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Explaining Interest Rate Spreads in Ghana

Anthony Q.Q. Aboagye, S.K. Akoena, T.O. Antwi-Asare and


A.F. Gockel

Abstract: The question of the optimal spread between bank lending


rates and rates that banks pay on deposits, which is fair to bankers, depositors
and borrowers, has dogged economies for some time. In Ghana, there is
widespread perception that the spread is too wide. Bankers, on the other hand
justify the spread on the basis of economic variables that affect them. This
paper contributes to the literature by identifying, in the case of Ghana, the
short-run response of the net interest margin of banks to changes in bankspecific, industry-specific and macroeconomic variables within the broad
framework of Ho and Saunders (1981). We find that increases in the following
factors significantly increase net interest margin bank market power (or
concentration), bank size, staff costs, administrative costs, extent of bank
risk aversion and the rate of inflation. On the other hand, increases in the
following variables decrease net interest margin significantly bank excess
cash reserves, the central bank lending rate, management efficiency and the
passage of time. To help reduce interest rate margins, we recommend that
banks should not get too big, the central bank should consider lowering the
capital adequacy ratio and banks should be required to pass on to borrowers
the full extent of reductions or increases in the central bank lending rate.
Continued efforts at keeping inflation at bay will also help.

1. Introduction
Stakeholders in the Ghanaian economy have been concerned about what
many consider to be the wide spread between the interest rates that banks
charge on the loans that they grant and the rates that they pay depositors.
The spread in lending and deposit rates is a key variable to investigate
since it borders on the efficiency of banks in playing their intermediation
The authors are grateful to USAID/TIPCEE/CARE for funding and facilitating this study.
Corresponding author: Anthony Q.Q. Aboagye, University of Ghana Business School, P.O. Box
LG 78, Legon, Ghana. Tel: 23324-4252596; Fax: 23321-500024; Email: qaboagye@ug.edu.gh

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9600 Garsington Road, Oxford OX4 2DQ, UK and 350 Main Street, Malden, MA 02148, USA.

Explaining Interest Rate Spreads in Ghana

379

role, and how the welfare of society as a whole is enhanced. A wide


gap may be a consequence of low deposit rates, high borrowing rates or
both. If deposit rates are considered too low, potential depositors may move
their funds into other securities, such as government treasury bills, thereby
depriving the banking system of funds that it would have used to carry out
its functions. On the other hand, if lending rates are considered too high,
genuine borrowers may be discouraged from taking loans for projects that
are considered marginally profitable. In either case, the consequence is that
financial markets and the economy as a whole may not work well. The focus
of this paper is to start from economic theory and then econometrically
identify factors that in the short run explain interest rate spreads in Ghana.
We also estimate the elasticity of our measure of interest rate spreads to
changes in factors identified.
Authors who have investigated interest rate spreads in Ghana include
Bawumia, Belnye and Ofori (2005) and Buchs and Mathisen (2005). They
provide evidence that the interest rate spread in Ghana has been the widest
among a number of sub-Saharan African countries that have been liberalizing
their economies. Throwing light on interest rate spreads in Ghana, Gockel
and Mensah (2006) used an accounting approach to study bank income
statements over the period 19972004 and concluded that The economy of
Ghana experienced high interest rate spreads that averaged 15.79 percentage
points. They pointed out that the largest source of the interest rate spread
was the operating costs of banks. Upon further analysis, they concluded that
large banks were more efficient in terms of cost and exploit their size for
better profitability.
In practice, banks have several lending rates and several deposit rates
according to the different asset and liability products. To get a good grasp of
bank lending and deposit rates, Brock and Rojas-Suarez (2000) suggested
six alternative implicit measures of interest rate spreads, namely:
1. (interest received on loans/loans) (interest paid on deposits/deposits)
2. (all interest received /loans) (all interest paid out/deposits)
3. (interest plus commissions received/loans) (interest plus commissions
paid out/deposits)
4. (interest received interest paid out)/total assets
5. (interest received/all interest-bearing assets) (interest paid out/all
interest-bearing liabilities)
6. (interest plus commissions received/all interest-bearing assets) (interest
plus commissions paid out/all interest-bearing liabilities).
They referred to 1, 2 and 3 as narrow definitions of interest rate spread and
4, 5 and 6 as wide definitions of interest rate spread. Definition 4 is the
one most commonly used in the literature because, in general, it is the one

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Figure 1: Net interest margin six biggest banks


0.0900

0.0800

0.0700

0.0600
Bank 1
Bank 2
Bank 3
Bank 4
Bank 5
Bank 6

0.0500

0.0400

0.0300

0.0200

0.0100

0.0000
1

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

Quarterly from Q1 2001 - Q4 2006


1 = Q1 2001; 5 = Q1 2002; 9 = Q1 2003; 13 = Q1 2004; 17 = Q1 2005; 21 = Q1 2006

Source: Authors computations from bank data.

that is easiest to estimate from bank income statements and balance sheets.
This measure has drawbacks, however, as noted by Brock and Rojas-Suarez.
For one thing, it ignores fees and commissions that may increase the cost
of loans to borrowers and reduce interest received by depositors. Second,
by including all assets (implicitly all liabilities), the resultant measure may
deviate from banks marginal costs and revenues.
In this study we shall refer to measure 4 as the net interest margin (NIM).
In addition to the authors we have just cited, further indication that bank
interest rate spreads have been wide in Ghana is obtained by computing the
NIM for Ghanaian banks. Figure 1 depicts the NIM of the six biggest banks
in Ghana, quarterly from the start of 2001 to the end of 2006 (actual figures
are provided in the Appendix). It is clear that but for a few spikes around
the third quarter of 2001, second and fourth quarters of 2004 and the fourth
quarter of 2005, NIM has broadly remained between a range of 0.015 and
0.04 in spite of what has generally been considered an improving business
environment.
With improving macroeconomic environment, economic agents and
managers of the economy expected interest rate spreads to have shown signs
of narrowing. For example, commenting on the spike of Q3 2001, the central
bank (Bank of Ghana, 2001) said Despite the fall in inflation and borrowing
rates, the DMBs [deposit money banks] lending rates increased during the
quarter, from June to September, thus further increasing the spread in interest

