Discussion Paper No. 05 of 2000 on Banking Sector Interest Rate Spread in Kenya

Abstract

A key indicator of financial performance and efficient 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 economywide 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 liberalisation should improve efficiency in the intermediation process. This implies that the spread will decline over time as liberalisation is accomplished and the financial sector develops. But in Kenya, financial liberalisation 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 polity factors impact on transaction costs and compound the effects of risks and uncertainty in the market, thus exacerbating the spread.