An empirical analysis of

interest rate spread in Kenya

By

Rose W. Ngugi
University of Nairobi

AERC Research Paper 106

African Economic Research Consortium, Nairobi
May 2001
AN EMPIRICAL ANALYSIS OF INTEREST RATE SPREAD IN KENYA 1

1. Introduction

F inancial intermediaries arise because of information asymmetry and transaction costs

between agents. The intermediaries serve to ameliorate the problems created by
information and transaction frictions. They facilitate mobilization of savings,
diversification and pooling of risks, and allocation of resources. However, since the
receipts for deposits and loans are not synchronized, intermediaries like banks incur
certain costs. They charge a price for the intermediation services offered under uncertainty,
and set the interest rate levels for deposits and loans. The difference between the gross
costs of borrowing and the net return on lending defines the intermediary costs.1 The
wedge between the lending and deposit rates also proxies efficiency of the intermediation
process. For example, under perfect competition the wedge is narrower, composed only
of the transaction cost, while in an imperfect market, the wedge is wider, reflecting
inefficiency in market operation.
Inefficiency in the intermediation process is a characteristic of a repressed financial
system. This is because in a control policy regime selective credit policies involve
substantial administrative costs, and interest rates with set ceilings fail to reflect the true
cost of capital. Such a policy regime constrains the growth of the financial system in
terms of diversity of institutions and financial assets and encourages non-price
competition. The market fails to develop direct debt and equity to complement the banking
institutions. Consequently, the asset portfolio is not diversified to reduce investment
risk. If diversification of risks is optimal, idiosyncratic risk disappears and investors pay
only a premium to cover the systematic risk. Risk reduction acts as a catalyst in promoting
the intermediation process as savings and investment become attractive.
Inefficiency also stems from information asymmetry that is enhanced by a weak legal
framework, which creates a disincentive for banks to invest in information capital. A
weak legal system constrains the enforcement of financial contracts, exposing banks to
legal and credit risk. This arises because of the inability to make agreements that restrict
the ability of borrowers to divert funds away from the intended purpose, the lack of
disclosure of accurate information on borrowers and the inability to write easily
enforceable legal contracts. A weak legal system (without clearly spelled out property
rights) also restricts diversification of institutions and therefore denies institutions a chance
to diversify the asset portfolio. As a result, the premium charged on credit is high, keeping
lending rates high while widening the interest rate spread.
Kenya’s experience with the financial reform process shows a widening interest rate
spread following interest rate liberalization. This period is characterized by high implicit
costs with tight monetary policy achieved through increased reserve and cash ratios. In
2 RESEARCH PAPER 106

addition, financial institutions witnessed declining profitability, non-performing loans

and distress borrowing. The treasury bill rate increased as the government relied heavily
on the domestic market to finance its fiscal deficit, while the expansionary fiscal policy
resulted in increased inflation and tightening of monetary policy. The market was still
dominated by commercial banks, especially with the conversion of non-bank financial
institutions (NBFIs) and the sluggish development of the capital market. Finally, the
period was characterized by macroeconomic and financial instability and yet-to-be
accomplished legal reforms. The question is, which of these factors contributed
significantly to the widening spread? Does this represent inefficiency or increased costs
of the intermediation process? This study aims to assess factors responsible for the
widening spread.
The rest of the paper is organized as follows. In Section 2 we trace the trends in the
interest rate spread for the period before and after liberalization. Section 3 reviews the
literature, emphasizing factors determining the interest rate spread. Section 4 covers the
methodology, and Section 5 discusses the data and provides summary statistics. Empirical
results are provided in Section 6, and the conclusion in Section 7.
AN EMPIRICAL ANALYSIS OF INTEREST RATE SPREAD IN KENYA 3

2. Financial sector development

I n this section we capture the interest rate spread in four phases that are defined by
changes in financial sector policies. Phase I covers the period before 1974, when
interest rates remained unchanged. Phase II (1974–1979) is the period when interest rate
ceilings are revised upward for the first time. In Phase III (1980–1990), interest rates
assume an important role as a monetary policy instrument, while in Phase IV (1991–
1999) financial reform is mounted and interest rates are liberalized. Table 1 reports on
the observed trends and attempts to relate the spread to developments in the financial
market and the economy in general. The period before interest rate liberalization is
characterized by financial repression with selective credit controls and fixed interest rate
spreads. Variations in the interest rate spread were realized when interest rate ceilings
were adjusted to protect any loss in real terms following increased inflation rates. The
Central Bank of Kenya (CBK) controlled inflation by increasing the liquidity and cash
ratios with no interest paid on reserves. Such statutory requirements act as implicit costs
to the banks. With a successful financial reform the interest rate spread narrows to reflect
gained efficiency in the intermediation process and reduced costs of transactions with
improved market competitiveness. The widening spread in the Kenya market in the post-
liberalization period indicates a combination of market inefficiency and increased costs
of intermediation. The spread represents the failure to meet prerequisites for successful
financial liberalization including lack of fiscal discipline, financial instability and
macroeconomic instability. It also shows poor sequencing in the shift to monetary policy
tools where reserve requirements continued to take priority in curbing inflationary
pressure. Furthermore, the financial market remained uncompetitive and the legal
framework was still weak.

Phase I (before 1974)

T he CBK pursued a low interest rate policy aimed at encouraging investment with
low-cost capital. This was achieved by fixing minimum saving rates for all deposit
taking institutions and maximum lending rates for commercial banks, NBFIs and building
societies. Before 1974, interest rates remained unchanged for fear that any changes would
create uncertainty and adversely affect investment, but also because the impressive
economic performance sustained positive real interest rates. Consequently, the maximum
interest rate spread remained constant. Following the balance of payments crisis in 1971–
1972, however, increased inflationary pressure induced a negative real saving rate, and a
 4
Table 1: Trends in interest rates, monetary aggregates and macroeconomic variables

Period Saving Lend Spread Real Real Tbill NBFIdep Cbass NBFIas GDP Exrate Inflation Minliq Avliq M2 M2/M0 M2/GDP
rate rate saving lend /CBsdep GDP /GDP grow grow
rate rate

1970 3 9 6 6.7 7.14 5.0 30

1971 3 9 6 -0.8 4.8 1.42 13.6 22.8 5.0 6.3 7.14 3.8 12 18 7.5 5.1 29
1972 3 9 6 -3.3 2.4 3.49 16.7 23.1 5.5 6.8 7.14 6.4 15 22 13.9 4.8 30
1973 3 9 6 -6.3 -0.5 2.12 15.0 25.5 6.0 4.0 6.9 9.5 15 25 24.7 5.5 32

Average 3 9 6 -3.47 2.23 2.34 15.1 23.8 5.5 5.95 7.06 6.57 14 21.67 15.4 5.1 30.25

