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

1

It is often argued that the higher the IRS.CHAPTER I: INTRODUCTION 1. Since then no such direct or indirect restriction is 2 . the provision of interest rate spread of 5. the continuing high level of interest rate spread suggested that greater financial sector development (FD) had not brought efficiency in the financial system. The promulgation of Nepal Rastra Bank Act 2002 attempted to address development in the financial market. Nepal’s controlled interest rate regime was completely abolished on August 31. 2009). Resources are mobilized through savings. NRB attempted to maintain the interest rate spread of commercial banks at a desired level through using moral suasion only. Additionally. A high IRS acts as an impediment to the expansion of financial intermediation necessary for growth and development of an economy. 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rate determination as there has existed a high interest rate spread between deposit and lending rates. 1989.5% was withdrawn by the NRB in 2003. 2010). a high IRS could mean unusually low deposit rates discouraging savings and limiting resources available to finance bank credit (Mujeri & Younus. Therefore. known as the interest rate spread (IRS). Alternatively. Banks and financial institutions were now given full autonomy to determine their interest rates on deposits and lending. which. economic development hinges critically on patterns and levels of resource mobilization and allocation. To address this. Major indicator of bank efficiency is interest rate spread and the difference between lending and deposit interest rates. pave the way for the allocation of resources for consumption and investment (Afzal & Nawazish. in the spirit of interest rate deregulation. Efficient financial intermediation is an important factor in economic development process as it has implication for effective mobilization of investible resources. the objective of interest rate deregulation to lower the financial intermediation cost was not met.1 BACKGROUND OF STUDY In any country. Consequently. 2008). But. at the level of the macro-economy. banking sector efficiency plays significant role in an economy (Folawewo & Tennant. the higher would be the cost of credit to the borrowers for any given deposit rate. Although the NRB has given the autonomy to determine the interest rate.

cost will be lowered and funds will be allocated more efficiently. this may lead to an exercise of market power in order to earn higher margins. 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. 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. As banks operate more efficiently. and institutional inefficiencies that ultimately lead to high margins between commercial banks’ lending and borrowing rates. The impact of relatively higher banking spreads can be devastating for businesses with less financial flexibility. Moreover. which has major contribution on the financial system in Nepal.2 STATEMENT OF PROBLEM The banking system. 2010). especially small and medium enterprises. consequently reducing investments or promoting only short-term highrisk ventures. informational. makes the banking system more important. Finally. In such a system efficiency of banks is more important. there will be improvement in the society’s welfare. Higher margins might also reflect high intermediation costs and managerial inefficiencies. 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. hence earning higher spreads. and can ultimately retard economic growth (Afzal & Nawazish. As a result. sustained high spreads is a vital indicator of the poor performance of a financial system and inter alia the inadequacy of banking regulations. Banks’ interest margin or spread can play an important role to lower the social cost of 3 . since more and more lenders and borrowers will participate. To measure the desirable state of efficiency of Nepal’s banking system. These high spreads emanate from elevated and volatile lending rates and lead to a higher cost of capital for borrowers.implied as far as determination of interest rate is concerned. although NRB has shown intermittent concern regarding interest rates. if there is a concentration in banking activities among a few banks. Financial systems in most developing and underdeveloped countries are subject to structural.

Here impact of interest on core banking business has been focused. The interest rate spread. It is a long debate between borrowers and bankers that the margin is to high.financial intermediation and encourage lenders and borrowers contribution to the financial system (Eralp). is an offshoot of a competitive environment.3 FOCUS OF THE STUDY Most of the financial institutions in Nepal are profit motivated. Since interest rate is the main subject of study. so determination of interest rate is also important function of financial market. These organizations survive who can make profit in the long. This study also attempts to analyze the interest rate spread and its relationship with bank specific as well as macroeconomic variables. To what extent bank controlled variable affect the interest rate spread and margin of commercial bank? 2. thus it is important issue to notify the determinants of interest rate spread in Nepalese commercial banking system.4 OBJECTIVES OF THE STUDY We know that interest rate is important in financial market in collecting the funds and lending the loans. This study tries to fulfill following objective: 4 . Interest rate is believed as one of the most important factors for the development of financial institutions and financial system as a whole. How do key macroeconomic variables influence commercial bank’s spread in Nepal? 1. IRS as a measure of bank efficiency and determinant of intermediation cost and profitability of the banks. The interest rate is a key variable in the financial system. 1. Thus this study tries to solve following problems. 1. and this discourages borrowers to borrow from the banks. Similarly there are also arguments that high interest rate spread (IRS) is one of the major factors behind poor economic growth and development.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. The interest rate margin provides profit for a bank to continue to remain in the business. which is also related to the degree of efficiency of the financial sector.