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rates. Clearly, the central bank was hard pressed to explain what happened.
The same may be said of the other spikes.
Finding it necessary to explain how they arrive at their lending and deposit
rates, Mensah (2005), in a paper for the professional association of bankers in
Ghana (the Association of Bankers), indicated that the following indicators
inform the rates that bankers pay on deposits and charge on loans: (i)
central bank reserve requirements; (ii) earnings on reserves; (iii) central
bank lending rate; (iv) projected turnover on customer account balance; (v)
expected duration of deposits; (vi) average cost of operations; (vii) customer
risk profile; (viii) duration of lending; (ix) level and quality of security and
timeframe for loan realization in case of default; (x) treasury bill rate; and
(xi) macroeconomic conditions. It is our objective in this paper to investigate
the extent to which these and other factors explain net interest margin.
Following this introductory comment we present an overview of the
Ghanaian banking sector. Then we discuss the literature on interest rates
spread which will serve as the framework for our investigations. Next, we
present our methodology, followed by our estimation results. We conclude
by highlighting the policy implications of our study.

2. Overview of the Ghanaian Banking Sector


Following the poor performance of the economy in the 1970s and early
1980s, the government in 1983 adopted a deliberate policy of reforming
the entire economy. The policy in respect of the financial sector was
referred to as the Financial Sector Adjustment Programme (FINSAP). Its
main objective was essentially to de-repress the financial environment
in the sense of McKinnon-Shaw. Specifically, for the banking system,
the exercise was to enhance its soundness through improved regulatory
framework; strengthening banking supervision; restructuring financially
distressed banks; improving deposit mobilization; increasing efficiency in
credit mobilization; and strengthening competition and efficiency within the
banking sector.
Financial intermediaries that have evolved since FINSAP was introduced
include deposit money banks (DMBs), life and general insurance companies,
discount houses, finance houses, leasing companies, savings and loan
associations, credit unions, a stock exchange, brokerage houses and rural
banks.
DMBs are licensed as regular banks which take deposits from the public
and make loans. There is no restriction on the number of branches that they
may have anywhere in the country. DMBs, as a group, are by far the largest
component of the financial system, whether measured by size of assets or
number of customers. Between 2001 and 2006 the ratio of the total assets of

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DMBs to GDP averaged 35 per cent. However, domestic credit to the private
sector has remained at around 10 per cent of GDP only for some time. In
general, 10 per cent is considered too low if the private sector is to help the
economy do better.
Under FINSAP, the Banking Law was promulgated in 1989 to govern
the conduct of banking business in Ghana. Among its many provisions is
the pegging of the capital adequacy ratio of bank equity to bank assets at
6 per cent. This ratio, however, was increased in 2004 to 10 per cent under
the successor law, the Banking Law 2004, and remains the same under the
current law, the Banking (Amendment) Law, 2007. Following FINSAP, the
health of the banking sector appears to have improved. For example, at
the dawn of FINSAP in 1988, 41 per cent of all bank credit was considered
non-performing, but the corresponding average for the period 20012006
was 14 per cent.
The number of banks in the system too has increased steadily (Table 1).
At the end of 2006, 23 deposit money banks were operating in the country as
against about six at the start of the exercise in 1988. However, preliminary
evidence suggests that the Ghanaian banking industry is dominated by a few
banks. Thus, the potential for them to behave as monopolists or oligopolists
at a cost to the economy as a whole exists. The dominance of the six biggest
banks is also illustrated in Table 1, which indicates the proportion of total
bank assets and total bank branches that are owned by the six biggest
banks. The table suggests that the six biggest banks do indeed command
a high proportion of both indicators. The proportions have been falling but
still remain substantial, however. Some observers of the Ghanaian banking
system point to the concentration of assets and branches as the reason for
the large spread between bank lending and bank borrowing rates.
Table 1: Total assets and total branches of six biggest banks as a
percentage of total banking industry assets and branches

Year

Assets of 6
big banks as
a percentage
of total bank
assets

Branches of 6
big banks as
a percentage
of total bank
branches

Number of banks
in industry

Total
branches of
all banks

1999
2000
2001
2002
2003
2004
2005
2006

83
85
84
82
77
73
69
65

87
86
84
83
80
73
74
76

14
15
17
17
18
18
19
23

300
304
326
322
329
384
378
350

Source: Authors computations from bank data.



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Above are the indications of the state of affairs in the Ghanaian banking
industry and the economy. We now turn to systematic economic analysis for
a better insight of the factors that explain interest rate spreads.

3. Literature Review
First, we summarize the conceptual framework on interest rate spreads that
takes its roots from the seminal work of Ho and Saunders (1981), then follow
with some empirical evidence and finally outline our model.