1974 5 10 5 -11.7 -6.6 5.59 16.5 24.1 5.6 3.1 7.14 17.3 15 21 8.7 5.4 29
1975 5 10 5 -13.8 -8.6 5.70 21.5 22.8 6.9 3.1 8.25 19.5 15 19 17.1 5.5 29
1976 5 10 5 -5.9 -1.1 6.23 20.0 24.1 6.7 4.2 8.31 11.2 18 25 24.1 5.2 29
1977 5 10 5 -9.1 -4.2 1.41 20.1 27.4 7.5 8.2 7.95 14.6 18 28 46.8 5.7 33
1978 5 10 5 -11.6 -6.6 6.67 23.3 28.5 9.2 7.9 7.40 17.2 18 23 13.7 6.1 34
1979 5 10 5 -2.8 1.9 4.45 27.2 30.2 10.9 4.2 7.33 7.9 16 23 16.1 6.1 36

Average 5 10 5 -9.15 -5.73 5.01 21.43 26.18 7.8 5.12 7.73 14.62 16.67 23.17 21.1 5.67 31.67

1980 6 11 5 -7.5 -2.6 5.57 34.7 28.1 12.1 3.9 7.57 13.9 16 18 -1.2 5.4 31
1981 10 14 4 -1.5 2.1 9.99 36.3 27.6 12.9 5.3 10.29 11.6 15 20 13.3 5.2 30
1982 12.5 16 3.5 -7.1 -3.9 13.35 39.0 27.4 14.6 4.8 12.73 20.5 15 26 16.1 5.7 30
1983 12.5 15 2.5 1.0 3.1 15.00 45.5 25.4 21.8 2.3 13.77 11.4 20 20 4.9 5.5 28
1984 11 14 3 0.7 3.3 12.43 54.8 25.8 22.3 0.8 15.78 10.2 20 24 12.9 5.8 28
1985 11 14 3 -1.9 0.8 14.14 57.1 25.2 21.9 4.8 16.28 13.1 20 22 6.7 5.4 27
1986 11 14 3 5.7 8.2 12.15 52.1 28.1 19.0 5.5 16.04 4.7 20 31 32.5 5.6 30
1987 11 14 3 3.0 5.5 13.00 52.6 28.9 13.6 4.8 16.52 7.7 20 31 14.2 5.3 31
1988 10 15 5 -1.1 3.3 13.52 55.7 26.6 13.9 5.1 18.60 11.2 20 24 8.3 5.2 29
1989 12.5 18 5.5 -0.4 4.3 14.00 58.6 27.1 14.5 5.0 21.60 12.9 20 24 20.8 5.5 31
1990 13.5 19 5.5 -1.9 2.9 15.93 66.0 28.7 16.1 4.3 24.08 15.6 20 30 15.5 5.7 31

Average 11 14.91 3.91 -1.0 2.45 12.64 50.22 27.17 16.61 4.2 15.75 12.07 18.73 24.55 13.1 5.48 29.64
RESEARCH PAPER 106
Table 1 continued

Period Saving Lend Spread Real Real Tbill NBFIdep Cbass NBFIas GDP Exrate Inflation Minliq Avliq M2 M2/M0 M2/GDP
rate rate saving lend /CBsdep GDP /GDP grow grow
rate rate

1991 12.9 20 7.1 -6.0 0.3 16.77 59.1 30.3 16.5 2.2 28.07 19.7 20 22 20.9 5.8 34
1992 12.8 22.3 9.5 -12.7 -3.9 16.96 51.1 36.5 16.7 0.5 35.22 27.1 20 31 33.6 5,8 39
1993 11.3 38.6 27.3 -31.2 -5.4 39.34 42.4 36.0 16.3 0.2 68.16 46.0 20 50 25.7 5.9 37
1994 8.6 30.9 22.3 -18.6 1.6 17.90 37.5 40.6 15.0 3.0 44.84 28.8 25 53 30.4 6.6 41
1995 6.9 33.5 26.6 5.0 23.9 20.90 25.6 45.0 10.2 4.8 55.94 1.6 25 41 18.4 6.7 41
1996 8.0 36.5 29.6 -1.0 20.2 21.60 16.7 50.4 7.5 4.6 55.02 9.0 25 42 23.8 7.8 45
1997 9.7 33.7 24 -1.3 16.9 26.40 8.2 52.0 5.1 2.4 63.05 11.2 20 37 16.6 7.7 46
1998 7.9 28.6 20.7 1.2 17.1 11.10 8.7 47.3 4.3 1.8 61.82 6.6 20 38 2.4 7.4 40
1999 10.9 27.1 16.2 6.7 18.6 20.5 7.2 - - 1.4 73.94 3.5 20 40 3.9 6.9 -

Average 9.89 30.13 20.37 -6.7 9.93 17.41 23.32 37.57 9.16 1.9 54.01 13.95 21.67 39.33 19.5 6.73 32.3
AN EMPIRICAL ANALYSIS OF INTEREST RATE SPREAD IN KENYA

Note: This table captures nominal and real minimum saving and maximum lending rates. Real interest rates are calculated as r = (i-π)/(1+π). Interest rate spread is
defined as the difference between the nominal lending and saving rates measuring the maximum spread. Financial market structure is captured using the financial
deepening proxied by the M2/GDP ratio; the ratio of NBFI’s and commercial bank assets to GDP (NBFIas/GDP; and Cbsass/GDP); and the ratio of NBFI deposits to
commercial bank deposits (NBFIdep/CBsdep). Policy actions are proxied by the minimum reserve requirement (Minliq), M2 growth, money multiplier (M2/M0) and the
treasury bill rate (Tbill).

Source: Central Bank, Statistical Bulletin, (various issues).

5
6 RESEARCH PAPER 106

control policy regime was adopted. To curb inflationary pressure, a cash ratio was imposed
on commercial banks at 5% and credit controls were tightened, especially on imports of
consumer durable goods. The cash ratio was rescinded in 1972 and in its place the liquidity
ratio introduced in 1969 at 12.5% was raised to 15%. The liquidity ratio, which intended
to allow banks a hedge against liquidity risk, was extended to cover the NBFIs in 1974.
These actions pulled in conflicting directions. A controlling policy regime distorts
the operation of the market and increases inefficiency.Statutory requirements increase
the implicit costs, especially if no interest is paid on the reserves. Kenyaís financial
market was not competitive, with a few commercial banks dominating the sector, while
the stock market remained almost dormant as an alternative source of long-term finance.
Thus, the spread reflected inefficiency in the financial market, with the high transaction
costs attributable to control on credit and interest rates.

