An empirical analysis of interest rate spread in Kenya

Abstract

Financial reform predicts achievement of efficiency in the intermediation process and reduced transaction costs, which is proxied by a narrowing wedge between the lending and deposit rates. Kenya’s experience shows a rise in interest rate spread during the financial reform and subsequent financial liberalization process, which suggests the failure to meet the prerequisites for successful financial liberalization. Interest rates were liberalized amidst inflationary pressure, declining economic growth, financial instability, the failure to sustain fiscal discipline and lack of proper sequencing of the shift to use monetary policy tools. At the micro level, our results show that when the profit margin is threatened, banks sustain a widening spread. Faced with a rising credit risk due to distress borrowing and poor macroeconomic conditions, banks charge a higher risk premium on their lending rate. The accumulation of non-performing loans results from a weak legal system and a poor business environment that squeezes the profit margin, and banks respond by increasing the lending rate. Policy actions also affect the spread. An asymmetric response is indicated with the treasury bill rate where lending rates increase with the treasury bill rate, and become sticky downward when the treasury bill rate declines. Further, increased implicit costs that accompany tight monetary policy sustain a widening spread even when inflationary pressure is reduced. Thus a widening interest rate spread indicates inefficiency in the intermediation process and rising costs of intermediation.