HOW BANKING WORKS · INTEREST AND PRICING 27
The difference between a loan rate and a deposit rate has many jobs to do
A saver might receive 2 per cent on a deposit while a borrower pays 5 per cent on a loan. It is tempting to say the bank simply keeps the 3 percentage-point difference.
That is too simple. The bank must pay for credit losses, people, technology, fraud controls, regulation, liquidity, deposit infrastructure, capital and the possibility that loans and funding reprice on different schedules. Some loans are funded partly by deposits, some by wholesale money, and some deposits provide services beyond interest.
The spread between lending and deposit rates is therefore a gross economic corridor, not a pure profit margin.
This article continues Batch 07 under How Banking Works.
A deposit is funding to the bank
When a customer holds money in a bank account, the deposit is a liability of the bank. If the bank pays 2 per cent interest, that is part of the bank’s funding cost.
But deposits are not the bank’s only funding source. Banks can also use wholesale borrowing, secured funding and issued debt. The relevant cost for a loan therefore depends on the bank’s wider funding stack.
This is why the deposit rate on one savings account cannot be treated as the universal “cost of money” for every bank loan.
A loan carries expected credit loss
Some borrowers will not repay in full. The bank has to price portfolios so that interest from performing borrowers helps absorb expected losses from borrowers who default.
A secured mortgage with a strong borrower can therefore be priced differently from an unsecured personal loan. The second may have greater default probability and lower recovery after default.
Higher lending rates often reflect greater expected credit cost, not simply greater profit.
Operating a bank is expensive
A loan and deposit sit inside a large operating machine. The bank must fund branches or digital channels, customer service, payment infrastructure, cybersecurity, fraud prevention, compliance, legal work, finance, audit, data systems and resilience.
Many of these costs exist even when the customer never visits a branch. Digital banking changes the shape of cost; it does not abolish operational cost.
Part of the lending spread pays for that infrastructure.
Liquidity has to be funded too
Banks hold liquid assets so they can meet withdrawals and settlement obligations. Those assets may yield less than loans.
The yield sacrifice is a resilience cost. A bank cannot responsibly put every dollar of funding into the highest-yielding, least-liquid asset and assume depositors will never want access.
Loan pricing therefore indirectly supports liquidity capacity as well as the loan itself.
Capital is not free
Bank shareholders and other eligible capital providers absorb losses before many creditors. They therefore expect compensation for supplying risk-bearing capital.
Riskier lending can consume more capital or more internal risk capacity. A bank can therefore reject a loan even when its interest rate exceeds the deposit rate if the spread is too small relative to capital usage.
Capital cost is one reason lending rates cannot be reduced to funding cost plus a tiny markup.
A simplified pricing stack
loan rate ≈ funding cost + liquidity cost + expected credit loss + operating cost + capital cost + optionality / structure cost + target return.
This is not a universal formula. Banks allocate costs differently. It is a useful first-principles map of why lending rates generally need to sit above the cost of stable funding.
Why some deposit accounts pay little interest
A current account provides more than a yield. It can provide payment access, salary crediting, bill payment, card functionality, cash access and relationship services. Customers may therefore hold transaction balances even when another product pays more interest.
Those balances can be valuable to banks because they may be relatively stable and low-cost. Competition, customer behaviour and market rates still constrain how low deposit pricing can remain.
Read Why Banks Pay Interest on Deposits for the funding side of the mechanism.
Why term deposits can pay more than current accounts
A term deposit commits funds for a clearer contractual period. That can make the funding more predictable for the bank. The bank may therefore pay more for the additional time commitment.
But longer maturity does not guarantee a higher rate in every market. Yield curves, funding needs and expectations about future rates can produce different pricing relationships.
The correct question is what type of funding the bank needs at that moment.
Competition compresses spreads
If many banks compete aggressively for high-quality mortgage borrowers, lending rates can fall. If they simultaneously compete for deposits, deposit rates can rise. The spread narrows from both sides.
