The Determinants of the Interest Rate of Financial Institutions: Theoretical Model and Empirical Analysis

We develop a mathematical model for determining the interest rate applied by a financial institution. Our model mathematically isolates the four main components of the total cost of credit, including net operating costs, weighted average cost of financial resources, cost of risk and weighted cost of equity. Our equations enable to determine the floor interest rate, which is the minimum interest rate that a financial institution should set in order for its credit operations to be profitable. The results of the empirical analyses carried out over a 15-year period, from 2004 to 2018, corroborate the suggestions of our model that, interest rates follow the evolution of the floor interest rate. One of the contributions of our model is that the results can be useful in policies that seek to improve the credit conditions of financial institutions by reducing their credit costs rather than imposing low interest rates to them.