1

EFFECT OF INTEREST RATES SPREAD ON THE

PERFORMANCE OF BANKING INDUSTRY IN KENYA
BY
Langat Leonard
langleon@yahoo.com

Post Graduate Student JKUAT

Mr. Bellah Chepkulei;
belatoo2004@gmail.com

Lecturer
Taita Taveta University College

Dr. Bernard K Rop
Senior Lecturer
Jomo Kenyatta University of Agriculture and Technology

June 2013


ABSTRACT
Banks being at a strategic position constituting a large share of money used in every day
transactions, needs to be effective, efficient and competitive in their operations. Interest
rates spread, as sensitive economic variable, ought to be adequately harmonized so that
savers have the assurance that they are getting the best returns on their savings and that
borrowers are getting rates appropriate to their investments. The main objective of the
study was to establish the effects of interest rates spread on the performance of banking
industry in Kenya. The researcher further sought to determine the influence of credit risk
and banking regulations on interest rates spread in the banking industry and their
possible effects on banks performance. Additionally, the researcher wanted to ascertain
the influence of macro-economic environment on interest rates spread and its possible
effect on commercial banks performance. The research study utilized descriptive
research design and embraced systematic random sampling technique on selecting the
fifteen commercial banks in Nairobi city out of the existing forty four in the country. Both
primary and secondary data were analyzed and presented inform of tables, means,
percentages and frequencies. The raw data was analyzed to provide a clear picture of
how interest rates spread (IRS) contribute in the success or failure of the banking sector.
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Findings showed that Central Bank regulations, credit risk and macro-economic
environment played a major role in influencing the extent of interest rates spread and
hence contributed to the performance of banking industry. It is evident from the research
findings that the spread provided sufficient margins for banks to continue operating in
the market. In conclusion, the study found out that interest rates spread to a large extent
affect the performance of commercial banks in Kenya. Therefore, the researcher
recommended to the banks management to be both proactive and reactive in
harmonizing those elements that have an influence on interest rates spread in order to
cushion their institutions from any financial shocks that could be experienced in the
banking industry in Kenya. Lastly, it is of great importance for the commercial banks to
pay great attention to credit risk when evaluating customers loan proposals due to the
fact that a large chunk of banks revenue accrues from loans from which interest income
is derived.

Background of the Study

Interest rates spread is defined as the difference between average interest rate earned on
interest earning assets (loans) and average interest rate paid on deposits (from savers)
(Baraja, et al,1999). In their study they found that interest rates spread affects the banks
capability to transact business; as high interest rate spread means that borrowers of funds
are being charged high interest rates on loans thus decreasing their demand for loanable
funds. Also, high spread shows that savers are getting low interest rates on their savings
and thus can reduce the supply of loanable funds, as they can channel their funds to other
activities; all this affects the banks performance in the economy.

The subject of interest rate spread has been receiving great attention world wide and has
been severally described as determinant for struggle for funds for investment purposes. It
has been expressed in popular press and by investors as a cause for capital crisis and in
economics literature as the primary cause of declining labour productivity and of relative
decline in the stock market values (Jianzhou, 2007).

Kenya has been observed to have relatively high interest rates spread (IRS) as compared
to those prevailing in developed countries. Despite the ongoing financial sector reforms
aimed at enhancing competition, the spread instead of narrowing down has been either
stagnant or growing. High interest rates spread imply that a bank is charging high interest
rate on loans thus decreasing its loan customer base. It also indicates that savers are paid
low interest on their savings hence decreasing supply of loanable funds. This trend has
significant implications for the banking industry and it would be important that industry
players fully understand how their interest rate spread affect the performance of their
businesses. Also based on an assumption that a correlation between interest rate spread
and performance exists it was tempting to further examine which implications interest
rate spread have on banks performance.

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Literature review.

Interest rates spread is the centrepiece of commercial banks core business of financial
intermediation. Interest rates constitute the key price in the financial sector, the main
transmission mechanism of monetary policy, the main vehicle for matching supply and
demand and normally the key determinant of profitability. Their level reflects banks
perception of risk (country and creditor), market liquidity conditions, the cost of doing
business and the level of competition in the financial sector (Folawewo et al., 2008).

Zarruk (1989) considering risk management by banks found that risk-averse banks
operate with a smaller spread than risk-neutral banks, while Paroush (1994) explained
that risk aversion raises the banks optimal interest rate and reduces the amount of credit
supplied. Actual spread, which incorporates the pure spread, is in addition influenced by
macroeconomic variables including monetary and fiscal policy activities. Hanson and
Rocha (1986) emphasized the role of direct taxes, reserve requirements, cost of
transactions and forced investment in defining interest rate spread.