Phase II (1974–1979)

T he first review of interest rates in the post-independence period was made in June
1974. At that time the rise in inflation following the first oil crisis made both lending
and saving rates negative in real terms. The maximum lending rate was increased by 1%,
while the savings rate went up by 2% and the spread was reduced by 1%. Following the
coffee boom in 1976/77, inflation came down but with the expansionary fiscal policy,
money supply went up, the liquidity ratio was increased and in 1978 the cash ratio was
reintroduced. Interest rates offered by government securities were low in order to cause
a shift toward quality assets, while the credit guidelines made asset portfolio reallocations
inflexible. The effects of these changes were felt in 1979; inflation came down and lending
rates became positive in real terms, as money supply was brought under control. However,
deposit rates were set at a low level and remained negative in real terms.
The structure of the market changed following the coffee boom as Kenyans started
investing in the financial sector and setting up NBFIs. This was made possible by a
regulatory framework with lenient entry requirements. For example, the minimum capital
requirement for NBFIs was relatively low compared with commercial banks and they
were not subjected to the cash ratio. They were allowed to charge higher lending rates
and they earned a higher margin compared with commercial banks. For example, for the
period before 1974, NBFIs enjoyed a spread of 9%, which was 3 percentage points
above the commercial bank margin; in the second phase they had an average of 7%,
which was 2 percentage points above the commercial bank margin. Commercial banks
set up NBFIs to circumvent the stringent controls and NBFIs mushroomed in a sector
previously dominated by commercial banks. NBFI deposits grew rapidly as a ratio to
commercial bank deposits, increasing from an average of 15% in Phase I to an average
of over 20% in Phase II. Financial deepening gained very marginally, however.
AN EMPIRICAL ANALYSIS OF INTEREST RATE SPREAD IN KENYA 7

Phase III (1980–1990)

D uring this period interest rates were reviewed several times in an effort to allow
commercial banks more room to compete and greater flexibility to meet the needs
of customers, thus narrowing the difference in interest rates between NBFIs and
commercial banks. The reviews also aimed to make interest rates responsive to changes
in the international markets so as to provide protection against adverse movements of
funds internationally. In addition, because interest rates have an important role as an
instrument of monetary policy, adjustments were made to contain inflationary pressure.
For example, the minimum saving rate was increased by 1% in 1980 to a record 6%. In
1981, the saving rate increased to 10% and in 1982 to 12.5%; interest on deposits then
became positive in real terms. The rate was reduced to 11% in 1984 following the decline
in inflationary pressure. The maximum lending rate was raised to 16% in 1982 and then
dropped to 14% in 1984. As a result, the spread narrowed from 5% to 3% in 1980 and
1984, respectively. Further reviews were made in the late 1980s following the increased
inflationary pressure resulting from increased money supply. The savings rate increased
to 12.5% and 13.5% in 1989 and 1990, but with high inflation it remained negative in
real terms. The maximum lending rate was raised to 18% and 19% and the spread widened
to 5.5%. By 1990, the CBK had achieved its objective of harmonizing NBFI and
commercial bank interest rates, as both institutions faced the same level of lending rate
ceiling and maximum interest rate spread.
Following the high inflationary pressure in the early 1980s, the minimum reserve
requirement was increased in 1983, and in 1986 the cash ratio was reintroduced, at the
rate of 6%, and the liquidity ratio was raised to 20%. Inflationary pressure was mainly
attributed to an expansionary fiscal policy and the second oil crisis experienced at the
end of the 1970s. When a tight fiscal policy was adopted in 1983 and 1984, inflation
came down. However, this was not sustained as expansionary fiscal policy was again
experienced in the mid 1980s, making achievement of monetary policy effectiveness
difficult.
There was tremendous growth in the number of NBFIs, from 23 in 1981 to 48 in 1985
and 54 in 1988. At the same time commercial banks increased from 16 in 1981 to 24 in
1988. Commercial banks owned 12 of the largest NBFIs by 1985. Competition intensified
between the NBFIs and commercial banks in both the deposit and the credit markets.
The deposits for NBFIs as a ratio to commercial bank deposits increased to an average of
50%, from 34.7% in 1980 to 66% in 1990. Because of low entry capital requirements
and inadequate supervision, however, most NBFIs were under-capitalized and poorly
managed. They mismatched asset and liability maturities, invested in riskier assets, and
squeezed their margins by offering higher rates than commercial banks. Ultimately, they
faced a credit squeeze, with systemic problems of illiquidity and insolvency affecting a
large part of the NBFI sector. For the period 1984–1989, two commercial banks and nine
NBFIs were in problems.
In response to the financial crisis, the Banking Act was reviewed and approved in
1989 with the aim of enhancing the regulatory and supervisory functions of the CBK.
8 RESEARCH PAPER 106

NBFIs were subjected to stringent licensing and operating regulations, where for example
the minimum capital requirement was raised as indicated in Table 2.
A deposit protection fund (DPF) was established to enhance the stability of the banking
industry by protecting the interests of depositors, especially small depositors who may
not have the capacity to evaluate the financial conditions of the banks. The DPF serves
as a mechanism for liquidating the assets and paying off the liabilities of failed banks
and financial institutions. All deposit taking banks and financial institutions licensed to
carry on banking services in Kenya are required to contribute to the fund. Each member
pays an annual contribution fee equal to 0.15% of the previous year’s average deposits,
or Ksh300,000, whichever is higher. The maximum deposit loss covered by the fund is
Ksh100,000, consisting of the aggregate credit balance of any accounts maintained by a
customer less any liabilities of the customer to the bank or financial institutions.

Table 2: Minimum capital requirements for financial institutions (Ksh millions)

Institution 1980 1982 1985 1994 1997

Bank incorporated in Kenya 5 10 15 75 200

Bank incorporated outside 50 100 150 200 200
NBFI incorporated in Kenya 1 1 7.5 37.5 150
NBFI incorporated outside 5 5 7.5 150 150
Mortgage incorporated in Kenya 1 1 7.5 37.5 200
Mortgage incorporated outside 5 5 7.5 150 500

Source: Kimura (1998).

