An analysis of interest rate spread in Nepalese commercial bank

A Research Project Proposal

Submitted to:

School Of Business

Pokhara University

In partial requirement for the degree of

Masters of Business Administration

By:

Uday Kumar Sharma

Roll no: 01/2009

21th June, 2011

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CHAPTER I: INTRODUCTION

1.1 BACKGROUND OF STUDY

In any country, economic development hinges critically on patterns and levels of

resource mobilization and allocation. Resources are mobilized through savings,

which, at the level of the macro-economy, pave the way for the allocation of resources

for consumption and investment (Afzal & Nawazish, 2010).

Efficient financial intermediation is an important factor in economic development

process as it has implication for effective mobilization of investible resources.

Consequently, banking sector efficiency plays significant role in an economy

(Folawewo & Tennant, 2008). Major indicator of bank efficiency is interest rate

spread and the difference between lending and deposit interest rates, known as the

interest rate spread (IRS). A high IRS acts as an impediment to the expansion of

financial intermediation necessary for growth and development of an economy. It is

often argued that the higher the IRS, the higher would be the cost of credit to the

borrowers for any given deposit rate. Alternatively, a high IRS could mean unusually

low deposit rates discouraging savings and limiting resources available to finance

bank credit (Mujeri & Younus, 2009).

Nepal’s controlled interest rate regime was completely abolished on August 31, 1989.

Banks and financial institutions were now given full autonomy to determine their

interest rates on deposits and lending. Although the NRB has given the autonomy to

determine the interest rate, the Bank has been forced to intermittently issue directives

in regard to anomalies in the interest rate determination as there has existed a high

interest rate spread between deposit and lending rates. Therefore, the objective of

interest rate deregulation to lower the financial intermediation cost was not met. The

promulgation of Nepal Rastra Bank Act 2002 attempted to address development in the

financial market. But, the continuing high level of interest rate spread suggested that

greater financial sector development (FD) had not brought efficiency in the financial

system. To address this, NRB attempted to maintain the interest rate spread of

commercial banks at a desired level through using moral suasion only. Additionally,

in the spirit of interest rate deregulation, the provision of interest rate spread of 5.5%

was withdrawn by the NRB in 2003. Since then no such direct or indirect restriction is

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implied as far as determination of interest rate is concerned, although NRB has shown

intermittent concern regarding interest rates.

Since there are no restrictions on lending and deposit rates so banks will invariably

extend credit at high rates for the sake of profit maximization and pay lower returns

on their deposits, hence earning higher spreads. Moreover, if there is a concentration

in banking activities among a few banks, this may lead to an exercise of market power

in order to earn higher margins. Higher margins might also reflect high intermediation

costs and managerial inefficiencies. This acts as a disincentive to both saving and

investment and implies that the banking system is inefficient in performing its role of

effective resource allocation.

Financial systems in most developing and underdeveloped countries are subject to

structural, informational, and institutional inefficiencies that ultimately lead to high

margins between commercial banks’ lending and borrowing rates. These high spreads

emanate from elevated and volatile lending rates and lead to a higher cost of capital

for borrowers, consequently reducing investments or promoting only short-term high-

risk ventures. The impact of relatively higher banking spreads can be devastating for

businesses with less financial flexibility, especially small and medium enterprises.

Finally, sustained high spreads is a vital indicator of the poor performance of a

financial system and inter alia the inadequacy of banking regulations, and can

ultimately retard economic growth (Afzal & Nawazish, 2010).

To measure the desirable state of efficiency of Nepal’s banking system, it is critical to

study spreads and net interest margins as they are often used as proxy variables for

measuring the intermediary efficiency of commercial banks

1.2 STATEMENT OF PROBLEM

The banking system, which has major contribution on the financial system in Nepal,

makes the banking system more important. In such a system efficiency of banks is

more important. As banks operate more efficiently, cost will be lowered and funds

will be allocated more efficiently, since more and more lenders and borrowers will

participate. As a result, there will be improvement in the society’s welfare. Banks’

interest margin or spread can play an important role to lower the social cost of

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financial intermediation and encourage lenders and borrowers contribution to the

financial system (Eralp). It is a long debate between borrowers and bankers that the

margin is to high, and this discourages borrowers to borrow from the banks. The

interest rate is a key variable in the financial system. The interest rate spread, which is

also related to the degree of efficiency of the financial sector, is an offshoot of a

competitive environment. Similarly there are also arguments that high interest rate

spread (IRS) is one of the major factors behind poor economic growth and

development. The interest rate margin provides profit for a bank to continue to remain

in the business. IRS as a measure of bank efficiency and determinant of

intermediation cost and profitability of the banks, thus it is important issue to notify

the determinants of interest rate spread in Nepalese commercial banking system. Thus

this study tries to solve following problems.

