Determinants of Interest Rate Spread: Some Empirical Evidence from Kenya’s Banking Sector

Moses C Kiptui

doi:10.5539/ibr.v7n11p94

Abstract

This paper analyzes the role played by bank and industry-specific factors as well as macroeconomic variables in the determination of interest margins in Kenya’s banking sector. Decomposition of the spread using income and balance sheet of the banking sector as a whole and panel data analysis of 39 commercial banks yielded consistent results which highlight the significant role played by bank and industry specific factors and macroeconomic variables in interest rate spread determination. It is shown that between 7 – 10 per cent of the interest margin was attributable to operating costs. Moreover, a 1 per cent increase in operating costs translates to 0.38 per cent increase in interest margins for the sample of banks studied. In addition, a 1 per cent increase in non-performing loans leads to an upward adjustment of interest margins by 0.12 per cent. Macroeconomic factors also contribute to changes in the interest margin. A 1 per cent increase in Treasury bill rates leads to an upward adjustment of interest margins by 0.1 per cent. Likewise, a 1 per cent increase in GDP growth and exchange rate variability results in 0.05 and 0.06 per cent increase in interest spread respectively. In contrast, a 1 per cent increase in loans-liabilities ratio (reflecting degree of intermediation) results in interest margin reduction by 0.17per cent. The results therefore emphasize the need to improve banking sector efficiency, deal with non-performing loans and maintain general macroeconomic stability.

Highlights

The unusually high cost of financial intermediation in Kenya, as measured by the interest rate spread, is a major source of policy concern and has been haunting policy makers and analysts alike, for a while
Interest margins are hypothesized to be a function of bank and industry specific variables, the macroeconomic environment and market structure
Decomposition of the spread using income statements and balance sheets of commercial banks shows that between 7.3 percent and 10 percent of the interest margin over the period of study was attributable to operating costs

Summary

Introduction

The unusually high cost of financial intermediation in Kenya, as measured by the interest rate spread, is a major source of policy concern and has been haunting policy makers and analysts alike, for a while. This has generated a raging debate within the media; the general public and the banking sector regulator on why interest rate spreads (IRS) are high in Kenya, its effects on the economy and the kind of policies that can be implemented in order to reduce it. A higher spread limits financing for potential borrowers (Ndung’u & Ngugi, 2000)

Methods

Results

Conclusion