Interest rate spread

Also called: Interest spread, Spread · Topic: Banking, Credit Creation and Monetary Policy · NCERT: Class 7, Ch 8 "Banks and the Magic of Finance"; Class 10, Ch 3 "Money and Credit"; Class 12, Ch 3 "Money and Banking"

Meaning

Interest rate spread is the gap between the interest rate a bank charges borrowers and the rate it pays depositors.

Formula: Interest rate spread = lending rate − deposit rate

It is a bank's main source of income. Out of it, the bank pays its costs, covers loans that are not repaid, and earns profit.

Explanation

How a bank earns from the spread

• A bank takes deposits (money people place in a bank account) from people who have spare money.
• It lends that money to people who need it.
• It pays depositors a lower rate and charges borrowers a higher rate. The gap is the spread.
• Worked example (Class 7 NCERT):
• Anand deposits ₹200 at 2%, so the bank pays him ₹4.
• The bank lends the same ₹200 to Shreya at 5%, so it collects ₹10.
• Spread in rupees = ₹10 − ₹4 = ₹6.
• Spread as a rate = 5% − 2% = 3 percentage points.

Where the spread goes

• The spread is not all profit. The ₹6 in the example pays for:
• Running costs: staff salaries, branches, and so on.
• Bad loans: loans that borrowers do not repay (default).

• Profit: whatever is left after the first two.

• So a bank with many bad loans needs a wider spread just to break even.

Why the deposit rate and the lending rate differ

• The deposit side: the rate depends on the type of account.
• Current account (used by businesses): no interest.
• Savings account: some interest.

• Fixed deposit (FD): the highest rate. The depositor gives up liquidity (quick access to their money). The bank can then lend that money for longer periods and earn more.

• The lending side: the rate depends on the terms of credit, which are the interest rate, collateral (an asset pledged to the lender, such as land or a house), documentation, and mode of repayment.

• A riskier borrower is charged a higher rate. This is a credit risk premium.

What makes the spread rise or fall

• Reserves that earn nothing (CRR):
• Banks must keep part of their deposits with the RBI as the Cash Reserve Ratio (CRR). This balance earns no interest [2].
• The bank still pays interest on those deposits, so the locked money raises its cost of funds (what the bank pays, on average, for the money it lends).

• CRR cut → less money earning nothing → cost of funds falls → the bank can offer lower loan rates and keep the same margin.

• Bad loans:

• More defaults → more losses to cover → banks keep lending rates high → the spread stays wide.

• Competition among banks:

• Banks now set their own deposit rates. So they can compete for depositors by paying more, which squeezes the spread.

• Changes in the RBI's rate:

• Loan rates linked to the repo rate change quickly. Most deposits are at fixed rates, so deposit costs change slowly.
• Repo rate cut → loan rates fall within 3 months → deposit costs stay fixed for now → the spread narrows for a while.

In India

• Banks set both sides themselves. No law fixes the spread. It comes from how banks price their deposits and their loans.
• Deposit side: from RBI control to market rates
• Before 2011, the RBI fixed the savings bank rate. It stayed at 3.5% a year from 1 March 2003 [4].
• Rates on all other deposits had already been freed by then [4]. The savings rate was freed later in 2011.
• Each bank now sets its own deposit rates.

• The RBI's 2011 discussion paper argued that freeing the rate would improve monetary policy transmission (RBI rate changes reaching depositors and borrowers faster) and push banks to design new deposit products [4].

• Lending side: external benchmark (from 1 October 2019) [5]

• All new floating-rate loans must be linked to an external benchmark. This covers personal and retail loans (home, auto, etc.) and loans to micro and small enterprises.
  • A floating rate is a loan rate that can move up or down during the life of the loan.
  • An external benchmark is a rate the bank does not control.
• Allowed benchmarks: the repo rate (the rate at which the RBI lends money to banks for a short time), the 3-month or 6-month Treasury Bill yield published by FBIL, or any other FBIL-published market rate [5].
• Loan rate = benchmark + the bank's spread over the benchmark. The rate must be reset at least once every three months [5].