Although financial sector reforms in Pacific Islands Countries are in full swing with
complete deregulation of interest rates, their impact has not been seriously felt (Chand
2002 & Jayaraman 2001). Remedies suggested in the media with a view to controlling
IRS such as bringing fees and charges under direct monitoring by government, though
appealing to bank customers are likely to run counter to the ongoing efforts towards
promoting competition. This has left the banks management to fix interest rates at a
given margin to suit their institutions interests at the expense of their customers.

Mugume (2000) noted that banking systems in Africa are characterized not only by low
levels of intermediation but also by high interest rates, wide intermediation spreads and
substantial bank profitability. High lending interest rates whether caused by inefficiency
or lack of competition do more than add to borrowers costs. Costs that a borrower may
be charged in addition to the interest rate include: commitment/ facility fees, processing
fees, early repayment fees, negotiation fees, valuation fee, insurance, appraisal fee and
legal fee.

Ngugi (2001) observed that the interest rate spread in Kenya increased because of yet -to-
be gained efficiency and high intermediation costs. The increase in spread in the post-
liberalization period stemmed from the failure to meet the prerequisites for successful
financial reforms and the laxity in adopting indirect monetary policy tools and reforming
the legal system. Variations in the interest rates spread are attributable to bank efforts to
maintain threatened profit margins. For example, banks that faced increasing credit risk
as the proportion of non-performing loans went up responded by charging a high risk
premium on the lending rate, hence increasing the spread. High non-performing loans in
the banking sector reflect the poor business environment and distress borrowing. That
was attributed to the lack of alternative sourcing for credit when banks increased the
lending rate and the weak legal system in enforcement of financial contracts, Ngugi
(2001).

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The level of interest rates spread (IRS) affect banks investment portfolio thus directly
influencing the allocation of money and real capital to specific industries and firms,
Parkin (1939).His study stipulated that the level of interest rates in the equilibrium
determines the supply and demand for loanable funds in the market. He found out that at
high interest rates on savings households makes available a large quantity of funds than at
low interest rates. The larger the amount of this payments the larger the deferral of
household consumption and thus the greater the amount of funds available to borrowers.
This will prompt banks to reduce the interest rates charged on borrowers of funds in order
to increase their demand thus leading to reduction in the interest rates spread (IRS).

According to Mugume (2005) the inability of banks to diversify risks in a competitive
market due to market failures or non-existing markets results in increased lending interest
rate beyond the level necessary to cover the creditors marginal cost of funds plus the
intermediation costs. Consistent with this, banks whose loan portfolios are more exposed
to risky and volatile sectors such as agriculture have often higher interest rate spreads.
Finally, the incapability of the lender to perfectly ascertain the creditworthiness of the
borrower gives rise to adverse selection and moral hazard effectively adding another risk
premium to lending interest rates.

The existence and quality of collateral (i.e. whether it can be easily recovered) have a
major impact on interest rates spreads, Tarsila et al, (2002). In their study The
Determinants of Bank Interest Spreads in Brazil they found that spreads on auto loans
are much lower than spreads for personal credit although the borrowers are similar and
have similar credit risk. That was due to the fact that Auto loans are generally made
through chattel mortgage contracts in which ownership of the good being financed, in
this case a car, is transferred from the debtor to the creditor as a guarantee on the loan
while the debtor remains as a depositary of the good or asset. In the case of delinquency
the loan can be recovered or renegotiated easily. Other types of credit contracts, like
overdraft accounts and credit card loans offer little or no collateral and typically require
the creditor to undertake long and expensive legal procedures in order to seize collateral.

Additionally, credit risks affect the level of a banks profitability due to un-paid loans.
These loans will carry with them the interest income that could have accrued had they
been honoured thus reducing the banks profitability. The higher the level of high-risk
loans, the higher the level of unpaid loans due to customer defaults. This can easily lead
to a bank failure as a result of poor financial asset quality and low levels of liquidity. The
allowance for doubtful debts represents a direct measure of difference in credit quality
(Miller & Noulas, 1997).

