Term deposits provide financial institutions with cheap capital to fund their investment activities. They borrow funds from the public by offering deposit accounts including everyday transaction accounts, savings accounts and term deposits, in exchange for a fixed rate of interest on the funds they borrow.

Like all businesses, keeping overheads low (including financing costs) is the key to maximising profits. Accordingly, banks are regularly balancing their cost of capital with the expectations they have set with their shareholders.

If they offered higher rates of return on deposit holder funds, their profitability would decline, and for ASX-listed institutions, this would potentially lead to a decline in share price.

Put differently, term deposit holder funds are used by the banks to make their shareholders profits. These profits in many instances are in the billions of dollars each year.

Balancing this out is the fact that term deposits with Australian banks are a relatively low risk investment. The interest rate is the risk premium the banks pay for your capital, and smaller or growing banks will often pay a higher risk premium than larger, more established banks who are less inclined to bid for your capital.

Banks use interest rates as a way to attract or detract customers. Higher interest rates gives them access to more capital, at a cost of course, and lower interest rates helps boost profitability at the cost of a smaller amount of capital to leverage and invest.

Why do term deposits only pay a low rate of interest?

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