3.1 Conceptual Framework of this Study


The position of Ghanaian bankers in respect of factors that influence lending
and deposit rates (referred to in the introduction) has support in the literature.
In a frequently cited paper, Ho and Saunders (1981) conceived of banks
as risk-averse entities intermediating between savers and borrowers. As
intermediaries, they must contend with the fact that demands for loans and
receipt of deposits may arrive at different points in time. Ho and Saunders
reasoned that banks set loan rates and deposit rates optimally so as to
minimize the risk they face in respect of interest rates on money markets or
the inter-bank market when there is excessive loan demand, or insufficient
supply of deposits. Thus, banks set interest rates with margins relative to the
money market rates one margin (positive) for the loan rate and another
(negative) for the deposit rate. They deduced that interest margins have two
components: the degree of competition and the interest rate risk to which the
banks are exposed.
The Ho and Sauders model has been extended by other authors. For
example, Lerner (1981) extended the model to incorporate production costs
associated with intermediation. Other extensions allow for the existence of
different types of credits and deposits (Allen, 1988); and Angbanzo (1997)
extended the model to allow for credit risk as well as interest rate risk.
McShane and Sharpes (1985) version replaces the interest rate risk on
credits and deposits with uncertainties in the money markets.
Our investigation of the short-run determinants of interest rate spreads
in Ghana is conducted within the Ho and Saunders framework and follows
the version by Maudos and Fernandez de Guevara (2004). Maudos and
Fernandez de Guevara reason as follows. Suppose the prevailing market
interest rate is r, then banks are assumed to set deposits margin a, and loans
margin b, relative to r (a and b both greater than all equal to zero) such that
the deposit rate r D , and loan rate r L , are given as
r D = r a; and r L = r + b

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Thus, the spread between the lending and deposit rates is given as
s = rL rD = a + b
Given a banks initial wealth as the difference between its assets and
liabilities, and incorporating the production costs of intermediation, which
are assumed to be functions of its deposits and loans, Maudos and Fernandez
de Guevara (2004) derived the banks end of period wealth as a function of
the interest rate risk and credit risk faced by the bank.
Next, given that banks are maximizers of expected utility, a banks utility
function, U, is approximated by the Taylor expansion around the expected
level of wealth, (W = E[W ]). That is,
E[U (W )] = U (W ) + U  (W )E[W W ] + 1/2U  (W )E[W W ]2
It is assumed that the banks utility function is continuous, doubly
differentiable with U  > 0 and U  < 0, to ensure that the bank is risk averse.
Incorporating the cost of producing deposits and credits, random arrival of
deposits and loan requests (both assumed to be random Poisson processes),
and substituting the expression for terminal wealth, the expression for the
optimal spread s is shown to have the following determinants:

the competitive structure of markets


average operating costs
extent of risk aversion
volatility of money market rates
riskiness of a banks loan portfolio
covariance of interaction between interest rate risk and credit risk, and
the average size of credit and deposit operations.

Elsewhere in the literature, other variables have been hypothesized to


explain interest rate spreads. These include the opportunity cost of
maintaining regulatory reserves and the quality of management (Maudos
and Fernandez de Guevara, 2004). Other formulations include the impact of
the macroeconomic environment, for example Chirwa and Mlachila (2004).

3.2 Brief Review of Related Empirical Studies


As far as we are aware, the Ho and Saunders framework has not been
used to investigate interest rate spreads in Ghana. Two recent studies that
investigated interest rate spreads in Ghana have been alluded to. One is
Bawumia et al. (2005) who assessed the role of the structure of the banking
industry, measured by market share, in explaining bank interest rate margins
in Ghana. They also investigated the impact of policy factors (inflation,
treasury bill rate and liquidity requirements). In their model, they allowed

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lagged hypothesized explanatory variables to impact net interest margin


to capture dynamic effects. They used quarterly panel data for the period
20002004 for 16 banks. They concluded that market share (their indicator
of the structure of the industry), operating cost, indicator of lagged nonperforming loans, bank net worth, and inflation are important in explaining
net interest margins. The other study, Gockel and Mensah (2006), studied
bank income statements over the period 19972004, and concluded that
interest rate spreads in Ghana were higher than in many other jurisdictions
and that operating costs of banks were the largest contributor to this spread.
Studies on rate spreads in other parts of sub-Saharan Africa include Chirwa
and Mlachila (2004) who investigated the impact of financial sector reforms
on interest rate spreads in the commercial banking system in Malawi. Their
model specified interest rate spreads as a function of bank characteristics,
market characteristics, operational expenses, the regulatory environment,
and the Malawian macroeconomic environment. They used monthly panel
data for five Malawian commercial banks for the period 198999. Panel
regression results suggest that the observed wide spreads can be attributed to
high monopoly power, high reserve requirements, high central bank discount
rates, and high inflation.
Postulating an error correction model and using monthly data from 1991
99, Ngugi (2001) found that for Kenya, rising inflation resulting from
expansionary fiscal policy, tightening of monetary policy, yet-to-be realized
efficiency of banks and high intermediation costs explained interest rate
spreads.
Outside Africa, Maudos and Fernandez de Guevara (2004) analyzed
interest margins in the principal European banking countries over the
period 19932000 by considering banks as utility maximizers bearing
operating costs. They found that factors that explain interest margins are the
competitive condition of the market, interest rate risk, credit risk, operating
expenses, and bank risk aversion among others.
Elsewhere Angbanzo (1997) tested the hypothesis that banks with more
risky loans and higher interest rate risk select lending and deposit rates so
as to earn wider net interest margins. He used United States bank data from
198993 and found evidence in support of the hypothesis.

