In recent times, the challenge of saving money has become increasingly formidableWith interest rates on bank deposits declining, one must wonder if this decline is outpaced by the depreciation of currency valuesAs we step into 2025, it’s curious to note that some smaller banks have opted to raise their deposit rates despite this continuous downturnCould there be an underlying phenomenon of competition and price wars among banks that mirrors other industries?

The other day, the president of a significant commercial bank articulated a call for major banks to refrain from engaging in price warsThis begs the question: how do banks engage in these kinds of price conflicts? The nature of pricing wars in banking diverges significantly from what is seen in sectors like automotive manufacturing, particularly the fiercely competitive electric vehicle marketIn the latter, with an oversupply of brands and models, manufacturers often resort to slashing prices to maintain or increase their market share and boost sales

The situation becomes dire as each brand fights to capture a larger slice of the market pie, forcing some to compromise their profit margins considerably.

However, the banking sector operates under rather monopolistic conditionsFor instance, a typical consumer cannot deposit money into foreign banks as easily, and international banks often find it extraordinarily challenging to penetrate the domestic marketThis monopoly effect means that consumers have rather slim choices when selecting their banking institutions for depositsTheoretically, banks could lower their deposit rates to minuscule levels, but they are bound by stringent regulatory controls that prevent them from drastically altering interest ratesThe robustness of these regulations acts as a safeguard against radical fluctuations in depositor interest rates.

So, what drives banks to engage in pricing wars? In the realm of electric vehicles, the motivation is clear: companies aggressively compete to capture market shares

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The drive for higher sales translates directly into profit, whether through thin margins realized via high volume or through encouraging sustainability until market conditions stabilizeOn the flip side, when analyzing where banks derive their profitability, we find three primary sources: lending, service fees, and investment returnsUltimately, the crux of a bank's income stems from net interest margin, which is the difference between what banks pay in deposit interest and what they charge in loan ratesThis margin constitutes roughly 75% of total banking profits.

Nonetheless, if deposit rates dip too low, consumer willingness to save diminishes, tightening the available resources banks have for lendingHence, attracting deposits remains a crucial aspect of a bank’s operational strategyTo improve their deposit base, banks may need to raise their deposit rates higher to motivate consumer action

However, raising the interest they pay out incurs additional costs—a paradox emerges where in trying to attract deposits, profits can dwindle as the banking model relies on the spread between deposit and loan ratesIn most situations, banks do not dramatically raise deposit rates merely to gather deposits, especially when saving behaviour among consumers remains robust.

Now, when it comes to lending practices, how do banks engage in their own form of price competition? By lowering the cost associated with loans, banks aim to attract a greater number of borrowersIt is interesting to note that this operational strategy is not too dissimilar from a clearance saleThis leads to an environment where price wars dominate the lending sector, and in dire scenarios, loan interest rates can dip below the yield on government bonds for similar durationsSince government bond yields typically represent the market's risk-free interest rate, diminished loan rates present a potential risk scenario.

Consider this example: if one year’s government bond yield is pegged at 2%, and a borrower secures a loan from the bank at a mere 1% interest rate, the borrower can subsequently invest in the government bond

Upon maturity, they gain a return of 2 million while repaying only 1 million, pocketing a tidy profit of 1 million, effectively engaging in a risk-free arbitrage opportunity using borrowed moneySuch scenarios create instances where loaned funds don't stimulate economic activities as intended but merely circulate within the financial system, benefiting the borrowers at the expense of the broader economy.

This situation gives rise to policies that discourage banks from offering loans with yields lower than corresponding bond ratesAdditionally, to increase loan disbursements, certain banks become lax in their risk management protocols, approving low-quality loans, which inevitably raises the default probability—leading to a potential crisis of incomplete projects and overall financial integrityAs loan and deposit challenges compound, the stark reality is that net interest margins can quickly get squeezed, reducing bank profitability

Recent statistics reveal that in 2024, the net interest margin for banks has plummeted to 1.53%. Industry consensus dictates that a margin below 1.8% signals a critical alert for banks, jeopardizing their financial health.

For smaller banks, persistent operating at a deficit can catalyze a downward financial spiral, exacerbating liquidity and credit risksShould external funding fail to materialize, these institutions teeter on the brink of bankruptcyWhen smaller banks raise deposit rates to attract savings, it creates pressure on their competitors, potentially triggering a domino effect within the industryWith growing deposits in the market, even slight increases in interest rates can amount to significant costs for banks, which reinforces the narrative of discouraging price wars.

From the aforementioned discussion, it becomes clear how price competition manifests within the banking sector, reflecting a greater conundrum