Discussion Paper No. 41 of 2004 on Determinants of Interest Spread in Kenya

Abstract

This paper examines the determinants of interest spread in Kenya using micro level data. Panel data analysis is used with a sample of 36 banks covering the period 1998-2002. Results show that wide interest spreads are explained by an imperfect credit market that is characterized by credit, interest rate, and liquidity risk. Other factors include capital costs, operational costs, costs of financial innovation, limited diversity of banks’ asset portfolio, weak management, and failure to maintain price stability. Therefore, to narrow the interest rate margins, efforts must be made to deal with the problem of non-performing loans and to make the credit market more competitive. Efforts to resolve the problem of a large stock of non-performing loans would complement the policy action of reducing implicit tax in narrowing the interest spread. Current efforts by individual banks to rationalize operational costs also need to be encouraged. The study shows that cost-inefficiency is a major factor explaining the high interest rates despite the policy action to reduce the cost of implicit tax. Banks also need to invest in quality management, which has implications on quality of bank assets. Reduced government borrowing in the domestic market through Treasury bills is paramount, but it should be accompanied by an enhanced competitive credit market and diversification of financial assets to curtail bank instability. Promotion of personal loans by banking institutions is a way forward in enhancing the intermediation role of the banking sector. Above all, monetary authority must achieve the objective of maintaining low and stable prices to ensure that the desired interest structure is achieved.