3.3 Our Model


We conduct our study of interest rate spread in Ghana by operationalizing
the conceptual framework discussed in Section 3.1 and incorporating into
the model the factors identified by the Ghanaian Association of Bankers,
as well as other variables identified in the literature as helping explain
interest rate spreads. Some of these explanatory variables are bank specific,

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x, some pertain to the industry, y, while others pertain to the macroeconomic


environment, z.
For our dependent variable we use the net interest margin of banks
(NIM) defined in the introduction as interest income less interest expenses
expressed as a fraction of total assets. Use of this variable avoids the huge
difficulty of coping with multiple lending and borrowing rates in the face of
insufficient data on these variables.
In Ghana, banks report only one figure on their income statements as
interest income, and another as interest expense.
As NIM is defined, fees and commissions are excluded. Fees and
commissions may be earned on many services, but bank income statements
in Ghana report only one item as fees and commissions. A detailed analysis
of privileged banking data suggests that banks earn far more on fees and
commissions on additional products such as use of automatic teller machines,
trust services, advisory services and funds transfer services than they earn
making loans. Thus, we do not think this figure should come into play in a
study of the spread between lending and deposit rates.
Our model incorporates a number of standard explanatory variables. In
addition, we reason that in Ghana, it is the central bank lending rate, rather
than the money market rate that banks say is relevant in setting lending
rates (Mensah, 2005). Further, while the framework we are using recognizes
operating costs as explaining interest rate spreads, we take this a step
further and decompose operating costs into three components. These are
staff costs, depreciation and occupancy costs, and administrative and other
costs. Staff costs are costs incurred by a bank on behalf of its employees.
Occupancy costs are incurred because of the premises that a bank occupies.
Depreciation costs are assumed to proxy the annual amounts consumed
as equipment and other infrastructure such as expenditures on information
and communication technology. The definition of administrative and other
expenses is amorphous. Depending on the bank in question, this variable
may include administrative expenses, advertising and marketing, training,
amount spent fulfilling corporate social responsibility, remuneration for
board of directors and auditors, travel expenses, etc. We reason that these
components of operating costs relate to different aspects of bank operations
and disaggregating them will allow us to focus on the impact of each on the
dependent variable.
In Table 2 we report the average of the three categories of operating
expenses for the six biggest banks (out of the 17 banks being investigated for
the period 20012006). The table suggests that staff costs, and occupancy
and depreciation expenses are generally higher than administrative and other
costs. None of the two bigger categories, however, dominates across all
banks. For example, while staff costs dominate occupancy costs for Bank 4
and Bank 6, the reverse is the case for Bank 1, Bank 2, Bank 3, and Bank 5.

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Explaining Interest Rate Spreads in Ghana

Table 2: Proportions of annual operating costs: six year average,


20012006
Component

Bank 1 Bank 2 Bank 3 Bank 4 Bank 5 Bank 6

Staff costs (%)


28
Occupancy and depreciation (%)
61
Administrative and other costs (%) 11

28
39
33

23
55
22

50
28
22

30
44
26

42
26
32

Source: Authors computations from bank data.

4. Methodology
We now specify the short-run response of banks net interest margin to
changes in bank specific variables, industry variables and macroeconomic
variables in Ghana. Quite often, banks are expected to respond quickly
to changes in certain policy variables taking their own situation into
consideration. Results of this study would indicate to policy makers those
variables that do indeed influence interest rate spreads in the short run.
We specify our model as:
NIM it = f (xit , yt , z t , t )
That is, NIM it , the net interest margin of bank i at time t is a function
of bank-specific variables at time t, x; industry characteristics y (including
regulatory environment) at time t; values of macroeconomic variables z at
time t; and t is the error term at time t. This error term is conceived of
as having bank-specific and time-specific components as well as a random
term.
Candidate explanatory variables include:
1. Bank-specific explanatory variables, x
Components of operating costs. As indicated earlier, Lerner (1981)
emphasized the importance of this variable. In a previous section we
discussed the rationale for decomposing it. The variables employed are (i)
staff cost as a ratio of total assets (STAFF), (ii) depreciation and occupancy
costs as a ratio of net fixed assets (CAPITAL), and administrative and
other costs as a ratio of total assets (ADMN). It is expected that NIM
will increase with STAFF and ADMN. On the other hand, if banks are
spending on new technology and passing on the benefits to customers,
NIM will decrease with CAPITAL.
Scale of operation. Large-scale operations may influence NIM by
lowering average costs and enabling the bank to make higher profits
or pass on cost savings to customers in the form of lower margins. If

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2.

A.Q.Q. Aboagye et al.

banks do benefit from scale operations and they in turn pass on cost
savings to their customers, NIM will decrease with the scale of operation.
Three proxies of the scale of operations are considered: total assets (TA),
total deposits (DEPOSITS) and total loans (LOANS).
Extent of risk aversion. We reason that a more risk averse bank will have
more equity in its capital structure and will thus charge wider margins in
order to earn the higher return that equity suppliers demand. Risk aversion
is proxied by the ratio of equity to total assets (RSK_AV).
Credit risk. Typically, a bank will try to compensate for the credit risk
it faces by charging higher risk premiums on its loan rates. This will
translate to higher NIM. We estimate the default risk that a bank faces
as the ratio of the provisions it makes for bad and doubtful debt to gross
loans (CRDT_RSK).
Quality of management. Clearly, the quality of bank management affects
profitability. We gauge the quality of bank management by computing the
ratio of a banks total operating expenses to total revenue (MGMT). The
variable measures operating costs incurred to generate a unit of revenue.
Increases in this variable should have a negative impact on NIM because
an increase in this ratio implies a decrease in efficiency hence a reduction
in net interest margin. Angbanzo (1997) recognized the importance of
this variable.
Industry characteristics
Banking industry structure. The literature notes that wide interest rate
spreads will persist if the industry structure within which banks operate
remains unchanged. In Ghana to date, a few banks dominate the
industry suggesting a non-competitive industry. This was discussed earlier
(Table 1). In the literature, investigations of the market structure of
the banking industry and bank behaviour have involved a number of
instruments. One is the Lerner index. A second indicator of industry
structure is the Herfindahl-Hirschman index. Market share is also used
as a third indicator.
The Lerner index is defined as LI = (P MC)/P, where P is the marginal
price set by a bank and MC is the banks marginal cost. The index
defines disparity (mark-up) between price and marginal cost expressed
as a fraction of price, thus measuring the capacity to set prices above
marginal cost. This is referred to as market power. The literature is of the
view that intermediation margins increase with market power.
To compute the LI, we set the average price, P, of a bank as the ratio
of total revenue to total assets. The banks marginal cost, MC, is derived
from estimating a trans-logarithmic total cost function in terms of the
exogenous price of inputs, namely, price of labour, w 1 , price of physical
capital, w 2 , price of deposits, w 3 , price of administrative and other costs,
w 4 . Total assets, TA, are considered as the banks output.