Phase IV (1991–1999)

I nterest rates were liberalized in July 1991. Although financial theory predicts an increase
in interest rates in a post-liberalization period, in Kenya the minimum saving rate
declined from 13.5% in 1990 to 6.9% in 1995, while the maximum lending rate increased
to a peak of 38.6% in 1993. As a result, the spread assumed a rising trend. Interest rate
liberalization was mounted amidst increasing inflationary pressure and deteriorating
economic conditions, indicating a failure to meet the prerequisite for successful financial
reform.2 Inflationary pressure was attributed to the expansionary fiscal policy, which
saw an increase in money supply. In addition, the financing of the fiscal deficit shifted to
the domestic market using treasury bills and this accelerated the increase in interest
rates. As a result, the lending rate went up while the low savings rate became negative in
real terms in the first half of the 1990s.
The savings rate increased during the second half of the 1990s but never reached the
rates recorded early in the decade. Lending rates declined, but settled at higher levels
compared with the period immediately after liberalization. The interest rate spread peaked
in 1996.3
AN EMPIRICAL ANALYSIS OF INTEREST RATE SPREAD IN KENYA 9

Monetary policy

D uring the period, the sector witnessed a shift to indirect monetary policy tools, marked
by the first auctioning of treasury bills in the primary market in 1991.4 The treasury
bill market was viewed as a mechanism for facilitating the shift to an indirect monetary
policy framework as it allowed the authority to influence the reserve money through the
OMO. To enhance its role, treasury bill auction techniques and procedures for tender
were revised in 1993. Acting as sales agent for the government, the central bank determined
the volumes to be sold in the primary auction, using budgetary needs and monetary
policy considerations as guides.
Following the increased money supply and peaking of inflation, the cash ratio was
reactivated and raised to 8% in April 1993.5 It was then increased to 10% in July 1993,
12% in October and 14% in December 1993. The ratio was further raised to 16% in
February 1994 and then 20% in March 1994, before declining to 18% in September
1994, 15% in October 1997 and 12% in December 1998. Interest of 5% was paid on the
reserves for a short period (December 1995 to May 1996) in order to create an incentive
for the banks to reduce their lending rate. The increased cash ratio was accompanied by
penalties for institutions failing to meet the set targets. At the same time, activities at the
discount window were discouraged by punitive rates as compared with the earlier practice
of allowing distressed banks access to the CBK overdraft facility and the discount window.
For example, from 1 June 1993, overnight lending by the CBK was restricted in terms of
eligibility of securities as collateral. The eligible securities were treasury bills, treasury
bonds and government bearer bonds. Treasury bills were discounted if halfway to maturity
and securities if they had at least two working days to maturity. By April 1994, commercial
banks could borrow for a maximum of only four days and could not exceed ten days in
any one month. Bank lending in the inter-bank market did not qualify for borrowing
from the CBK on the same day. A penalty of 0.2% per day was introduced for banks that
failed to comply, and banks that failed to meet the cash ratio for over 30 days were
placed under the statutory requirement.
Although the tight monetary policy seemed to reduce the money supply, its
effectiveness remained elusive especially in the presence of expansionary fiscal policy.
Tight monetary policy, with a credible money market, is expected to yield growth in
financial assets and liabilities. However, the experience was an increasing money
multiplier measured as the ratio of M2/M0, which implies a temporary loss of monetary
control and loss of public confidence. In addition, only marginal gains were realized
with financial deepening, with the increasing M2/GDP to some extent showing a shift in
assets and liabilities from the NBFIs to commercial banks as it coincided with the time
when NBFIs were converting to commercial banks.
Monetary policy faced a challenge following the reversal of capital flows after the
liberalization of the exchange rate in October 1993, where the CBK faced a loss of
foreign exchange reserves. A strong linkage between the money and foreign exchange
markets was portrayed, as developments in the treasury bill market were associated with
the high interest rate differential that attracted capital inflows. The inflow of capital
10 RESEARCH PAPER 106

fueled inflationary pressure that did not come down till mid 1994. In the face of capital
inflows and appreciation of the exchange rate, the CBK intervened to limit the appreciation
and sterilize the domestic liquidity through the massive sale of treasury bills. These
actions were not enough to bring down liquidity injection from the capital inflows,
however, as parts of the monetary expansions were attributable to fiscal expansion. Thus,
there was need at the same time to achieve fiscal discipline. Another intervention was
made in April 1995 to contain further depreciation and loss of international reserves.
This was achieved by tightening fiscal policy and extending the reserve requirements to
NBFIs. In 1996, the CBK increased the sale of treasury bills to sterilize liquidity injected
into the economy due to the large purchase of foreign exchange by the central bank from
the inter-bank market and to minimize the impact of increased government borrowing
from the central bank. This saw a rise in the treasury bill rate, which pulled up the lending
rate. High treasury bill rates were accompanied by excess holding of liquidity by the
commercial banks, an indication of a shift in quality assets. A decline in treasury bill
rates was desirable to pull down the lending rates. However, even when the treasury bill
rate came down, the reduction of lending rates was sluggish and when they did decline
they settled at a high level.
By 1996, the restrictions on the use of the discount window were relaxed and new
facilities introduced to stabilize commercial bank liquidity. The repurchase order (REPO)
was introduced in September 1996, to be used in the money market by the CBK to alter
reserve levels, thus improving the bank’s efficiency in the day-to-day management of
banking system liquidity. The REPO6 increased the liquidity of existing short-term
instruments, especially government securities used in the market, and hence their
marketability. At the same time, borrowing from the central bank was relaxed and treasury
bills were accepted as collateral for either borrowing or discounting regardless of their
time to maturity and even when commercial banks participated in the inter-bank market.7
By January 1996, the central bank stopped displaying the OMO interest rate on the Reuter
in order to allow participants in the inter-bank market to set their interest rates
competitively without reference to OMO. Thus, the CBK negotiates OMO rates with
individual investors depending on the supply and demand for liquidity in the money
market.

Regulatory framework

T he review of the Banking Act aimed to harmonize the regulatory framework across
institutions. Together with the removal of interest rate regulatory differences, the
minimum capital requirements were equalized. There was a change in the licensing
procedures of the banks and financial institutions, where institutions were expected to
apply to the Ministry of Finance through the CBK. In addition, NBFIs were to convert to
commercial banks following the adopted universal banking policy; several NBFIs did so
by the mid 1990s as indicated in Table 3. This saw a decline in size of the NBFI subsector
and commercial banks again dominated the sector.
AN EMPIRICAL ANALYSIS OF INTEREST RATE SPREAD IN KENYA 11

Table 3: Conversion of NBFIs to commercial banks

1994 1995 1996

Action Approved Commence Approved Commence Approved Commence

Converted and 5 0 11 9 4 11
commenced
operation as bank

Approved; yet to 1 2 2
commence
operation as bank

Merged institutions 3 1 1 6 5 2

Converted to 1 1
mortgage finance

Source: Central Bank of Kenya.

Prudential regulations were tightened in order to strengthen CBK’s supervisory role.

For example, in 1995 prudential guidelines were prepared to encourage self-regulation,
including the code of conduct of directors, chief executives and other employees, duties
and responsibilities of directors, chief executives and management, appointment duties
and responsibilities of external auditors, and provisions for bad and doubtful advances
and loans. The minimum cash balance requirement was extended to NBFIs.
The amendments of 1996 saw the monetary authority gain more independence in
formulating and implementing monetary policy. For example, the following conditions
were set for lending to the government and commercial banks:

• Terms of loans to banks limited to six months.