1. To what extent bank controlled variable affect the interest rate spread and

margin of commercial bank?

2. How do key macroeconomic variables influence commercial bank’s spread in Nepal?

1.3 FOCUS OF THE STUDY

Most of the financial institutions in Nepal are profit motivated. These organizations

survive who can make profit in the long- run. The profit for these organizations is the

interest spread between sources and uses of funds. The focus of this study is to

examine the influencing factors of interest rate spread and net interest margin in

Nepalese commercial banks taking 17 commercial banks as sample. Interest rate is

believed as one of the most important factors for the development of financial

institutions and financial system as a whole. This study also attempts to analyze the

interest rate spread and its relationship with bank specific as well as macroeconomic

variables. Since interest rate is the main subject of study. Here impact of interest on

core banking business has been focused.

1.4 OBJECTIVES OF THE STUDY

We know that interest rate is important in financial market in collecting the funds and

lending the loans, so determination of interest rate is also important function of

financial market. This study tries to fulfill following objective:

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1. To analyze the interest rate spread and net interest margin of commercial

bank.

2. To identify the trend of deposit rate, lending rate, interest rate spread and risk

free rate.

3. To access the relationship of interest rate spread with some bank specific.

4. To access the relationship of interest rate spread with inflation and GDP

1.5 SIGNIFICANCE OF THE STUDY

Development of banking system is a vital issue for the growth of the economy. The

economic development of any country depends up on the effective mobilization

of the accumulated and mobilization of funds collecting and lending strategy is

effected by interest rate. Interest rate is the main factor of the commercial banks. It is

also important in depositor and lenders. Present study is important in the point of view

national economy. It is determining price of money, which is called interest rate,

whose effects shows on financial system, economic growth in business sector and

public sector. Nepal is sufferings a high inflation rate and it is important factor

in economy. It plays role in determination of interest rate. The interest rate is

difference in commercial banks. They have own strategy to determine in rate. The

rate of interest is one clue for competition in financial market. The reason of

fluctuation in interest, these factors are affecting in rate default risk, political

crisis, uncertainty, demand and supply, computation of financial market etc.

These various factors are responsible in determination of interest rate.

The subject is important in national and international financial markets, person,

parties, business holder's depositors etc. It is a one key of business sector. It also

important to measure on running positions of economy so many reason and objectives

it is significant in study.

1.6 LIMITATIONS OF THE STUDY

The subject matter is very large and it is dynamic in nature. Therefore this research

study has following limitation.

1. As topic is broad it’s not possible to all nature of impact of interest rate on

banking business in limited time period.

2. Only few factors have taken to see impact on interest rate spread.

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3. The data is fully based on data published by NRB.

4. Only commercial bank has been taken as sample for the study.

5. The study concentrates data of five year from FY 2005/06 to 2009/10

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CHAPTER II: LITERATURE REVIEWS

There is an exhaustive body of literature on the determinants of banking spreads both in

developed and developing economies. Since Nepal is a developing economy, we will focus

mainly on literature from similar countries. Here is some reviews of different article and paper

investigated in similar topic by different investigator.

Maudos and Solis (2009) have investigated the determinants of net interest income in the

Mexican banking sector for the period 1993 to 2005. Their sample consists of 43 commercial

banks with 289 annual observations of unbalanced panel data. They observe high interest

margins approximately 5% for Mexico vis-à-vis international standards. They consider various

explanatory factors to explain the behavior of banking spreads, including operating costs,

volatility of interest rates, implicit interest payments, quality of management, noninterest

income, credit risk, degree of risk aversion, market risk, transaction size, liquidity, cost to gross

income, GDP growth, and inflation rate. The reported results reflect that, except for liquidity, all

other variables are significantly related to interest rate spreads. They conclude that high Mexican

spreads are a function mainly of average operating costs and market power while noninterest

income, despite having increased over the years, has a low economic impact.