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The Herfindahl-Hirschman index (HHI) is viewed as a measure of


concentration the extent to which a few banks dominate market shares
in respect of total assets, loans or deposits. It is measured as the sum of
squares of banks market shares of the banking industrys total assets, total
deposits or total loans. Market share may be computed as a banks total
assets, total deposits or total loans as ratios of their respective industry
totals.
Opportunity cost of non-earning bank reserves (primary reserves). In
Ghana, banks must by law set aside a percentage of the deposits
they mobilize as non-earning reserves against contingencies to provide
liquidity cushion. Liquidity reserve requirements are a burden on the
industry impacting negatively on profitability and must therefore be
passed on to customers in the form of wider margins. Banks may make up
for this by keeping interest rate spreads wide. For all of the period covered
by this study, banks had to set aside liquid funds to cover contingencies.
Since the actual minimum primary required reserve ratio did not change
over the life of this study, we focus on how banks managed their cash in
the face of changing interest rates for some insight into how banks behave
in respect of liquidity and interest margins. The variable we use is the
ratio of the sum of cash and near cash items to total assets. We label this
(L_RSV).
3. Macroeconomic variables
Macroeconomic environment. In addition to bank and industry specific
factors, banks also keep an eye on the economic environment when setting
their lending and deposit rates. Clearly, an unstable macroeconomic and
policy environment is perceived as more risky and banks may compensate
for it by requiring wider margins. Given that interest rates are determined
by expected inflation and money supply, we include proxies of both
variables in our model.
For expected inflation we use actual values of inflation, and for money
supply we use the central bank lending rate. Including the inflation rate also
allows us to investigate bankers assertion that they keep an eye on treasury
bill rates when setting their lending rates. Treasury bill rates in Ghana are
highly correlated with the rate of inflation. Please refer to Table 3. For the
period in question, the correlation coefficient between the two was 0.86
with a highly significant t-value (15.56) for the number of observations
in question. Practitioners also indicate that they consider the central bank
lending rate in setting their own lending rates. We conceive of the central
banks lending rate as an indicator of monetary policy. Quarterly values of
this variable are also given in Table 3. The overall trend in both has been
downwards. With the economy appearing to be doing better one would expect
interest rates to fall, which they have. The concern of observers, however,

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Table 3: End of quarter inflation, treasury bill and central bank rates
Year

2001

2002

2003

2004

2005

2006

Quarter

Inflation
(%)

91-day treasury
bill rate (%)

Central bank
rate (%)

Q1
Q2
Q3
Q4
Q1
Q2
Q3
Q4
Q1
Q2
Q3
Q4
Q1
Q2
Q3
Q4
Q1
Q2
Q3
Q4
Q1
Q2
Q3
Q4

41.9
36.8
28.3
21.3
16.0
13.7
12.9
15.2
29.9
29.6
26.8
23.6
10.5
11.9
12.6
11.8
16.7
15.7
15.0
14.8
9.9
10.5
10.8
10.5

43.47
46.68
38.80
29.70
23.37
23.42
24.44
24.96
26.91
32.41
24.36
23.16
22.41
21.51
19.42
17.08
17.23
16.50
13.90
11.77
9.80
10.19
11.15
10.70

27.0
27.0
27.0
27.0
25.5
25.5
25.5
25.5
27.5
27.5
26.5
24.5
20.0
19.5
19.5
19.5
19.5
16.5
15.5
15.5
14.5
14.5
14.5
12.5

Source: central bank publications (various issues) and website, www.bog.gov.gh; assessed 31 May 2007.

is that the spread between bank lending and bank deposit rates does not
appear to have fallen to reflect the improving macroeconomic environment.

4.1 Estimation
In our model, we allowed the error term to have bank-specific and timespecific effects. Estimation was by fixed-effects generalized least squares
panel regression on quarterly data for all the 17 banks that existed in 2001
(and through 2006). We specified fixed-effects (individual bank dummies)
because these 17 banks were not sampled randomly. Thus, a random effect
specification cannot be justified. Any inferences made will be in respect of
these 17 banks and may not necessarily apply to any new banks that enter the
system. On the other hand, to reduce loss of degrees of freedom, we dropped
time dummy variables and introduced a time trend to capture the impact of
technological changes as well as effects of omitted trending variables.
Quarterly data for this estimation were extracted from quarterly bank
balance sheets and income statements submitted to the Banking Supervision

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391

Department of the central bank of Ghana. The data spanned the first quarter
of 2001 through the fourth quarter of 2006. Data cleaning was performed in
Microsoft Excel.
Estimation was done on a desktop computer running RATS Version 6. Tests
on residuals suggested existence of first order serial correlation and some
heteroskedasticity. Rather than transform the variables to remove these we
heeded the advice of Dagenais (1994), Mankiw (1995) and others who argue
that such transformation may introduce bias in coefficient estimates. This
concern arises from the possibility of measurement errors in the variables.
RATS allows for estimation of the variance-covariance matrix by a robust
estimator that takes into consideration heteroskedasticity and autocorrelation
without transforming the variables. Other basic tests for regression adequacy
were all satisfied.