• All loans secured by treasury bills or other government instruments specified by the
CBK.
• Advances to the government secured with negotiable government securities that
mature within 12 months and at market rate.
• Maximum outstanding advance to the government at any time limited to 5% of the
gross current revenue of the government in appropriate account pertaining to the
latest audit.

Composition of the banking sector

A s a financial sector develops, institutional diversity is expected together with diversity

of services offered. Moreover, financial reform is expected to promote
competitiveness in the banking sector. Although Kenya’s financial sector is described as
significantly diversified in terms of the number of institutions,8 banking sector services
continued to dominate the sector. In addition, a few banks continued to dominate the
banking sector; four major commercial banks shared over 60% of the total credit.
12 RESEARCH PAPER 106

Performance of the financial sector and banking institutions

M aintaining financial stability is crucial to the achievement of positive results from

the liberalization process. In Kenya, the sector faced two major banking crises, in
the mid 1980s and during the early and late 1990s. Between 1993 and 1996, 6 commercial
banks and 12 NBFIs faced insolvency problems. In 1998, five banks were placed under
statutory management. The main factors in the financial sector crisis include: under-
capitalization, non-performing loans, over investment in speculative property market,
which saw a decline in prices, insider lending to directors, loans to non-viable projects
under the influence of officials, difficulties in recovering non-performing loans through
the judiciary, and conflict of interest in those cases where shareholders participate in
day-to-day management of their banks.
By 1997, 11 NBFIs and 5 commercial banks were placed under liquidation as shown
in Table 4. In 1996 a total of 4.2% of the total deposits for liquidated banks were under
protection, and 79% of the protected deposits had been paid. In 1997, the total protected
deposits were 6.8%9 of the total deposits and 71% had been paid. On the debt recovery,
in 1997, the total debt collected was 17.7% of the total at closure date, compared with
16% in 1996. Lack of securities documentation and unresolved court cases hampered
the loan collection process.

Table 4: Institutions liquidated, debt collected and deposits paid by deposit protection fund
(DPF)

Year Number Debt at Debt Total Deposits Deposits

closure collected deposits protected paid
(Ksh) (Ksh) (Ksh) (Ksh) (Ksh)

NBFIs
1993 9 5,500 1,742 5,530 236 173
1994 2 1,662 118 908 63 31
1995 0
1996 0

Commercial banks
1993 1 3,955 617 4,680 461 254
1994 1 1,433 103 2,526 121
1995 0
1996 3 3,010 173 3,172 448 356

Source: Deposit Protection Fund Annual Reports (various issues).

Loans dominate the asset portfolio of the commercial banks, although government
securities comprise an increasing share of the portfolio, as shown in Table 5. The larger
loan proportion partly reflects the financial distress of the risk borrowers where loan
demand increased with increasing lending rates, the declining role of NBFIs in the credit
market and the slow growth of the capital market as an alternative source of credit. The
level of non-performing loans increased to over 30% of the total loans, which was a
AN EMPIRICAL ANALYSIS OF INTEREST RATE SPREAD IN KENYA 13

major factor defining the decline in profitability of the banks. Consequently, the provision
for bad loans increased as a requirement to improve banks’ asset quality. The overall
performance of the banks indicates a decline as the proportion of banks rated “strong”
went down (Table 5).

Table 5: Performance of the banking sector (%)

1994 1995 1996 1997 1998 1999

Measuring performance using rating scale

Capital adequacy
Strong 45 32 32 49 55
Satisfactory 33 59 48 33 32
Fair and below 21 10 20 19 13

Asset quality
Strong 52 37 34 29 35
Satisfactory 9 10 18 14 14
Fair and below 39 54 48 57 51

Earnings
Strong 57 59 44 33 29
Satisfactory 3 7 18 10 14
Fair and below 39 34 38 57 57
Liquidity
Strong 76 73 70 66 57
Satisfactory 6 15 24 13 14
Fair and below 18 13 6 21 29
Overall
Strong 42 52 6 15 21
Satisfactory 24 44 32 45 40
Fair and below 18 52 29 40 40
Measuring bank performance using ratios calculated using the consolidated balance sheet and
income statements
Loan/total assets 38.83 46.35 46.70 48.84 49.89 54.83
Treasury bills/total assets 17.93 9.86 12.70 11.36 16.72 16.40
Loan interest income/total earnings 60.67 56.09 62.32 64.09 64.08 57.41
Treasury bill income/total earnings 11.68 12.07 12.81 12.08 14.47 13.24
Profit before tax/total assets 11.17 13.00 12.86 12.05 11.62 11.44
Non-performing loans/total loans 20.17 18.05 18.09 30.55 32.01 41.21
Provisions for bad loans/total loans 2.15 1.07 1.10 2.35 3.94 5.26

Source: Central Bank of Kenya.

14 RESEARCH PAPER 106

3. Literature review

I nterest rate spread is defined by market microstructure characteristics of the banking

sector and the policy environment. In differentiating between the pure spread and the
actual spread Ho and Saunders (1981) observe that pure spread is a microstructure
phenomenon, influenced by the degree of bank risk management, the size of bank
transactions, interest rate elasticity and interest rate variability. Zarruk (1989), considering
risk management by the bank, found that risk-averse banks operate with a smaller spread
than risk-neutral banks, while Paroush (1994) explains that risk aversion raises the bank’s
optimal interest rate and reduces the amount of credit supplied. Actual spread, which
incorporates the pure spread, is in addition influenced by macroeconomic variables
including monetary and fiscal policy activities. Hanson and Rocha (1986) emphasize
the role of direct taxes, reserve requirements, cost of transactions and forced investment
in defining interest rate spread.

Market structure

M arket structure encompasses the degree of competition, which reflects the number
of market players and the diversity of financial assets, the market share of individual
participants, ownership structure and control, policy regime (controlled vs uncontrolled),
and the adequacy of the legal and regulatory framework (see Fry, 1995). In a market
where the government sets interest rates and credit ceilings, allocation of resources is
inefficient because of uneven credit rationing criteria and the lack of incentive by banks
to compete for public deposits. In addition, the allocation of funds to poor performing
sectors increases the credit risk for commercial banks. With interest ceilings, however,
banks are constrained in charging the appropiate interest rate on loans, and the only
option is to offer the minimum possible interest rate on deposits. Further, the presence of
government owned and controlled banks creates an uncompetitive environment and to
some extent makes it difficult to enforce the set regulatory framework, weakening the
stability of the banking sector.
Financial reform emphasizes the abolition of interest rate and credit ceilings and the
promotion of a competitive environment with reduced government control and ownership.
Although achieving competitiveness does not imply nonexistence of an interest rate spread,
Ho and Saunders (1981) note that the size of the spread is much higher in a non-competitive
market, which also calls for strengthening the regulatory and legal framework to enhance
the stability of the market. Caprio (1996) notes that a weak legal system, where the
AN EMPIRICAL ANALYSIS OF INTEREST RATE SPREAD IN KENYA 15

