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

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).

Nepals 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 highrisk 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 Nepals 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 societys 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 banks 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 fluctuation in interest, these factors are affecting in rate of

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 its 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

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--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 Pakistans commercial banking sector in the post-transition period (20042009), 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.

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.

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 = + 1LOG (TAit) + 2 (NIIit/TAit) + 3ROAit + 4 (OHit/TAit) + 5 (NPLit/TLit) + 6CARit + 7I + 8gGDP + it

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 = + 1LOG (TAit) + 2 (NIIit/TAit) + 3ROAit + 4 (OHit/TAit) + 5 (NPLit/TLit) + 6CARit + 7I + 8gGDP + it

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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