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28/03/2022

Author: Borko Božović, Director of the Directorate for Financial Stabiltiy and Payment System Oversight 

The interest rate is the amount of interest ratio to the borrowed funds ratio. It is usually expressed as a percentage and represented annually.

Several theories were formed during the economic thought development. Moreover, there are several interest rates types depending on the observation angle. Thereby, it is quite complex to talk about the factors that (uniformly) affect interest rates formation.

There are, for example, interest rates on loans from credit institutions (banks) to customers - the so-called lending interest rates. On the other hand, there are interest rates on deposits that credit institutions grant to clients - the so-called deposit interest rates. Of course, there are also interbank interest rates, i.e. rates on loans between credit institutions. However, this market in Montenegro is poorly developed because some (larger) credit institutions can borrow funds from their parent credit institutions (owners) and due to credit institutions’ high liquidity and unemployed part of their free cash assets.

With its reference interest rates, a central bank primarily affects both lending and deposit interest rates, mainly the short-term ones. The reference interest rate is the rate at which the central bank borrows funds from credit institutions (or, sometimes, the interest rate at which it pays interest for depositing credit institutions’ funds). It determines them administratively, based on the desired interest rates’ impact on the country’s economic and financial developments, primarily on inflation and sometimes on unemployment or other developments. Simply put, the economy’s overheating or its expected overheating will, in principle, lead the central bank towards the decision to raise the reference interest rates to discourage consumption and stimulate savings. Vice versa, the central bank will lower the reference interest rates level in recessive trends. However, it is not uncommon for macroeconomic developments to be divergent, so the central bank must optimise interest rate decisions in these complex circumstances, sometimes targeting the least possible damage to achieve its objectives.

Since the CBCG is not the issuing central bank, because Montenegro uses the euro (foreign currency) as legal tender, the CBCG does not have its own reference interest rate. Therefore, the reference interest rates of the European Central Bank have a key impact on the interest rates level in Montenegro’s banking market.

In addition to the base in the form of reference interest rates, lending and deposit interest rates are influenced by market forces and other particular factors. At the same time, lending rates are higher than deposit interest rates. Credit institutions use their difference to service operating and other general expenses, ultimately generating profits or dividends for their shareholders.

The general public is particularly familiar with lending interest rates, i.e. interest rates on loans. In addition to the mentioned reference interest rates’ influence, lending interest rates are also affected by the general credit risk level in the market (often approximated by the share of non-performing loans in total loans), which is influenced by several factors. In addition, a credit institution that performs better in the long run, i.e. one better managing financial and operational risks, will be able to offer its clients lower lending interest rates. At the same time, the interest rate will, in principle, be lower for a client with a better credit rating (a more creditworthy client), for a loan with better collateral and a loan with a shorter maturity.

Loans can be approved with fixed and variable interest rates, mainly referring to long-term or housing loans. The fixed-rate is unchanged during the loan repayment period, while the variable is occasionally adjusted to a reference value from the international market. In an ideal situation, when concluding a contract, market power and expectations should act to equalise a fixed rate and a variable rate impact on the client (and the credit institution). Still, market estimates are also prone to error.

Loans also have a nominal and effective interest rate. The nominal interest rate is the primary agreed rate. In contrast, the effective interest rate is obtained by converting some clients' costs concerning the loan into the nominal interest rate, e.g. loan approval fee.

Loans are usually repaid monthly. When applying the annual interest rate monthly, there are two types of (sub-annual) interest rates - relative and conformal interest rates. The conformal interest rate is formed so that the monthly interest rate on an annual level leads to an interest rate equal to the contracted annual rate. On the other hand, the relative rate is obtained by simply dividing the contracted annual rate by 12. The monthly interest rate thus leads to a somewhat higher annual interest rate than the contracted annual rate.

In addition, the general public also knows about interest rates on securities, primarily those on government securities. In theory, the interest rate on government securities is risk-free. In contrast, interest rates on securities of other (private) entities in the country should reflect the additional credit risk they carry to it. However, government securities issues of different countries are mainly conducted on international markets. They do not hold zero or the same interest rate but different interest rate levels, reflecting the public finances' stability and, ultimately, the international competitiveness of the country's private sector. Investors in government securities will demand higher interest rates for a country with a lower credit rating than a country with a higher credit rating and vice versa.