courts are not oriented toward prompt enforcement of contracts and property rights are
ill defined, increases credit riskiness and banks have no incentive to charge lower rates.
Cho (1988), in addition, observes that the liberalization theory overlooks endogenous
constraints to efficient allocation of resources by the banking sector, where, in the absence
of a well functioning equities market, efficient allocation of capital is not realized even
with financial liberalization. Fry (1995) explains that in the absence of direct financial
markets and an equity and bonds market, financial institutions absorb too much risk, as
business enterprises rely excessively on debt finance. Thus, conclude Demirguc-Kunt
and Huizinga (1997), the interest spread fluctuates, reflecting the substitution between
debt and equity financing. As the equity market expands, offering competitive returns,
banks increase their deposit rates to compete for funds from the public. The expanded
market also reduces the risk absorbed by the banking sector and banks charge competitive
lower lending rates, reducing the interest rate margin. Thus, remarks Fry (1995), even in
an oligopolistic banking system, there is need for competition from the direct financial
market.
Empirical results show that market imperfections widen the interest rate spread. Ho
and Saunders (1981), approximating market power with bank size, found a significant
difference in spread between large and small banks, where smaller banks had higher
spreads than the large banks. Barajas et al. (1996) also show a significant influence of
loan market power on the interest spread. Elkayam (1996) observes that in a competitive
banking system. The interest rate spread derives solely fron central bank variables
(including the discount window loans, reserve requirement and interest on liquid assets
on deposit with the central bank), while under a monopolistic (or oligopolistic) structure
the interest rate spread is in addition affected by elasticities of demand for credit and
deposits. He also found that there was more market power in the credit market than the
deposit market. In addition, considering monetary policy, Elkayam (1996) found that an
increase in money supply under elastic demand reduces the spread more in a monopolistic
than in a competitive market.

Legal and regulatory framework

T he regulatory and legal framework influences the functional efficiency of banking

institutions and thus defines financial stability. In the reform process, financial
stability is identified as a prerequisite for successful financial liberalization. Financial
instability, with unsound and improperly supervised lending practices, increases the risk
premium charged on loan rates and widens the spread. This is because weak supervision
gives rise to moral hazard and adverse selection problems. With adequate supervision
an increase in interest rates results in banks’ rationing credit instead of taking new
borrowers. However, regulatory differences across financial institutions destabilize the
financial sector by diverting intermediation into the informal, less regulated and less
taxed part of the sector.
The legal framework incorporates the adequacy of commercial law and the efficiency
with which the judicial system makes and enforces legal decisions. Weaknesses in
16 RESEARCH PAPER 106

enforcement of financial contracts create credit management problems and the premium
charged on credit increases. This is because banks are unable to make agreements that
limit the ability of borrowers to divert funds away from the intended purpose, to disclose
accurate information on borrowers, and to write easily enforceable legal contracts. On
the other hand, a weak legal system without clearly spelled out property rights denies the
diversity of institutions a chance to diversify risk. Banks have no incentive to invest in
information and human capital, which propels the information asymmetry problem. In
their study, Demirguc-Kunt and Huizinga (1997) found that better contract enforcement,
efficiency of the legal system and lack of corruption are associated with lower realized
interest margins. This is because of the reduced risk premium attached to the bank
lending rate. As Fry (1995) explains, liberalization in the presence of inadequate prudential
supervision and regulation magnifies the impact of exogenous shocks by accommodating
distress borrowing. Notable is that in developing countries, regulations exist on paper
but in practice they are not enforced consistently and effectively.
A deposit insurance scheme is instituted to protect the depositors and maintain the
stability of the financial sector. However, insurance (explicit or implicit) promotes moral
hazard and adverse selection problems. Fry (1995) argues that adverse selection arises
with deposit insurance schemes, especially if they are accompanied with high macro
instability. On the other hand, banks never seek to reduce adverse selection in credit
rationing, especially if there is a positive relationship between instability and returns on
alternative banking financed projects. With protection for depositors provided, banks
choose riskier lending strategies especially if macro instability produces strongly
correlated outcomes. Thus, in setting up explicit insurance schemes, the banking system
must be fairly stable, prudential regulation and bank supervision effective, and funding
for the depository fund adequate. Also, the fund should have the necessary backup support
that may be required to get the system through a period of stress.

Taxation

B oth implicit and explicit taxes widen the interest spread as they increase the
intermediation costs. These include: reserve requirement, withholding taxes, stamp
duties, transaction taxes, value added taxes, profit taxes and license fees.
Reserve and liquidity requirements, mandatory investment levels, and interest controls
are categorized as implicit taxes. A reserve requirement with no interest payment tends
to have a higher opportunity cost as it squeezes the excess reserve available for banks to
advance credit, reducing the bank’s income earning asset. However, Fry (1995) observes
that the impact of a reserve requirement will depend on the elasticity of loan and deposit
interest rates. On the other hand, mandatory investment, where banks continue providing
funds to priority sectors despite the rate of return, squeezes the bank profit margin if the
sector’s investment yield is low. And interest rate controls limit the bank’s efforts to
capture high yielding investments.
Explicit taxes, just like the implicit taxes on the financial intermediation process,
may provide a negative effective protection to the domestic financial system and encourage
AN EMPIRICAL ANALYSIS OF INTEREST RATE SPREAD IN KENYA 17

financial intermediation abroad especially if there is tax discrimination. Discriminatory

taxation of financial intermediation reduces the flexibility of the system by significantly
reducing the funds for discretionary are lending. Tax discrimination also leads to financial
sector instability by driving intermediation into the informal, less regulated and less
taxed part of the market. The presence of explicit and implicit taxes also discourages the
development of the inter-bank market, which can play a major role in improving resource
allocation and the effectiveness of monetary policy. With heavy taxation at the inter-
bank market, all financial transactions make short-term overnight borrowing
uneconomical, and increase the reliance on central bank discount facilities that provide
inexpensive and unlimited loans to banks in need of funds. In case the discount facility is
restrictive, however, then banks may face liquidity problems and be forced to offer
attractive deposit rates to attract more deposits. Conversely, interest ceilings prevent
banks from negotiating terms of inter-bank loans and insufficient penalties for shortfalls
in required reserves. Barajas et al. (1996) and Demirguc-Kunt and Huizinga (1997) saw
a positive relationship between high interest rate spreads and high levels of taxation of
the intermediation.