Macroeconomic factors such as inflation and currency exchange rates contribute to
variations in interest margins (Demirguc-Kunt & Huizinga, 1999). Inflation was
associated with both higher costs and higher income although their study found clear
implications that income increases more than costs hence increasing the banks
profitability. Demirg-Kunt and Huizinga (1999) further suggested that the positive
relationship between inflation and bank profitability implies that bank income increases
more with inflation than bank costs. High inflation rates are also generally associated
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with high loan interest rates and therefore high spreads leading to high bank incomes.
Banks also obtain higher earnings from float or delays in crediting customer accounts in
an inflationary environment.

According to Molyneux and Thornton (1992) there is a positive relation between inflation
and long term interest rates with bank performance. Gerlach et al. (2003) also found that
changes in profitability are directly related to the net interest margin and to the non-
performing loan (NPL) ratio which manipulate banks provisioning decisions. Major
component of banking profitability is the interest margin on loans (Doliente, 2003). High
loan rates render the cost of funds increasingly excessive to potential users thereby
reducing investment activities and also forcing banks to hold huge amounts of cash which
could have been lend to earn interest income.

In an environment where the exchange rate is volatile and the interest rates are sticky
downward expectations of exchange rate depreciation would result in higher lending rates
(Ndungu, 2011). This is evidenced by the recent depreciation of the Kenya shilling to as
low as Kshs.107 against the US dollar on which CBK and commercial banks reciprocated
by increasing their lending rates. Additionally, exchange rate plays an important role in a
countrys level of trading with other economies around the world. Constant appreciation
of the foreign currencies against a given countrys currency has direct impact on business
performance. An increase in price of goods and services as a result of unfavourable
exchange rate will in turn increase inflation hence affecting interest rates, loan rate and
the composition of debt in the financial structure and possibly declining banks
profitability (Adzraku, 2011).

In the year 2000, Kenyas relatively high lending interest rates which averaged 24% were
a topical issue in the country. As a measure aimed at bringing down interest rates in the
country, the Central Bank of Kenya (Amendment) Act 2000 was passed by Parliament in
December, 2000. The Act required nominal interest rates to be pegged to the 91-days
Treasury bill rates by maintaining a constant margin between the lending rates and the
deposit rates. It was recommended that depositors be paid at 70% of the 91-days Treasury
bill rate, while lending rate would be at 4% above the 91-days Treasury bill rate.
However, banks did not follow the directive and empirical literature shows that at that
particular year 91-days treasury bill was trading at 20.30%, average deposit rates were
7.27% and average lending rates was 24%.If the CBK directive was to be followed the
depositors would have been paid at the rate of 14.21% and borrowers would have been
charged at the rate of 21%.This led to banks having wider interest rates spread than
expected (Central Bureau of Statistics, 2000).

In Kenya, the Central Bank of Kenya is responsible for regulation and supervision of
banks. The Banking Act has been reviewed over time to give more legal powers to the
regulatory authority and to broaden its responsibilities and coverage. In 1998 the Central
Bank enhanced capital requirements to avoid a repeat of the banking crises experienced
in the mid-1980s and early 1990s. To this end the ratio of Capital to Total Deposits was
raised to 7.5% from 5% and currently it stands at 8% (Thorsten Beck, et al., 2010). Also
as a measure to strengthen institutional structures in the banking sector, the Finance Act
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2008 raised the minimum Core Capital from Ksh.250 million to Ksh.1.0 billion. The new
capital requirements are to be met gradually by 31st December 2012 (CBK banking
sector supervision, 2008).

Section 39 (1) of the CBK (Amendment) Act No. 4 of 2001 states that the maximum rate
of interest which specified banks or specified institutions may charge on loans or
advances shall be the 91-day Treasury Bill rate published by the Bank on the last Friday
of each month, or the latest published 91-day Treasury Bill rate, plus four per-centum.
Section 39(2) states that the minimum rate of interest which specified banks or specified
institutions may pay on deposits held in interest earning accounts shall be seventy per-
centum of the 91-day Treasury Bill rate published by the Bank on the last Friday of each
month, or of the latest published 91-day Treasury Bill rate, plus four per-centum (CBK
Amendment Act No. 4 of 2001).Despite the above stipulations commercial banks charge
their customers at high rates far much above the recommended rates.