Nepal is sufferings a high inflation rate and it is important factor in economy. 2. As topic is broad it’s not possible to all nature of impact of interest rate on banking business in limited time period. these factors are affecting in rate of default risk. Therefore this research study has following limitation. 3. It plays role in determination of interest rate. To access the relationship of interest rate spread with some bank specific. which is called interest rate.6 LIMITATIONS OF THE STUDY The subject matter is very large and it is dynamic in nature. Present study is important in the point of view national economy. It is a one key of business sector.1. The interest rate is difference in commercial banks. political crisis. computation of financial market etc. These various factors are responsible in determination of interest rate. Only few factors have taken to see impact on interest rate spread. To identify the trend of deposit rate.5 SIGNIFICANCE OF THE STUDY Development of banking system is a vital issue for the growth of the economy. 1. lending rate. business holder's depositors etc. Interest rate is the main factor of the commercial banks. It is also important in depositor and lenders. whose effects shows on financial system. The rate of interest is one clue for competition in financial market. 2. It is determining price of money. 4. 1. The reason fluctuation in interest. demand and supply. uncertainty. 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. The subject is important in national and international financial markets. 5 . To access the relationship of interest rate spread with inflation and GDP 1. It also important to measure on running positions of economy so many reason and objectives it is significant in study. parties. interest rate spread and risk free rate. To analyze the interest rate spread and net interest margin of commercial bank. They have own strategy to determine in rate. economic growth in business sector and public sector. person.

4. 5. The study concentrates data of five year from FY 2005/06 to 2009/10 6 .3. The data is fully based on data published by NRB. Only commercial bank has been taken as sample for the study.

the two-step approach due to Ho and Saunders (1981) is advanced by Ho and 7 . has a low economic impact. noninterest income. cost to gross income. 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. liquidity. 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. 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. public sector deficits. including operating costs. quality of management. volatility of interest rates. credit risk. except for liquidity. the paper show that the extent of government crowding out in the banking sector. reserve requirement. They conclude that high Mexican spreads are a function mainly of average operating costs and market power while noninterest income. discount rate. and inflation rate.CHAPTER II: LITERATURE REVIEWS There is an exhaustive body of literature on the determinants of banking spreads both in developed and developing economies. Afanasieff. level money supply. Using annual data covering 33 countries. The reported results reflect that. Here is some reviews of different article and paper investigated in similar topic by different investigator. market risk. They consider various explanatory factors to explain the behavior of banking spreads. Maudos and Solis (2009) have investigated the determinants of net interest income in the Mexican banking sector for the period 1993 to 2005. all other variables are significantly related to interest rate spreads. and population size are important determinants of interest rate spreads in SSA countries. using a dynamic panel data estimation technique for period of 1988 to 2005. Among others. Since Nepal is a developing economy. Their sample consists of 43 commercial banks with 289 annual observations of unbalanced panel data. level economic development. we will focus mainly on literature from similar countries. transaction size. GDP growth. despite having increased over the years. inflationary level. degree of risk aversion. implicit interest payments. They observe high interest margins approximately 5% for Mexico vis-à-vis international standards.

however. using an exhaustive set of macro. There is negative relationship between deposit market share and spread. the inflation rate. is not confirmed. The result shows that there is strong evidence that bank size explains interest rate spreads.Saunders (1981) to uncover the influence of bank characteristic variables: a) number of employees. The result shows that large banks charge higher interest spreads. Similarly. and h) bank leverage as well as macroeconomic influences as the main explanatory factors of the bank spread in the country. There is evidence of deposit market share and deposit market concentration. e) bank liquidity. operational efficiency. risk absorption capacity and GDP growth are found to be important determinants of banking spreads. as expected. 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). to higher solvency risk. An increase in bank leverage (lever) is associated with higher interest margins due. These results suggest that microeconomic do not seem to be a major determinant of interest spreads in Brazil. 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. The coefficient on bank net worth (netw) is negative. c) the ratio of interest bearing funds to total earning assets. The paper suggests that there is no evidence found to support the impact of interest rate volatility and financial development indicators on banking spreads. The ratio of service revenues to operational revenues (servr) is found to have a positive impact on the interest spread. The vector of macroeconomic variables contains the estimated volatility of the market interest rate. asset quality.and firm-level variables to analyze their impact on intermediary efficiency. establishing the presence of an interest-sensitive deposit market. The ratio of non-interest bearing deposits to total operational assets (nibd) affects positively the interest spread. g) the bank net worth. b) the ratio of non-interest bearing deposits to total operational assets. d) operating costs. liquidity. The expected negative sign for liquidity (liquid). probably. f) the ratio of service revenues to total operational revenues. 8 . The ratio of interest-bearing funds to earning assets (ibf) is negative in equation (5). and the output growth rate. Operating costs (opc) act to increase the bank interest margin.

