Banking Sector Interest Rate Spread in Kenya
KIPPRA Discussion Paper No 5
Abstract
A key indicator of financial performance and efficiency is the spread between lending and deposit rates. If this spread is large, it works as an impediment to the expansion and development of financial intermediation. This is because it discourages potential savers due to low returns on deposits and thus limits financing for potential borrowers. This has the economy-wide effect of reducing feasible investment opportunities and thus limiting future growth potential. It has been observed that large spreads occur in developing countries due to high operating costs, financial taxation or repression, lack of a competitive financial/banking sector and macroeconomic instability. That is, risks in the financial sector are high.
Financial reforms and liberalization should improve efficiency in the intermediation process. This implies that the spread will decline over time as liberalization is accomplished and the financial sector develops. But in Kenya, financial liberalization seems to have led to a widening interest rate spread. The main factors that appear to propel this are distortions in the loans market, institutional impediments and the policy environment. This paper presents empirical support for these views and argues that disequilibrium in the loans market is a major factor in driving the spread and has substantial feedback effects, which reflect persistence of the disequilibrium. Institutional and policy factors impact on transaction costs and compound the effects of risks and uncertainty in the market, thus exacerbating the spread.
To narrow interest rate spread, it is important to maintain a stable macroeconomic environment and thus reduce credit risks. There is also a need to minimize implicit taxes like reserve and cash ratios, accompanied by fiscal discipline to reduce the demand for financing budget deficit with low-cost funds. Banks should perform more intermediation/screening functions than simply investing in Treasury bills to enhance economic growth and promote financial development. In addition, banks should invest in information capital to reduce the moral-hazard and adverse-selection problems. Furthermore, by enhancing competitiveness in the Treasury bills market and promoting diversification of financial assets for investors, banks will have an incentive to increase deposit rates in order to compete for public funds. The result of this will be to squeeze the spread from the increasing deposit rate. Above all, strengthening the institutional base is important to enhance enforceability of contract.
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