Capital Structure

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Banking Sector Interest Rate

Spread in Kenya

Njuguna S. Ndung’u and Rose W. Ngugi

Macroeconomic and Economic Modelling Division

Kenya Institute for Public Policy Research and Analysis

KIPPRA Discussion Paper No 5

March 2000

Interest rate spread in Kenya

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Published 2000

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Abstract

A key indicator of financial performance and efficiency is the spread

between lending and deposit rates. If this spread is large, it works as an

impediment to the expansion and development of financial intermediation.

This is because it discourages potential savers due to low returns on deposits

and thus limits financing for potential borrowers. This has the economywide

effect of reducing feasible investment opportunities and thus limiting

future growth potential. It has been observed that large spreads occur in

developing countries due to high operating costs, financial taxation or

repression, lack of a competitive financial/banking sector and

macroeconomic instability. That is, risks in the financial sector are high.

Financial reforms and liberalization should improve efficiency in the

intermediation process. This implies that the spread will decline over time

as liberalization is accomplished and the financial sector develops. But in

Kenya, financial liberalization seems to have led to a widening interest rate

spread. The main factors that appear to propel this are distortions in the

loans market, institutional impediments and the policy environment. This

paper presents empirical support for these views and argues that

disequilibrium in the loans market is a major factor in driving the spread

and has substantial feedback effects, which reflect persistence of the

disequilibrium. Institutional and policy factors impact on transaction costs

and compound the effects of risks and uncertainty in the market, thus

exacerbating the spread.

To narrow interest rate spread, it is important to maintain a stable

macroeconomic environment and thus reduce credit risks. There is also a

need to minimize implicit taxes like reserve and cash ratios, accompanied

by fiscal discipline to reduce the demand for financing budget deficit with

low-cost funds. Banks should perform more intermediation/screening