5. Regression Results
The model was first estimated with bank specific dummies for each bank.
We found that no bank dummy was statistically significant. The test for
collapsing all dummies into a constant was rejected, however. We next
assigned one dummy variable to the 6 big banks, and another to the
11 small banks. Upon re-estimating we found that the coefficients of the
two dummies were again not significant. Estimates of the coefficients of
the explanatory variables in the two regressions were very similar. We report
results for the two-dummy case (one for the big banks, the other for the small
banks).

5.1 Regression Coefficients


We report the coefficient estimates in Table 4. In that table, the specification
for the column labelled (1) uses the Lerner index as an explanatory variable.
The specification for the column labelled (2) substitutes HHI based on total
assets (HHI_TA) for the Lerner index. Results obtained when we used total
deposits or total loans to calculate the HHI were very similar to those for
total assets and are not reported here. In the main, the results for (1) and
(2) are similar both in terms of magnitude of coefficients and marginal
significant levels, except for the fact that specification (1) does not find
MGMT significant whereas (2) does.
1. Bank specific variables
Bank size, represented by TA, does have a significant (p-value under 0.01)
positive impact on NIM in both equations. Its magnitude is small and similar
in magnitude in both equations.

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Table 4: Factors explaining net interest margin


Variablea

(1)

TA
STAFF/TA
CAPITAL/FA
ADMN/TA
RSK_AV
CRDT_RSK
MGMT
LI

0.004
(3.628)
0.253
(1.763)
0.005
(0.343)
0.905
(3.974)
0.030
(2.348)
0.004
(0.804)
0.002
(0.351)
0.009
(2.433)

HHI_TA
0.009
(2.514)
0.020
(2.099)
0.079
(2.827)
0.001
(3.711)
0.24
393

L_RSV
INFLATION
BoG RATE
TREND
Adjusted R2
D.F.
Significant at 0.10; significant
a Variables are defined as follows:

P
MC
C
TA
TA-squared
CRDT_RSK
STAFF
ADMN
CAPITAL
HH_TA
INFLATION
CREDIT
GDP
NIM
RSK_AV
MGMT
L_RSV
BoG RATE
TREND
LI

(2)
0.003
(3.288)
0.277
(1.996)
0.008
(0.519)
0.908
(4.054)
0.037
(2.753)
0.007
(1.204)
0.013
(2.823)
0.125
(2.397)
0.008
(2.521)
0.016
(1.729)
0.078
(2.749)
0.001
(3.246)
0.24
393

at 0.05; significant at 0.01.

Product price = total revenue/total assets


Marginal cost
Total cost
Total assets
Square of TA
Credit risk = provision for bad loans/Gross loans
Staff expenses
Administrative and other expenses
Expenses on capital = depreciation + occupancy expenses
Herfindahl-Hirschman Index using total assets
Changes in the consumer price index
Total credit extended by the banking industry
Gross domestic product
Net interest income = (Interest income Interest expenses) / TA
Equity/TA
Operational expenses/revenue
Liquidity reserves
Central bank lending rate
Time trend
Lerner Index


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The impact of STAFF is similar in both regressions. So is the impact of


ADMN. Both have positive impact on NIM. STAFF is significant at the
0.10 level, ADMN at the 0.01 level. CAPITAL is positive and smaller but
not significant at any reasonable level.
It is reasonable to expect that a bank with high staff and administrative
expenses will pass these on to consumers in the form of wide margins,
especially if the banking environment is not competitive. Occupancy and
depreciation expenses do not impact NIM significantly. Theory suggests that
benefits of putting in place modern technology will ultimately help banks
lower costs (which may be passed on to customers) and serve customers
better. Our results suggest that this is not yet being realized.
The indicator of a banks extent of risk aversion is positive and significant
(p-value less than 0.02 in all cases). It would appear that as banks deploy
higher equity, they charge their customers more so as to earn enough to
service the higher expected returns of shareholders. The coefficients are of
similar magnitude in both equations.
Our results also suggest that the ratio of provisions for bad and doubtful
debt as a ratio of total loans is not significant in explaining NIM. We meant
this variable to proxy the credit risk faced by banks. One would have thought
this variable would impact NIM positively and significantly as banks charge
wider spreads to make up for poor performing loan portfolios. Observers
of the Ghanaian banking scene suggest that our finding may reflect the fact
that the provisions being made by banks may understate the actual credit
risk that they face. Support for this may be gleaned from Bawumia et al.
(2005) who find that in their model, which involves lagged variables, it is
the second quarterly lag of the provisions for bad and doubtful debt that is
significant in explaining the spread.
Quality of bank management efficiency (MGMT). As defined, this variable
is hypothesized to have a negative impact on NIM. Our coefficient estimates
are also negative, but significant in Equation (2) of Table 4 only. Its impact
in Equation (2) is also larger.
2. Industry variables
The Lerner index, our measure of market power, has a small but significant
(p-value less than 0.015) positive impact on net interest margin. The
alternative measure of industry structure, the Herfindahl-Hirschman index,
HHI_TA, also has a positive but substantially bigger impact, with a p-value
of 0.017. It would thus appear that bank concentration has a bigger impact
on NIM than the market power of banks.
The impact of bank liquidity reserves (L_RSV) is small, negative (similar
magnitude in both equations) and significant at 0.01 level. At first blush
one would have thought that increases in this variable would have increased
margins as banks charge wider margins to make up for the opportunity