In the year 2000, the Central Bank adopted the Basel I standards on capital adequacy.
This led to the introduction of additional capital adequacy ratios of 8% and 12 % for core
capital and total capital to risk weighted assets respectively. These reforms were in
tandem with the then prevailing global trends that required financial institutions to
maintain capital commensurate with the credit risk inherent in their business. This
prompted commercial banks to set aside funds in order to meet the requirements of
minimum core capital hence leading to a reduction of money available for borrowers.
What followed was an upsurge in lending rates due to reduced supply of loanable funds
ending up with increased interest rates spread. Additionally, high implicit taxes (reserve
requirements) increase the spread through the lending rate as banks aim to maintain their
profit margins (CBK, 2000).

Licensing of credit reference bureaus to collect, analyze and disseminate credit
information among credit providers are among the latest initiatives in the banking
industrys regulations. Credit information sharing provides an opportunity for individuals
and businesses to rely on their credit history (information capital) as an alternative form
of collateral to the traditional physical collateral needed to secure credit facilities from
banks. Individuals would also be able to use their positive credit history to negotiate for
better terms and conditions from their banks. On the other hand banks would benefit from
the mechanism since it will address the problem of information asymmetry and by
extension the problem of non-performing loans which has in the past threatened the
stability of the banking sector. The traditional challenges of the moral hazard and adverse
selections can hinder financial sector growth (Ndungu, 2011).
EMPIRICAL RESULTS AND ANALYSIS
Descriptive analysis
Factors influencing the extent of interest rates spread
The research findings suggest that Central Bank regulations was a major factor that
influenced the extent of interest rates spread in the banking industry with the highest
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mean score of 4.40. It was followed by macro-economic variables, credit risk and
competition with mean scores of 4.13, 3.93 and 3.40 respectively.

Central Bank of Kenya, through its monetary policy committee, always set the ceiling
lending interest rates by directing banks to fix their lending interest rates at a rate of four
basis points above its lending rate. According to the Central Bank of Kenya
(Amendment) Act 2000, banks nominal interest rates need to be pegged on the 91-days
Treasury Bill rates by maintaining a constant margin between the lending rates and the
deposit rates. The Act further recommends that depositors be paid at 70% of the 91-days
Treasury bill rate, while lending would be at 4% above the 91-days Treasury bill rate.
This leaves the banks with no option other than try to adhere to the Central Bank of
Kenyas regulations to avoid heavy fines and penalties often imposed on the defaulters.

The anticipated changes in macro-economic variables, which include inflation, foreign
currency exchange rates, taxation, etc, encourage banks to increase their lending interest
rates thus widening the spread. This is due to the fact that these elements like inflation
rates are not precisely known in advance hence banks, as lenders, will demand a risk
premium on their lending interest rates necessitated by the uncertainty of this factor. The
impact causes a direct effect by increasing the interest rates on borrowings than on
deposits thus further widening the interest rates spread.

Credit risk, being the risk of loss due to a debtor's non-payment of a loan or other line of
credit, is also given great importance by banking institutions. From the respondents point
of view; most banks charge higher rates on loans to sectors perceived to have higher
credit risks.

Factors contributing in determination of lending interest rates.

Most respondents cited that Central Bank Rate, with a mean of 4.33, is a major factor in
determination of lending interest rates. It was followed by inflation, quality of collateral
and profit margins with 3.93, 3.60 and 3.47 mean, respectively. Commercial banks are
licensed and regulated, by Central Bank of Kenya, under the Banking Act and Prudential
guidelines and regulations, issued from time to time thus making the central bank rate to
be a key factor in lending rates determination.

Inferential analysis
Regression analysis of interest rates spread against banks performance.

The researcher conducted a linear regression analysis of the secondary data collected
from credible authorities and used it to test the relationship between interest rates spread
and the performance of commercial banks in Kenya. The regression of secondary data
was meant to supplement the primary data findings.
The regression model used was:
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y =
0
+
1
X
1
Where:
y =Performance of commercial banks; measured by profit before tax as a percentage of
total assets.

0
= Constant term

1
= Beta coefficients
X
1
= Interest rate spread; measured by the difference between interest rates charged on
loans and that paid on deposits.

Table 4.2.1: Model Summary for Regression analysis

Model

R

R
Square

Adjusted
R Square

Std.Error

Unstandardised
coefficients

Sig. F
Change

Partial
correlati
on
1 0.929(a) 0.864 0.830 0.03243 0.007
1 (constant) 0.019 -0.116 0.004 0.929
Interest
rates spread
0.404 2.036 0.929
a. Predictors: (Constant),DIFF (IRS,1)
b. Dependent variable: DIFF(PBT,1)
Source: Research data, 2012
Adjusted R Square is called the coefficient of determination and explains the extent to
which changes in the dependent variable can be explained by the change in the
independent variable or the percentage of variation in the dependent variable
(performance of banks in Kenya) that is explained by interest rates spread variable.