Folawewo and tennant (2008) have investigated the determinants of spreads between banks’

deposit and lending rates in Sub-Saharan African (SSA) countries from market and

macroeconomic view points, using a dynamic panel data estimation technique for period of 1988

to 2005. Using annual data covering 33 countries, the results obtained from the paper suggest

that different market and macroeconomic policy variables play significant role in explaining

variations in IRS in the region. Among others, the paper show that the extent of government

crowding out in the banking sector, public sector deficits, discount rate, inflationary level, level

money supply, reserve requirement, level economic development, and population size are

important determinants of interest rate spreads in SSA countries.

Afanasieff, Lhacer and Nakane (2005) have investigated the determinants of Bank Interest

Spread in Brazil Using a panel data of 142 Brazilian banks for the February 1997-November

2000 period, the two-step approach due to Ho and Saunders (1981) is advanced by Ho and

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Saunders (1981) to uncover the influence of bank characteristic variables: a) number of

employees; b) the ratio of non-interest bearing deposits to total operational assets; c) the ratio of

interest bearing funds to total earning assets; d) operating costs; e) bank liquidity; f) the ratio of

service revenues to total operational revenues; g) the bank net worth; and h) bank leverage as

well as macroeconomic influences as the main explanatory factors of the bank spread in the

country. The vector of macroeconomic variables contains the estimated volatility of the market

interest rate, the inflation rate, and the output growth rate. The result shows that large banks

charge higher interest spreads. The ratio of non-interest bearing deposits to total operational

assets (nibd) affects positively the interest spread. The ratio of interest-bearing funds to earning

assets (ibf) is negative in equation (5). Operating costs (opc) act to increase the bank interest

margin. The expected negative sign for liquidity (liquid), however, is not confirmed. The ratio of

service revenues to operational revenues (servr) is found to have a positive impact on the interest

spread. The coefficient on bank net worth (netw) is negative, as expected. An increase in bank

leverage (lever) is associated with higher interest margins due, probably, to higher solvency risk.

These results suggest that microeconomic do not seem to be a major determinant of interest

spreads in Brazil.

Afzal and Mirza (2010) have analyzed the determinants of interest rate spreads and margins in

Pakistan’s commercial banking sector in the post-transition period (2004–2009), using an

exhaustive set of macro- and firm-level variables to analyze their impact on intermediary

efficiency. The result shows that there is strong evidence that bank size explains interest rate

spreads. Similarly, operational efficiency, asset quality, liquidity, risk absorption capacity and

GDP growth are found to be important determinants of banking spreads. There is negative

relationship between deposit market share and spread. Similarly the negative relationship

between spreads and loans per employee and the positive relationship with performing loans per

employee clearly indicates that employee efficiency would count if asset quality were

maintained. There is evidence of deposit market share and deposit market concentration,

establishing the presence of an interest-sensitive deposit market. The paper suggests that there is

no evidence found to support the impact of interest rate volatility and financial development

indicators on banking spreads.

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CHAPTER III: RESEARCH METHODOLOGY

3.1 INTRODUCTION

Research methodology is a systematic way to solve the research problem. In other words,

research methodology describes the methods and process applied in the entire aspect of the

study. Research methodology refers to the various sequential steps ( along with a rational

of each step) to be adopted by a researcher in studying a problem with certain objectives in

view. Thus the overall approach to the research is presented in this chapter.

This chapter consists of research design, sample size and selection process, data collection

procedure and data processing techniques and tools.

3.2 RESEARCH DESIGN

A research design is the specification of methods and procedures for acquiring the

information needed. It is the overall operational pattern of framework for the project that

stipulates what information is to be collected from which sources and by what procedures.

The research design followed for this study is both inferential and descriptive. To analyze the

interest rate and spread historical data is analysed.

3.3 POPULATION AND SAMPLE

Since the research topic is about interest rate, all the Commercial Banks of Nepal are the

population of the study. The population for the study comprises 31 commercial banks. Out of

them 17 commercial banks are taken as sample on the base on given sampling criteria to draw

the conclusion about population.

