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FINANCIAL LAW SEMINAR FOR JUDGES HOW BANKS CALCULATE INTEREST RATES jnketsiah/01/12/11

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INTEREST RATES Interest is the price paid by a borrower for the use of money that is borrowed from a lender. It is expressed as a percentage of the amount borrowed; hence the term interest rate. Interest rate is the amount of interest expressed as a percentage of the amount borrowed jnketsiah/01/12/11

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NOMINAL VERSUS REAL Nominal interest rate is the actual interest paid expressed as a percentage of the amount borrowed. If a borrower pays interest of GHC10 on GHC100 borrowed for one year the nominal interest rate is 10% Real interest rate is a measure of the purchasing power of interest receipt jnketsiah/01/12/11

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NOMINAL VERSUS REAL Real interest rate is calculated by adjusting the nominal interest rate by inflation. If a borrower pays interest of GHC10 on GHC100 borrowed for one year when annual inflation rate is 8%, the real interest rate is 2%; i.e 10% minus 8% jnketsiah/01/12/11

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DETERMINATION OF LENDING RATES The key drivers of a banks lending rates are: The banks base rate; The industry of the borrower The borrowers specific risk jnketsiah/01/12/11

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BASE RATE It is the rate that banks lend to their prime (first class) customers; The main variables in a banks base rate are: Cost of funds Operating expenses Loan loss provision Profit margin/shareholders return jnketsiah/01/12/11

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COST OF FUNDS DepositAmountWeight (%)Cost (%)Adjusted*WACF Demand5002500.00 Savings4002044.710.94 Fixed1,000501214.127.06 Borrowing10051010.000.50 Total2,0001008.50 *Primary reserve of 9%, cash ratio of 6% jnketsiah/01/12/11

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OPERATING EXPENSES The operating expenses of a bank consist of: Personnel cost Occupancy cost Technology cost Administration cost jnketsiah/01/12/11

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OVERHEADS ABSORPTION RATE Example: A banks total asset is GHC2100 million Operational expenses is GHC80 million. Earning Assets ratio is 70% Overheads absorption rate is 80/(2100X70%) multiply by 100 (80/1470) X 100 = 5.44% jnketsiah/01/12/11

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LOAN LOSS PROVISION The Regulator requires Banks to make provision for loan losses according to the classification and formula below: Current 1% OLEM10% Sub standard25% Doubtful50% Loss10% jnketsiah/01/12/11

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LOAN LOSS PROVISION CLASSIFICATIONBALANCEREQUIREDPREVIOUSCHARGE Current1,00010 0 OLEM120120 Sub standard200503020 Doudtful1005070(20) Loss50 0 Total1,47017211062 Loan Loss Provision rate = (62/1,470) X100 4.22% jnketsiah/01/12/11

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BASE RATE Granted that a banks profit margin on loans is 2.5% the base rate of the bank becomes Cost of Funds8.50% Operational expenses5.44% Loan loss provision4.22% Profit margin2.50% Base Rate20.66% jnketsiah/01/12/11

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Accounting Page 313. Why? To measure the success of a business To assess performance To get loans from banks To plan ahead.

Accounting Page 313. Why? To measure the success of a business To assess performance To get loans from banks To plan ahead.

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