Rationale for the Bank Profit Approximation
A common method to estimate a bank's profit is to multiply the difference between the average interest rate on its loans and the average interest rate on its deposits by the total volume of its lending. Explain the core assumption about a bank's primary assets and liabilities that allows this calculation to be a useful approximation.
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Conditions for the Bank's Approximate Profit Formula to be Exact
Calculating Bank Profit Using the Interest Rate Spread Formula
A commercial bank has issued a total of $500 million in loans at an average interest rate of 7%. It holds $490 million in customer deposits, on which it pays an average interest rate of 2%. Using the standard approximation method based on the interest rate spread and total lending, what is the bank's estimated profit for the year from these activities?
Evaluating a Bank's Profit Approximation
Rationale for the Bank Profit Approximation
To approximate a bank's profit, the interest rate spread (the difference between the rate on loans and the rate on deposits) is multiplied by the total volume of deposits the bank holds.