All Banks should established before 2005

The sample data from 2005-06 to 2009/10 (five years).

Data on balance sheets and income statements should be available.

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3.4 SOURCES AND NATURE OF DATA

This study mainly based on secondary data. To show the relation between variables involved

secondary data are used. The sources of secondary data have been collected from published

annual reports, published bulletins and prospects of concerned organizations, various

publications of Nepal Rastra Bank, various thesis and various papers, journals, magazines

and websites.

3.5 DATA COLLECTION PROCEDURE/ TECHNIQUE

Secondary data on annual reports of concerning organizations, interest rate structure of such

organizations and introductory profiles of the institutions are collected by visiting the

respective organizations and from their web sites. Some secondary data of sample

organizations and Nepal Rastra Bank s regulation upon them are collected from the NRB

websites as well as visiting NRB office when required.

3.6 DATA PROCESSING AND PRESENTATION

Data collected for the study are presented in various forms. Most of the secondary data are

presented in tabular form and some graphical presentation is also used. Since the primary

data collected are more subjective they are presented in tables and graphs and conclusions have

been drawn. So far as the computation is concerned; it has been done with the help of scientific

calculator and computer software Programme.

3.7 DATA ANALYSIS TOOLS

The basic descriptive statistics like Mean, Standard Deviation, Coefficient of variation,

Coefficient of Correlation, Co-efficient of multiple determinations and t-test will be used to

analyze the data collected for this study. Further financial tools like Ratio analysis will be used to

analyze the proportion between several factors.

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Econometric model

The empirical test is concerned with the determinants of interest rate spread and interest rate

margin of Nepalese commercial bank. We use bank specific variable and macro-economic

variable as an independent variable to run regression over interest rate spread and NIM. The

econometric model for regression is

IRSit = α + β1LOG (TAit) + β2 (NIIit/TAit) + β3ROAit + β4 (OHit/TAit) + β5 (NPLit/TLit) +

β6CARit + β7I + β8gGDP + εit

Where IRSit is interest rate spread for bank i at time t. Five bank specific variable and two

macro-economic variable has been taken as independent variable: TA represent total assets,

NII/TA represent non-interest income over total assets. ROA represent return on assets. OH/TA

represents overhead cost over total assets. TC/TA represents Total cost over total assets. NPL/TL

represent non-performing loan over total loan. CAR represent capital adequacy ratio. I represent

inflation whereas gGDP is indicator of GDP growth rate.

Further ues alternative definition of Spread for robustness and run a regression of same

independent variable on Net Interest Margin.

NIMit = α + β1LOG (TAit) + β2 (NIIit/TAit) + β3ROAit + β4 (OHit/TAit) + β5 (NPLit/TLit) +

β6CARit + β7I + β8gGDP + εit

Where, NIM is net interest margin for bank i at time t.

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References

Afzal, A., & Nawazish, M. (2010). The Determinants of Interest Rate Spreads in Pakistan's

Commercial Banking sector. CREBWorking Paper No. 01-10 .

Eralp, B. (n.d.). Determinants of Net Interest Margin and Spread in north Cyprus Bank Market:

The Preliminary Findings.

Folawewo, A. O., & Tennant, D. (2008). DETERMINANTS OF INTEREST RATE SPREADS IN

SUB-SAHARAN AFRICAN COUNTRIES: A DYNAMIC PANEL ANALYSIS.

Mujeri, M. K., & Younus, S. (2009). An Analysis of Interest Rate Spread in the Banking Sector

in Bangladesh. The Bangladesh Development Studies .

Maskay, N. M. & Pandit, R. (2009).NRB Working Paper: Interest Rate Pass- through in Nepal,

NRB Research department (S. n. NRB/WP/5)

Maudos, J. & Solis, L. (2009). The determinants of net interest income in the Mexican banking

system: an integrated model

Shrestha M.K. & Bhandari D.B.(2008). Financial Markets & Institutions. Kathmandu: Asmita

Books Publishers and Distributors.

Wolf, K.H. & Pant, P.R. (2005). A Hand Book for Social Science Research and Thesis

Writing. Kathmandu: Buddha Academy.

Website: www.nrb.org.np

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