• Limits on changing the bank's spread [5]:

  • The credit risk premium can change only if the borrower's credit assessment changes a lot.
  • The operating cost part can change only once in three years.

• CRR, which affects the bank's cost of funds:

• CRR is kept with the RBI as a share of NDTL (net demand and time liabilities, roughly the bank's total deposits and similar liabilities to the public) [2].
• It was cut from 4.5% to 4.0% in two steps (effective 14 and 28 December 2024) [3].
• It was then cut by 100 basis points in four steps: 3.75% (6 Sep 2025), 3.5% (4 Oct 2025), 3.25% (1 Nov 2025) and 3.0% (from 29 November 2025) [2].
• Example: on ₹100 crore of NDTL, a 4% CRR locks ₹4 crore. At 3%, only ₹3 crore is locked, so ₹1 crore more can earn interest as loans.

Don't confuse with

• Spread over the benchmark (in external benchmark lending): this is the markup a bank adds on top of the repo rate or T-bill yield to set a loan rate. It is made up of the credit risk premium and the operating cost [5]. The interest rate spread compares the loan rate with the deposit rate.
• Net interest margin (NIM): this is net interest income (interest earned minus interest paid) divided by the assets that earn interest. It is a ratio for the whole balance sheet. The spread is simply the gap between two rates.
• Bank profit: the spread is gross income. Salaries, running costs and bad loans come out of it before any profit is left.
• Repo rate: this is the RBI's rate for lending to banks. It is an input into loan rates, not the bank's own margin.

Prelims Hooks

• Interest rate spread = lending rate − deposit rate. It is a bank's main source of income (Class 7 and Class 10 NCERT).
• Current accounts earn no interest. Fixed deposits pay the highest rate, because the depositor gives up liquidity.
• CRR balances earn no interest. CRR is 3.0% of NDTL from 29 November 2025, down from 4.0% (December 2024) [2][3]. A CRR cut lowers banks' cost of funds.
• The savings bank rate was fixed at 3.5% from 1 March 2003 until it was freed in 2011 [4]. Today banks, not the RBI, set deposit rates.
• External benchmark lending (from 1 October 2019): applies to new floating-rate retail and MSE loans. The rate resets at least every 3 months, and the operating-cost part of the bank's spread can change only once in 3 years [5].
• Trap: a wide spread does not automatically mean a very profitable bank. It may only be covering high costs and bad loans.

Mains Points

• Spread and transmission (GS-III, monetary policy): loans linked to the repo rate reprice within 3 months, but most deposits are at fixed rates [5].
• Repo rate cut → loan rates fall quickly → deposit costs fall slowly → bank margins get squeezed.

• Banks may then be slow to lower deposit rates, or careful about lending. Borrowers also face rate increases just as quickly when the RBI raises rates.

• Market efficiency vs protecting small savers (GS-III, inclusive growth): freeing deposit rates in 2011 was meant to speed up transmission and product innovation [4].

• It was also feared to cause unhealthy competition among banks and to leave out small savers, such as rural households and pensioners, who have little bargaining power [4].

• This is a trade-off between competition and fair returns for the weakest depositors.

• Cheaper formal credit through lower costs: cutting the CRR from 4.5% to 3.0% (December 2024 to November 2025) freed funds that earned nothing [2][3].

• Lower cost of funds → room for lower loan rates → formal bank credit becomes more attractive than moneylenders who charge 5% a month.
• But reducing bad loans is just as important. Otherwise banks keep spreads wide to cover defaults, and the poor stay shut out of cheap credit.

Related concepts

• Deposits
• Savings account
• Current deposit account
• Fixed deposit
• Demand deposits
• Cheque
• Passbook
• Debit and credit
• Interest
• Compound interest

Read more

• How a bank works: deposits, interest, spread and terms of credit