The Relationship Between Interest Rate Spreads and Bank Profitability in Competitive Markets

Abstract

This study critically investigates the relationship between interest rate spreads (IRS) and bank profitability within highly competitive financial markets, focusing on both theoretical and empirical dimensions. Interest rate spread, defined as the differential between lending and deposit rates, remains a critical determinant of banking sector margins and efficiency. The paper reviews classical banking theories, including the structure–conduct–performance paradigm, and modern approaches such as risk-adjusted intermediation frameworks, to establish a conceptual foundation. Empirical evidence highlights that while narrow spreads are often associated with efficiency and consumer welfare, they may constrain bank profitability in competitive markets. Conversely, wider spreads enhance short-term profitability but risk driving financial exclusion and reduced competitiveness. Case analyses of competitive banking systems demonstrate that profitability is influenced not only by spreads but also by cost efficiency, non-interest income, macroeconomic stability, and regulatory oversight.Furthermore, governance and policy implications are considered, with emphasis on balancing the objectives of financial stability, consumer protection, and profitability. Regulatory approaches such as interest rate liberalization, capital adequacy requirements, and prudential supervision are shown to significantly shape the spread–profitability nexus. The findings suggest that the optimal spread level in competitive markets lies in a “profitability–stability equilibrium” that sustains bank resilience without undermining consumer welfare.This article contributes to ongoing debates in financial economics by linking structural determinants of spreads with bank-level profitability outcomes, offering valuable insights for policymakers, regulators, and financial institutions seeking to balance growth, stability, and efficiency in an era of increasing global financial competition..