The determinants of interest rate spread: Empirical evidence from the Central African economic and monetary community

Abstract

In spite of the reforms undertook during the 1980s and 1990s in favour of financial deepening, the spread between the lending rate and the deposit rate is still high in the member countries of the Central African Economic and Monetary Community (CAEMC). Thus, the aim of this study is to investigate the determinants of banking spread in those countries. In that vein, the study employs two-step regression proposed by Ho and Saunders using country-level data from 2000 to 2010. On one hand, the study controlled for capital inflows and natural resources endowment. On the other hand, the study took into consideration the legal and institutional framework of the sample countries and the excess liquidity prevailing their banking systems. The results revealed that among bank-specific characteristics, bank asset, doubtful loan, and the volume of credit significantly determine the observed spread. As for macroeconomic characteristics, oil rents, foreign direct investment (FDI) inflows, and real gross domestic product (GDP) growth significantly affect banking spread. Meanwhile, political stability, corruption, government effectiveness, regulatory quality, and bank concentration in the deposit market are the significant institutional determinants of the interest rate spread in CAEMC countries.

Measuring the Impact of Risk on Bank Spreads in Commercial Banks in Kenya

“…A better proxy would be the coverage ratio as measured by loan loss provisions to non-performing loans ratio or the nonperforming loans rate measured by non-performing loans to total loans ratio. Increase in doubtful loans was found to be positively related to margins possibly because doubtful loans are an indicator of the level of uncertainty surrounding lending prompting banks to charge higher premiums (Fofack, 2016) Provisions on non-performing loans, credit-to -deposit ratio and liquidity ratio are significant and positively related to net interest margins (Koffie et al, 2014). Interestingly, some scholars have found a negative relationship between interest rate spread and credit risk contrary to theoretical expectation.…”

“…Achille Fofack, found credit risk to be positive and significant in determining interest rate spread in his study of the Central African Economic and Monetary Community member countries. This is attributed to the banks' behaviour of charging higher premiums in response to higher cases of default (Fofack, 2016). Manasoo(2012) finds the same result for Estonian banks though in this case, the share of credit risk in spread composition is surprisingly low, a possible indication that banks in Estonia manage a bigger part of its risk exposure by increasing capital buffers rather than relying on risk based pricing systems.…”

“…The relationship between credit risk and bank spread is based on the assumption that since loans default leads to bad debt provision costs, risk averse banks are likely to impose higher risk premium on loans in response to high default incidence thus increasing bank spread. Indeed several studies done in different countries and economic blocks have found significant positive relationship between credit risk and bank spreads (Fofack, 2016;Koffie et al, 2014;Rusuhuzwa et al, 2016). Other scholars like Ghasemi and Rostami (2015) have found a negative relationship between credit risk and interest rate spread a situation attributed to the interest reservation upon loans default which reduces interest income.…”

“…The variables that will be measured under risk are credit risk (CR) and liquidity risk (LR). Risks have the potential to reduce a bank's ability to generate income as a result of which banks generally hedge their exposure to risk by charging higher margins (Fofack, 2016). Inherent in the making of loans is the probability of a loan default in part or the whole.…”

“…Liquidity risk increases as the ratio decreases. Higher liquidity ratios correspond to lower risks and banks in such a situation are expected to charge lower risk premiums leading to lower bank spread (Ahokpossi, 2013;Fofack 2016). Liquidity risk is expected to have a positive effect on bank spread since faced with high liquidity risk, banks will source emergency funding at high costs which in turn are recovered through high liquidity premium on loans.…”