From Table 4.2.1, the value of adjusted R Square is 0.830. This shows that, at confidence
level of 95%, the interest rates spread confirmed only 83% of the banks performance in
Kenya. This therefore means that other factors, which could include credit risk, bank
regulation and macro-economic variables such as inflation and exchange rates, contribute
17% of the banks performance in Kenya. Therefore, this research-related work could
trigger further research to be conducted in order to investigate the other hidden factors
(17%) that affect banks performance in Kenya.

The significance value (0.007) is less that 0.05 thus the model is statistically significant in
predicting performance of banks in Kenya. Generally, when the significance level is
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smaller as compared with the alpha level (0.05) then the independent variable reliably
predicts the dependent variable.

Therefore, it can candidly be concluded that interest rates spread in the banking industry
determines a banks performance in the industry.

Additionally, the research data in Table 4.2.1 above shows that there is a strong positive
correlationship of 0.929 between Performance of commercial banks and the Predictor
factor which was Interest rate spread.
In the sampled Commercial Banks the researcher used the established regression equation
below:

Y = -0.116 + 2.036 X
1

Where:
Y = performance of commercial banks, and
X1 =

Interest rate spread
According to the research findings above, taking all factors into account and holding
independent variable, interest rates spread at zero commercial banks performance in
Kenya would be equal to -0.116 units.

The data findings analyzed also established that a unit increase in Interest rate spread at
Commercial banks would cause an increase in Performance of commercial banks by a
factor of 2.036. This infers that there is a strong relationship between Performance of
commercial banks in Kenya and Interest rates spread. The regression findings were
further supported by theoretical and empirical evidence from Molyneux and Thornton
(1992) and Demirg-Kunt and Huizinga (1999) which postulated that high interest rate
is significantly associated with higher bank profitability.

Conclusions

The study concludes that interest rates spread, to a large extent, affect the performance of
commercial banks in Kenya. The major factors that influenced the extent of interest rates
spread and eventually banks performance were Central Banks regulations and macro-
economic variables (inflation, exchange rates, credit risk and competition).

The study also concludes that credit risk have an impact on interest rates spread and in
the long run the commercial banks performance in the banking industry. This was
supported by findings from other authors such as Miller and Noulas (1997). They stated
that, as far as credit risk is concerned, there is a negative relationship between credit risk
and banks performance in form of profitability. Such a negative relationship signifies
that the higher the risk associated to loans the higher the level of loan loss provisions
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which thereby gnaw at the profit-maximizing force of a bank. The banks that faced
increasing credit risk as the proportion of non-performing loans went up responded by
charging a high risk premium on the lending rate hence increasing the spread.

The study further concludes that bank regulations had an influence on interest rates
spread in the banking industry in Kenya as cited by most of the respondents.
Additionally, the study found that macro-economic variables have an effect on interest
rates spread and possibly Commercial banks performance. The findings were supported
by Bourke (1989), Molyneux and Thornton (1992) who suggested that there is a positive
relation between inflation and long term interest rates with commercial banks
performance.
Rrecommendations

In the light of the findings and the conclusions reached from the research, the researcher
recommends the need for the commercial banks management to effectively harmonize
those factors that influence the extent of interest rates spread. The management should
also be creative and proactive in introduction of new loan products, to suit their different
clients, and to further diversify their investments; other than maintaining their current
portfolios which might be prone to credit risk and adverse changes in the macro-
economic environments.

When setting the interest rates the bank management should put in consideration the
Central Banks regulations, credit risk, competition, macro-economic variables (inflation,
exchange rates, among others). They should remember that a sound and lucrative banking
system is best able to bear any emerging internal or external negative shocks, such as the
US credit crunch crisis of 2008 which may be experienced in the banking industry and
entire financial sector.

The Commercial banks management is also advised to pay great attention to Credit risk
as it is by far the most significant risk faced by banks, since the performance and success
of their business depends on accurate measurement and efficient management of this risk.
This is due to the fact that a large chunk of banks revenue accrues from loans from
which interest is derived. Obviously, interest rate risk is directly linked to credit risk
implying that high or increment in interest rate increases the chances of loan default.
Additionally, the regulatory authorities are advised to ensure the development and
adoption of new methods of credit risk transfer that allow credit risk to be effectively
transferred other than through risk premiums on lending rates.





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