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394

A.Q.Q. Aboagye et al.

cost of cash on hand. However, a careful analysis of bank data shows that
the minimum primary required reserve ratio remained at 9 per cent for the
entire period of this study. On the other hand, the actual ratio of cash and
near cash items to total assets exceeded 9 per cent, but it has been falling
towards 9 per cent as treasury bill rates and central bank lending rates have
fallen.
To illustrate, the average actual primary reserve ratio of all banks in 2001
(January to September) was 12.31 per cent, whereas in 2006 (January to
September) the average was 9.63 per cent. Our point is that as treasury bill
rates have fallen (Table 3), banks have reduced the amount of cash and near
cash items that they hold. It would appear that falling interest rates has made
banks sit up to manage their cash better so as to possibly maintain a certain
level of revenue. Treasury bills have hitherto been an extremely popular
investment instrument with Ghanaian banks. Note that NIM, as used here,
includes interest income from investments in securities as well.
It is counter-intuitive, however, for banks to appear to be managing their
cash better as treasury bill rates fall. Falling treasury bill rates means that the
opportunity cost of idle cash has also been falling. However, the regression
results may be revealing bank behaviour in respect of liquidity management
as the economy improves. Banks seem to be holding less excess reserves
(for liquidity) than they used to, now being more confident in the economy.
Also, the falling borrowing rate from the central bank means if they have to
borrow from the central bank it will cost them less, and so they are willing
to take more chances than they used to.
3. Macroeconomic variables
Changes in the central bank lending rate have a strong negative impact on
NIM (p-value less than 0.01 and similar magnitude in both equations). That
is, as the central bank lending rate falls bank margins increase. Given that
the central bank lending rate has generally fallen (see Table 3), the evidence
disputes the position that a lower central bank lending rate will lower bank
margins. A careful analysis of the relationship between central bank lending
rates and bank base rates (in principle, rates available to the most credit
worthy borrowers) reveals that banks have not passed on the full amount of
decreases in the central bank lending rate to borrowers.
To illustrate, when the central bank lending rate was 15.5 per cent in 2005
(Q3 and Q4), the average base rate of all the banks was 22.114 per cent; when
the central bank lending rate dropped by one percentage point to 14.5 per
cent in 2006 (Q1, Q2 and Q3) the average base rate fell to 21.143 per cent,
less than one percentage point; when the central bank lending rate dropped
further to 12.5 per cent in Q4 of 2006 (a two percentage drop), the average
base rate only dropped to 19.358 per cent, a drop of less than two percentage
points.

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Table 5: Elasticity of NIM in response to a 1 per cent increase in


explanatory variables in the Lerner Index specification (1) and the
Herfindahl-Hirschman index specification (2)a
Variable

Impact on NIM
(1)

TA
ADMN/TA
RSK_AV
INFLATION
STAFF/TA
LI
HHI_TA
L_RSV
TREND
BoG RATE
a Elasticities

1.277
0.188
0.092
0.090
0.065
0.033
0.049
0.295
0.401

(2)
1.327
0.099
0.158
0.099
0.099
0.243
0.061
0.409
0.549

are computed only for explanatory variables with a p-value of at most 0.10.

The rate of inflation does have a positive impact on NIM in both equations
with roughly the same magnitude. Its impact is significant at 0.05 level in
Equation (1) and 0.10 in (2). Given that the rate of inflation has generally
fallen over the period covered by this study, our results are consistent with
NIM falling with improvements in the macroeconomic environment.
The impact of time is very small in both equations, negative and significant
(p-value less than 0.001). This suggests that with time, thanks to technology
and other trending effects, NIMs are falling, small though this is.

5.2 Elasticities
We assess the economic significance of the factors that explain NIM by
computing the elasticities of NIM at the sample mean of each explanatory
variable that is significant at no more than the 0.10 level, holding others
constant. Table 5 reports the elasticities of NIM for a 1 per cent change in
the variables in Equation (1) the specification involving the Lerner index
and Equation (2) the specification involving the Herfindahl-Hirschman
index.
From Table 5, the TA variable is the factor with the most impact on NIM
in both equations. A 1 per cent increase in TA leads to about 1.3 per cent
increase in NIM in each equation. (Note that TA is in natural logarithms
of millions of current cedis). Administrative and other expenses are next
in both equations but with an impact on NIM of about 0.2 per cent in
Equation (1) and 0.3 per cent in Equation (2) for every 1 per cent increase.
This is followed in Equation (1) by RSK_AV with an impact of 0.1 per cent

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396

A.Q.Q. Aboagye et al.

on NIM for a 1 per cent increase; and INFLATION also with an impact of
0.1 per cent. For Equation (2) it is HHI_TA that has the third biggest impact
of 0.2 per cent for every 1 per cent increase followed by RSK_AV also with
an impact of 0.2 per cent.
In Equation (1), STAFF has the fifth largest impact of 0.1 per cent, whereas
in Equation (2), STAFF and INFLATION are both in fifth place, also with
an impact of 0.1 per cent. LI is the least significant variable with positive
impact on NIM in Equation (1).
The variables whose increases reduce NIM are L_RSV, TREND
and BoG RATE in that order in both equations. That is, a
1 per cent increase in L_RSV results in a 0.1 per cent decrease in NIM
in both equations; a 1 per cent increase in TREND leads to a 0.3 per cent
decrease in NIM in Equation (1) and a 0.4 per cent decrease in NIM in
Equation (2). In both equations, BoG RATE has the most negative impact
on NIM. A 1 per cent increase in this variable reduces NIM by 0.4 per cent
in Equation (1) and 0.6 per cent in specification (2).

