
- Not all banks make money in the exact same way
- Some banks are less reliant on deposits for funds
- Banks are answerable to shareholders
- Banks constantly fight for market share
- Some interest rates are not controlled by the bank
The Interest Rate Changes Based on the Economic Situation
In general, economic downturns causes interest rates to fall.
When everyone is too afraid to buy, businesses slow the rate of production (their customer base shrinks). This means a bank gets fewer opportunities to loan money, and also that its customers can’t afford a high interest rate.
As such, the bank has to lower interest rates to be more attractive to potential borrowers. This in turns means they’ll pay lower interest rates on your deposits.
Although each bank has its own methods, they will look at economic data such as the Gross Domestic Product (GDP), Purchasing Managers Index (PMI), Consumer Price Index (CPI), and so forth.
This is one of the reasons why some people want to use an overseas bank (among many others, such as tax reasons). When the economy is bad for a prolonged period, some people will choose to bank in a stronger economy, to get a better rate on their deposits.
Not All Banks Make Money in the Same Way
Earlier, we mentioned that banks make money by loaning it and collecting interest. The difference between a deposited amount and the interest it earns is called the Net Interest Margin (NIM), and for some banks NIM is the bottom line.
However, not all banks operate the same way. For example, some banks place less emphasis on NIM, and more on fees and sales. A bank can also make its money by charging administrative fees, acting as a middleman in financial transactions (especially for trade financing), selling financial products like mutual funds, or even just charging people for deposit boxes (to lock away their valuables).
Banks that focus on fees and sales don’t make the bulk of their money from lending, so you may find their interest rates on deposits are lower.
Some Banks Are Less Reliant on Deposits Than Others
These days, banks don’t just rely on deposited monies for funds. Banks can also borrow from other banks, from corporations, and even from the government. The bank can also borrow from investors, by issuing bank bonds, or raise capital by issuing more shares.
Banks that like to raise money this way often give low interest rates on deposits.
Banks are Answerable to Shareholders
If you look at the Singapore Stock Exchange (SGX), you will see many of the largest blue chip companies are banks, such as DBS or UOB or Standard Chartered.
Banks are answerable to shareholders who hold their stock; they need to please those shareholders with rewards such as dividends. This sometimes pressures the bank to keep interest rates low, as the money saved on its various deposits could go toward a bigger payout for the shareholders.
Banks Fight Constantly for Market Share
Banks know that, once you open an account, you are not likely to change it for a long time. In fact, there’s an old joke in the banking industry that people “change their wives more often than they change their bank”.
(When was the last time you changed yours? Uh... the bank, we mean.)
Sometimes, banks will drop their loan interest rates for special promotions (e.g. zero interest loans). These promotions may also mean exceptionally high interest rates on deposits, to capture market share (get more customers).
Once a person signs up with a bank - be it for a loan or a fixed deposit - they seldom switch to another; so to the bank it may be worth the momentary cost. They may even achieve a rare feat, and steal another bank’s customer.
Some Interest Rates Are Not Controlled by the Bank
Sometimes, the bank can’t decide the interest rate. An example would be home loans (mortgages) pegged to an index, such as the Singapore Interbank Offered Rate (SIBOR). The SIBOR rate is the average interest rate among 12 different banks, so no single bank can control it.
In some cases, government regulations may control the interest rates set by a bank. For example, if a bank chooses to charge 48% interest per annum on a credit card, when most other banks charge 24% per annum, the Singapore government could intervene to prevent this (unfair interest rates cause social problems, and affect the overall economy).
What’s the Benefit of Choosing a Bank with a Higher Interest Rate?
Usually, you only pick a bank with a higher interest rate for reasons of convenience.
Some banks may not have the best interest rates, but they may have the biggest number of ATMs, or the most responsive customer service.
Other than that, there isn’t much benefit to it. You would be better off always searching for the best rate, and that’s why sites like SingSaver.com.sg exist. If you ever need to take a personal instalment loan, check our list of the best and newest offers.
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