This can benefit customers while putting pressure on bank profitability. Banks may respond by cutting costs, changing product mix or seeking fee income.
Competition therefore disciplines the spread.
Credit quality can compress or widen the loan rate
A borrower with strong cash flow, low leverage and good collateral can receive a lower rate because expected loss is lower. A riskier borrower may be charged more.
But higher pricing has limits. At some point increasing the rate can make the borrower less able to repay or attract borrowers who have fewer alternatives.
Responsible pricing therefore asks whether the risk can be supported, not merely monetised.
Fixed-rate loans can require a term premium or hedging cost
When a bank offers a fixed rate, it takes on uncertainty about future funding costs and market rates. It can fund or hedge that exposure using longer-term liabilities or derivatives, but those protections have a price.
The fixed customer rate therefore can include the cost of carrying rate risk across the fixed period.
This connects directly to Fixed Versus Floating Interest Rates.
Prepayment options have value
If a borrower can repay a fixed-rate loan early without meaningful penalty, the borrower holds valuable flexibility. When market rates fall, the borrower may refinance and leave the bank with funds to reinvest at lower rates.
The bank may therefore price some expected cost of that option into the loan, depending on the product and market.
Loan rates can fall below some deposit rates temporarily
The phrase “loan rates are usually higher than deposit rates” is deliberately not absolute. A bank can have an older fixed-rate loan earning 2 per cent while new term deposits cost 4 per cent after a sharp rise in market rates.
The historical contracts remain in force. The bank can therefore experience negative spread on particular assets and liabilities even though the long-run business model requires the total balance sheet to earn adequate returns.
This is repricing risk in visible form.
One loan is not funded by one matching deposit
It is usually misleading to imagine that Mrs Tan’s S$100,000 deposit funds Mr Lee’s S$100,000 loan at a neatly matched spread. Banks manage pooled balance sheets. Deposits move, loans remain, wholesale funding enters, securities mature and reserves settle payments.
Loan pricing therefore reflects the bank’s marginal and structural funding economics, not one labelled saver-borrower pair.
Fees can move the effective price away from the headline rate
A loan can include origination fees, annual fees, commitment fees, early repayment charges or other contractual costs. A deposit can include account fees, conditions or bundled benefits.
The headline interest-rate spread therefore does not necessarily capture the full customer economics or the bank’s full revenue.
Why the gap can widen during stress
During stress, expected credit losses can rise, wholesale funding can become expensive and banks may preserve capital. New lending rates can increase even if deposit rates also rise.
The widening spread can therefore reflect a more expensive risk environment rather than simple opportunism.
That does not mean every pricing decision is fair or competitive. Conduct rules and competition still matter. It means the mechanism has more layers than one visible rate difference.
Why the gap can narrow too far
Banks can underprice risk to gain market share. If lending rates are set too close to funding costs, the loan can look profitable before losses, operating costs and capital are recognised.
A thin spread is not automatically efficient. It can be a sign that the bank is assuming too optimistic a future.
Four misconceptions to remove
| Misconception | Better model |
|---|---|
| “The difference between loan and deposit rates is pure bank profit.” | The spread must cover funding, losses, operations, liquidity, capital and return. |
| “Every loan is funded by a matching deposit.” | Banks manage pooled balance sheets with multiple assets and funding sources. |
| “A higher loan rate always means higher profit.” | Higher rates can reflect greater expected loss, capital usage or funding cost. |
| “Loan rates must always be above every deposit rate.” | Historical fixed assets can temporarily yield less than newly repriced funding. |
A mastery test
- Why is the loan-deposit spread not pure profit?
- How does expected credit loss enter loan pricing?
- Why does liquidity create a cost even when held for safety?
- How can competition narrow the spread from both sides?
- Why can an old fixed-rate loan earn less than a new deposit costs?
If those answers connect, the gap between loan and deposit rates stops looking like a simple markup. It becomes the price corridor that supports an entire banking balance sheet through uncertainty.