5.3 Discussion and Policy Implications


Our results suggest that decreases in the following variables will decrease
bank net interest margin: market power, bank concentration, bank total
assets, bank equity, inflation, and bank staff expenses, capital expenditure
and administrative expenses as a proportion of total assets. We note that
there is substantial difference in the magnitude of the impact of market
power and bank concentration, both of which are our measures of industry
structure. Increases in both increase net interest margins, but the magnitude
of the impact of bank concentration is several times the impact of bank
market power. This finding suggests that for studies on Ghanaian net interest
margins, bank concentration is more relevant.
The other side of our findings is that decreases in the following are likely
to increase net interest margin: bank liquidity, central bank lending rate,
passage of time, and, depending on the specification, bank management
efficiency.
While our results are not directly comparable to the results of Bawumia
et al. (2005) in all respects (theirs was a specification incorporating lagged
explanatory variables, while ours is a search for indication of short-run
response), we find that the two studies have identified common variables
that positively impact bank net interest margins. These are, current level of
staff costs, administrative and other costs in our case (total operating cost
in their case), bank risk aversion, the structure of the industry (they used
market share) and the current level of inflation.

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Public Policy Related Findings


Our results suggest that the size of banks in Ghana is important in studying
bank behaviour and interest rate spreads. That is, an increase in bank size is
likely to increase the net interest margin more than any other variable. This
observation, together with the findings that increases in market power and
bank concentration tend to increase net interest margins, suggests a policy
prescription. That is, if the objective of the managers of the economy is
to lower net interest margins, they should not encourage or allow banks to
get too big. One way of doing this is to allow more banks into the system.
Alternatively, bigger banks may not be allowed to acquire other banks.
Another factor that should be noted in a policy context is the level of bank
equity. Increasing the proportion of shareholders equity relative to total
assets is likely to increase net interest margins. This finding suggests that the
current Banking (Amendment) Law 2007, or its immediate predecessor, the
Banking Law 2004, both of which raised the minimum capital requirement
to 10 per cent of bank assets from the previous 6 per cent ( Banking Law
1989) will not help efforts to reduce bank margins.
Another policy matter is the central bank lending rate. The finding is that
increases in the central bank lending rate are likely to reduce net interest
margins. We argued in the text that this must be due to the fact that banks
did not pass on the full extent of decreases in central bank lending rates that
were experienced during the period of this study to consumers. Our policy
prescription is that the authorities should demand that banks pass on all
reductions in the central bank lending rate to consumers. Naturally, the same
prescription may apply when the central bank lending rate rises in a bid to
tighten credit; banks must pass on the increases to borrowers.
Finally, improved macroeconomic environment is consistent with a narrow
net interest margin. Thus, efforts at managing the economy even better should
be intensified.

References
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Explaining Interest Rate Spreads in Ghana

Appendix
Table A1: Net interest margin for the six biggest banks (Interest Income
Interest Expense)/Total Assets

2001

2002

2003

2004

2005

2006

Quarter

Bank 1

Bank 2

Bank 3

Bank 4

Bank 5

Bank 6

Q1
Q2
Q3
Q4
Q1
Q2
Q3
Q4
Q1
Q2
Q3
Q4
Q1
Q2
Q3
Q4
Q1
Q2
Q3
Q4
Q1
Q2
Q3
Q4

0.0286
0.0464
0.0469
0.0331
0.0261
0.0382
0.0269
0.0293
0.0289
0.0284
0.0332
0.0330
0.0350
0.0604
0.0276
0.0430
0.0259
0.0268
0.0265
0.0687
0.0304
0.0304
0.0282
0.0343

0.0205
0.0251
0.0570
0.0332
0.0303
0.0286
0.0247
0.0244
0.0217
0.0312
0.0275
0.0194
0.0192
0.0409
0.0205
0.0391
0.0232
0.0240
0.0252
0.0245
0.0241
0.0234
0.0238
0.0194

0.0442
0.0388
0.0803
0.0451
0.0319
0.0242
0.0314
0.0297
0.0331
0.0452
0.0295
0.0218
0.0285
0.0639
0.0279
0.0479
0.0259
0.0241
0.0251
0.0152
0.0248
0.0249
0.0233
0.0239

0.0335
0.0364
0.0625
0.0356
0.0238
0.0274
0.0272
0.0278
0.0281
0.0377
0.0348
0.0285
0.0300
0.0614
0.0298
0.0450
0.0211
0.0261
0.0273
0.0260
0.0265
0.0257
0.0256
0.0239

0.0195
0.0199
0.0422
0.0254
0.0140
0.0135
0.0152
0.0166
0.0174
0.0179
0.0202
0.0270
0.0159
0.0328
0.0197
0.0336
0.0195
0.0195
0.0183
0.0339
0.0189
0.0194
0.0230
0.0216

0.0259
0.0445
0.0416
0.0337
0.0318
0.0082
0.0220
0.0209
0.0216
0.0204
0.0224
0.0199
0.0187
0.0376
0.0230
0.0397
0.0171
0.0162
0.0169
0.0208
0.0159
0.0184
0.0212
0.0220


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C African Development Bank 2008