Retail Interest Rate Rigidity after Financial Liberalization

Abstract

The argument for financial liberalization in developing countries is, broadly, that administered retail (lending and deposit) interest rates set below their market clearing levels result in the misallocation of credit, and thus retard investment and growth (see Fry 1994). The usual policy prescription in the development literature is therefore to allow commercial banks to determine their own retail interest rates. The fact that the commercial banks have this freedom does not, of course, imply that retail rates will be market clearing. Commercial banks may be sluggish when adjusting their retail rates, implying that the misallocation of credit may remain a problem even after liberalization. Furthermore, sluggish retail interest rate adjustment will increase the lags involved in the transmission of monetary policy. This is clearly an important issue, yet it has received very little attention in the financial liberalization literature. One possible reason for this lack of attention is that much of the literature on price rigidity in the banking system utilizes microeconomic crosssectional data sets -data of a type that is useful for examining issues of market concentration in different geographical markets (see Gilbert 1984). This type of data is typically unavailable for developing econornies. This paper introduces a different approach, using only the time series data that are available. The issue of rigidity is examined using the cointegration and error correction methodology, utilizing results on speeds of adjustment of retail (lending and deposit) rates to changes in wholesale (interbank) rates. A further innovation in the paper is the use of an asymmetric error correction methodology, which makes it possible to examine whether retail rates have greater rigidity upwards or downwards.