The relationship between interest rate spread and profitability of commercial banks in Kenya

Abstract

This research project sought out to determine the relationship between interest rate spread and profitability of commercial banks in Kenya. To achieve this objective, three regression models were developed using interest rates and profitability data for the period between 1996 and 2002. Interest Rate Spread was measured by the difference between lending and deposit rates. The profitability indicators used were the Return on Total Assets (ROTA), Return on Equity (ROE) and the Net Interest Margin (NIM). The study found out that interest rate spread contributes less than 50% towards the profitability of commercial banks in Kenya. Interest rate spread explains 38.4% of profitability as measured by NIM, 40.1 % when measured by ROTA and 43.3% when measured by ROE. Variations in interest rate spread explain 14.7% of the total variations in the profitability of commercial banks when measured by NIM, 16.1 % when measured by ROTA and 18.7% when measured by ROE. For peer group I, interest rate spread contributes less than 50% towards the profitability of commercial banks in Kenya when measured using ROT A and ROE while it contributes 77.9% when measured using NIM. For peer group 2, interest rate spread contributes less than 50% towards the profitability of commercial banks in Kenya when measured using NIM while it contributes to more than 50% when measured using ROTA and ROE. For peer group 3, interest rate spread contributes less than 500/0 towards the profitability of commercial banks in Kenya when measured using NIM and ROTA while it contributes to slightly more than 50% when measured using ROE. For peer group 4, interest rate spread contributes less than 50% towards the profitability of commercial banks in Kenya when measured using ROT A and ROE while it contributes to more than 50% when measured using NIM. This implies that commercial banks will no longer rely on interest rate spread as their main source of profitability. Commercial banks will in the long run rely less and less on their traditional intermediation role and instead move towards other innovative ways of raising fee income.