Macroeconomic environment

T he macroeconomic environment affects the performance of the banking sector by

influencing the ability to repay borrowed loans; the demand for loans with the
unpredictable returns from investment and the quality of collateral determine the amount
of premium charged and therefore the cost of borrowed funds to the investors. With an
unstable macroeconomic environment and poor economic growth, investors face
uncertainty about investment return and these raise the lending rates as the level of non-
performing loans goes up, squeezing the bank margin. For example, poor output prices
reduce firm profitability while reduced asset prices reduce the value of assets for collateral
and therefore the credit-worthiness of the borrowers. As a result, return on investment
declines, increasing the level of non-performing loans, and banks charge high-risk
premiums to cover their default risk.
Cukierman and Hercowitz (1990) attempt to explain the relationship between
anticipated inflation and the degree of market power measured as the spread between the
debit and credit rates. They find that when the number of banking firms is finite, an
increase in anticipated inflation leads to an increase in interest spread. When banking
firms approach infinity (competitive case), there is no correlation between interest spread
and inflation because the spread tends towards marginal cost of intermediation as the
number of banks increases.

Risk factors

B anks are exposed to various risks, including interest risk, credit risk, foreign exchange
risk and legal risk, as a result of uncertainty, information asymmetry and the policy
18 RESEARCH PAPER 106

environment. For example, when banks hold unmatched maturities of deposits and loans
they are exposed to interest rate risk.10 This is especially so when banks raise funds
through short-term deposits to finance long-term loans or purchase security with longer
maturity. Interest rate risk is also defined by variability of the market interest rate.
Banks are exposed to credit risk due to information asymmetry. Banks do not know
ex ante the proportion of loans that will perform and even when they carry out appraisals,
credit losses are not fully eliminated. To cover credit risk, banks charge a premium whose
size depends on the bank credit policy, interest on alternative assets, amount borrowed,
type of client and size of collateral. This increases the effective rates paid by borrowers
and reduces the demand for loans.
Foreign exchange risk arises especially when banks fund themselves abroad, while
legal risk is faced when the legal framework for collateral and bankruptcy is not clear.
Liquidity risk arises if depositors demand to withdraw their funds and leave the banks
with insufficient reserves (for example during a bank run customers withdraw their
deposits in response to their loss of confidence with the bank).

Interest rate elasticities

I nterest rate elasticity reflects market power. The lower the elasticity, the greater the
monopolistic power and the wider the spread. The effect is greater with an un-
diversified asset basket and with an underdeveloped money market. Elkayam (1996),
assuming market power in both the deposit and the loan markets, concludes that interest
spread depends on the elasticities of demand for credit and deposit. The higher the
elasticity, the more competitive the market and the narrower the spread.
AN EMPIRICAL ANALYSIS OF INTEREST RATE SPREAD IN KENYA 19

4. Modelling interest rate spread

I n modelling interest rate spread two models are used to define the spread: the accounting
value of net interest margin and the firm maximization behaviour. The accounting
value of net interest margin uses the income statement of commercial banks, defining
the bank interest rate margin as the difference between the banks’ interest income and
interest expenses, which is expressed as a percentage of average earning assets.11 However,
both Hanson and Rocha (1986) and Barajas et al. (1996) criticize the accounting approach,
saying that it does not indicate if there is equilibrium in economic sense or the type of
market structure generated.
The firm maximization behaviour, on the other hand, allows derivation of profit
maximization rule for interest rate and captures features of market structure. Depending
on the market structure and risk management, the banking firm is assumed to maximize
either the expected utility of profits or the expected profits. And, depending on the assumed
market structure, the interest spread components vary. For example, assuming a
competitive deposit rate and market power in the loan market, the interest rate spread is
traced using the variations in loan rate. But with market power in both markets, the
interest spread is defined as the difference between the lending rate and the deposit rate.
Barajas et al. (1996) uses a combination of firm maximization behaviour and the
accounting approach to model the interest rate spread. The study assumes a competitive
deposit rate market and market power in the loans market. When elasticity is infinite,
there is no market power (φ = 1), while definite elasticity implies existence of market
power (φ < 1). Super competitive solutions exist when (φ > 1). Given the competitive
deposit rate and assuming linear function of real level of financial intermediation, he
defines the lending rate as a function of policy and marginal cost variables. Interest rate
spread is equated to loan rate. Demirguc-Kunt and Huizinga (1997) use the accounting
method, defining the spread as the interest margin. Assuming a linear relationship between
the spread and various variables, they use cross-sectional data for both developed and
underdeveloped countries. Zarruk (1989) compares a risk averse and a risk neutral situation
and considers interest risk assuming no default risk and implicit tax (reserve requirements).
A bank is assumed to be an interest spread setter as it sets both loan and deposit rates
simultaneously. Assuming the bank is out to maximize the expected utility of profits the
study adopts the Von Neumann–Morgenstein utility function, so that the bank is assumed
to face the following model:
20 RESEARCH PAPER 106

Maxµˆ = E [µ(Π)] = µ(Π) g(µ) dµ

s.t. L + B = D* + E
D* = D( RD ) + ξ

g( µ ) = Random term for deposit uncertainty

Wong (1997) took the cost of goods sold and the firm maximization behaviour to
evaluate the determinants of the optimal bank interest margin. The model features a risk
averse bank with credit risk and interest risk. The bank is assumed to be a loan rate setter
and a quantity setter in the deposit market, so that deposit rate is not a choice variable
and the properties of the optimal bank interest margin are similar to the optimal loan
rate. The concept of market power is captured by the reciprocal of interest elasticity
where a high value indicates the bank possesses more market power. Paroush (1994)
models a risk neutral bank whose objective is to maximize expected profits. Credit risk
in addition to the deposit and lending rates is considered as a decision variable. Collateral
is used to categorize a short-run and medium-term period. Gheva et al. (1992) also assume
the bank has two decision variables, loan rates and deposit rates. The bank sets both
rates and allows the volumes to be set by public demand for credit and supply of deposits.
The model assumes a risk neutral bank, therefore a bank out to maximize expected profits.
In addition, the model assumes that a bank is out to minimize the difference between
actual (short-run) and desired (long-run) returns. To capture the adjustment process a
partial adjustment model is fitted and a linear relationship assumed. Ho and Saunders
(1981) integrate the hedging and expected utility approaches to analyse determinants of
bank margins. Their approach assumes a bank is a dealer in the credit market, acting as
an intermediary between demanders and suppliers of funds and aiming to maximize the
utility of expected terminal wealth. New loans and deposits are made in a passive way
so that prices and quantities are determined exogenously. The authors define the prices
of loan and deposit as:

