Determinants of interest rate spreads amongst commercial banks in Kenya

Abstract

This study sought to identify the determinants of interest rate spreads amongst commercial; banks in Kenya and to quantify the impact of those factors on interest rate spreads. Determinants from previous studies were used to guide the choice of independent variables, but instead of focusing on the customary spreads or margins of individual banks, the spreads for the banking sector as a whole were examined. Monthly data on the change in overall consumer price index (inflation), 91 day treasury bill rates, inter-bank rate, cash reserve ratio, Central Bank Rate, credit loss ratio (measured by specific provisions to total loans), the ratio of operating costs to total income, and the Herfindahl- Hirschman index (a proxy for market structure) for the entire banking sector were used as independent variables. A multivariate interest rate spread model was formulated to test the significance of each of the independent variables as determinants of bank’s spread. The monthly average data of the variables were regressed against the percentage of interest rate spread for the month as the dependent variable. The study covered the period 2007: 1 to 2011: 12 when the macroeconomic environment was quite volatile, and the debate on interest rate spreads was reignited. Secondary data was obtained from various published sources, but mainly from the Central Bank of Kenya and the Kenya National Bureau of Statistics. The R Statistical Package was used for analysis. The results of the study indicate that over the last five years, the Central Bank Rate and the Credit Loss Ratio have been the most significant determinants of interest rate spreads amongst commercial banks in Kenya. The Treasury Bill Rate and Market Structure have also contributed to banking sector spreads. The results however also clearly indicate that many of the factors commonly believed to be critical determinants of interest rate spreads may not in fact have been relevant to the size of the banking sector spreads over the last 5 years. Possibly most surprising was the statistical insignificance of the inflation, interbank rate and cost to income ratios. Although these variables have been highlighted in previous studies as determinants of interest rate spreads they were unable to explain the variation in banking sector spreads in Kenya for the period studied. This may be due to the relatively short period (5 years), which is insufficient to draw inferences over the long run. The results therefore do not suggest that inflation, inter-bank rate and cost to income ratio are not determinants of the size of spreads, but rather indicate the need for the further studies on these variables, taking a longer period into account.