CHAPTER III: RESEARCH METHODOLOGY 3. In other words.    All Banks should established before 2005 The sample data from 2005-06 to 2009/10 (five years). 3. data collection procedure and data processing techniques and tools. Data on balance sheets and income statements should be available. To analyze the interest rate and spread historical data is analysed. research methodology describes the methods and process applied in the entire aspect of the study. 3. all the Commercial Banks of Nepal are the population of the study. sample size and selection process. The research design followed for this study is both inferential and descriptive. The population for the study comprises 31 commercial banks.2 RESEARCH DESIGN A research design is the specification of methods and procedures for acquiring the information needed. Out of them 17 commercial banks are taken as sample on the base on given sampling criteria to draw the conclusion about population. 9 .1 INTRODUCTION Research methodology is a systematic way to solve the research problem. 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. 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.3 POPULATION AND SAMPLE Since the research topic is about interest rate.

Standard Deviation.4 SOURCES AND NATURE OF DATA This study mainly based on secondary data. journals. various thesis and various papers. magazines and websites. Coefficient of variation. 3. published bulletins and prospects of concerned organizations. Since the primary data collected are more subjective they are presented in tables and graphs and conclusions have been drawn.7 DATA ANALYSIS TOOLS The basic descriptive statistics like Mean.6 DATA PROCESSING AND PRESENTATION Data collected for the study are presented in various forms. 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. Coefficient of Correlation. various publications of Nepal Rastra Bank. So far as the computation is concerned. Co-efficient of multiple determinations and t-test will be used to analyze the data collected for this study.3. To show the relation between variables involved secondary data are used.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. it has been done with the help of scientific calculator and computer software Programme. 3. Most of the secondary data are presented in tabular form and some graphical presentation is also used. 3. Further financial tools like Ratio analysis will be used to analyze the proportion between several factors. The sources of secondary data have been collected from published annual reports. 10 .

Five bank specific variable and two macro-economic variable has been taken as independent variable: TA represent total assets. ROA represent return on assets. NIMit = α + β1LOG (TAit) + β2 (NIIit/TAit) + β3ROAit + β4 (OHit/TAit) + β5 (NPLit/TLit) + β6CARit + β7I + β8gGDP + εit Where. Further ues alternative definition of Spread for robustness and run a regression of same independent variable on Net Interest Margin. We use bank specific variable and macro-economic variable as an independent variable to run regression over interest rate spread and NIM. TC/TA represents Total cost over total assets.Econometric model The empirical test is concerned with the determinants of interest rate spread and interest rate margin of Nepalese commercial bank. NPL/TL represent non-performing loan over total loan. CAR represent capital adequacy ratio. 11 . 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. I represent inflation whereas gGDP is indicator of GDP growth rate. NIM is net interest margin for bank i at time t. OH/TA represents overhead cost over total assets. NII/TA represent non-interest income over total assets.

). NRB Research department (S.through in Nepal.H. M. Eralp. P. O. J. M. & Pandit. (2009). & Tennant. DETERMINANTS OF INTEREST RATE SPREADS IN SUB-SAHARAN AFRICAN COUNTRIES: A DYNAMIC PANEL ANALYSIS. R. Wolf. Financial Markets & Institutions.B. 01-10 .References Afzal. (2005). (n. K. D. A Hand Book for Social Science Research and Thesis Writing. CREBWorking Paper No. The Bangladesh Development Studies . & Nawazish.np 12 . A. L. & Pant.. K. & Bhandari D. Kathmandu: Asmita Books Publishers and Distributors. (2009). The Determinants of Interest Rate Spreads in Pakistan's Commercial Banking sector. & Younus. Kathmandu: Buddha Academy. NRB/WP/5) Maudos.. A.org. Maskay.nrb. An Analysis of Interest Rate Spread in the Banking Sector in Bangladesh. Folawewo.R. Mujeri. M. Determinants of Net Interest Margin and Spread in north Cyprus Bank Market: The Preliminary Findings.NRB Working Paper: Interest Rate Pass.d.(2008). The determinants of net interest income in the Mexican banking system: an integrated model Shrestha M. S. n. (2009). B. Website: www. N.K. & Solis.. (2010). (2008).

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