PL = P − b
PD = P + a

where P is the bank’s opinion of the price of loan or deposit, and (a) and (b) are fees for
provision of intermediation services. Spread was defined as (a + b).
Demirguc-Kunt and Huizinga (1997) note that interest margin and interest spread are
different unless there are zero non-interest bearing funds. However, spread is superior to
margin as an indicator of the bank policy in determining the conditions and volume of
intermediation. Interest spread can be measured ex post and ex ante. Ex ante spread
equals the difference between the contractual rates charged on loans and the rates paid
on deposits. Ex post spread measures the difference between the bank interest revenues
and their actual interest expenses. Ex ante spread is biased, however, as perceived risks
AN EMPIRICAL ANALYSIS OF INTEREST RATE SPREAD IN KENYA 21

are reflected in the ex ante yields. The ex post spread problem is in terms of interest
income and loan loss reserve associated with a particular loan that tend to materialize in
different time periods.
In this study we capture interest rate spread by combining the accounting and optimal
firm behaviour models. We attempt to incorporate the various factors identified in the
literature and the local market in modelling interest rate spread. These include market
power, credit risk, interest risk, tax and policy related variables. We assume the bank
makes decisions in a single period and both loans and deposit markets are imperfect. The
treasury bill market is explicitly included to capture monetary and fiscal policy actions.
For example, as indicated earlier, with a shift to local sources to finance its budget deficit,
the government relied so heavily on the treasury bills that fluctuations in treasury bill
interest rates tended to reflect the demand for funds by the government and thus the
position of the budget deficit. In addition, with the shift to indirect monetary policy
tools, the CBK used the open market operation to regulate money supply. At the beginning
of the period, levels of deposits and loans are unknown. At the end of the period, banks
adjust their portfolio by participating in the inter-bank market and/or the central bank
discount window. Participation in either of the markets depends on interest rate levels
and policy action.
Assume a simple intermediation model for the banking sector given by the following
balance sheet identity.:

L + B + R = D + IN + ONL (1)

where

L = loans
B = government securities
R = reserve requirement
D = deposits
IN = inter-bank market operations
ONL = other net liabilities

Reserve requirements are a proportion ( ρ ) of the total deposits. We assume no interest

is paid on reserve requirements. Thus, reserve ratio is an implicit tax, which reflects
fiscal and monetary policy actions (Hanson and Rocha, 1986).

R = ρD (2)

The choice between investing in government securities or in loans is determined by

expected returns. Banks set the loan interest rate ( rl ), while the government securities
interest rate ( rb ) is exogenous. The loan interest rate depends on the demand for investment
funds and other composite variables including the alternative sources. We assume a
homogenous class of loans, where demand for loans ( L ) is determined by the interest
rate on loans, interest rate on other sources of funds ( rother ) and income levels.
22 RESEARCH PAPER 106

L = f (rl , rother , y) (3)

Given the credit risk, the total earnings of the bank deviate from the contractual loan
repayment as defined by the realized loan repayment. The proportion of non-performing
loans (w) can be assumed to be random, taking values between (0,1). In his analysis
Klein (1971) assumes a bank with three assets, cash, government security and private
security (loans). He assumes that all borrowers are identical and face fixed and similar
non-interest loan terms. Private loans are influenced by contract rates of interest and
exogenous variables on the demand side. As a rational investor in an environment
characterized by risk or uncertainty, banks face default risk ( δ i ), so that the expected
returns on loans ( Ei ) are less than the contract rate of interest ( r ), thus, Ei < r if δ i > 0.
The default risk is measured as the standard deviation of the probability of loan
payments. With the assumption made on borrowers, the estimated standard deviation is
equal to population standard deviation δ i = σ i and the default risk is taken as exogenous
to the bank. Wong (1997) measured credit risk as a random variable ( Θ ) that is not
affected by the lending level, so that the degree of uncertainty per dollar is constant and
the actual loan payment is equal to (1 − Θ) Ri Lri where (Θ) is the increased returns.
Paroush (1994) defined the credit risk as a proportion of performing loans to non-
performing loans, assuming a non-zero probability of default. In the short run, collateral
policy was assumed constant, while in the medium term, the lending rate, the deposit
rate and collateral requirements are the decision variables. Credit risk brings a wedge
between the contractual interest rate and the expected rate of return ( E ) on its assets, so
that r = E + t and E = r (1 − w ) ; where r = interest on credit, E = expected returns, t
= risk premium, and w = the proportion of performing loans that is influenced by interest
rate on loans, uncertainty in the economy and the bank policy on collateral. Thus, credit
risk includes both the endogenous and exogenous risk.
Barajas et al. (1996) incorporated uncertainty by assuming that return for loans is an
exogenous risk of default. Thus, they assume it is independent of the bank’s action as
opposed to the situation where the risk incurred by adverse selection is an endogenous
risk because banks affect the risk by choosing the interest rate charged to the borrowers.It
is exogenous, and determined by economic performance, changes in interest rate policy,
and adequacy in monitoring and evaluation of investment. Assuming that the amount of
loan repaid is not influenced by the amount borrowed, then the degree of uncertainty per
shilling of loan is constant. The realized earnings at the end of the period are equal to:

rl (1 − w ) L (4)

The amount of deposits received by the bank at the beginning of the period is
determined by the deposit interest rate, the interest rate on other financial assets and
economic performance. In addition, the bank’s demand for liquidity and the bank’s
performance influence the level of interest rates set by the bank. At the end of the period,
if the bank is facing deficits or surplus in financing its investment, then it engages in
secondary market activities. Thus, the bank will raise funds from the central bank (discount
AN EMPIRICAL ANALYSIS OF INTEREST RATE SPREAD IN KENYA 23

window) and/or other banks (inter-bank market).12 The liquidity gap (IN) faced by the
bank is defined as:

IN = L − (1 − ρ ) D (5)

Assume that for any balances faced in one market the bank fills the gap by approaching
the other market. For example, if the bank is able to raise (ψ) proportion of liquidity gap
from the inter-bank market then (1 - ψ) proportion will be raised from the discount
window. Thus, the amount raised from the inter-bank market is (ψ IN) and from the
discount window (1 - ψ)IN. The two markets are used as either substitutes or complements
depending on market characteristics, including policy directives, interest rates charged
and the level of development of the market. Our model assumes that a high proportion of
gap filling is made in the inter-bank market, so that the discount window adjustments are
treated as part of the other net liabilities. Thus, substituting Equations 3 and 5 into Equation
1 we get:

L + B = (1 − ρ ) D + ψM + ONL (6)

Expressing Equation 5 to show the earnings and costs of the bank, the following
profit model ( π ) is derived:

Π = rl (1 − w ) Li + rb Bi − rd (1 − ρ) Di − rmψM − C ( Li , Di ) (7)

The profit maximization problem is defined as:

MaxΠ = rL (1 − w ) Li + rb Bi − rd (1 − ρ) Di − rM ψ ( L − (1 − ρ) D) − C ( Li , Di )
Subject to: Li + Bi = (1 − ρ ) Di + ψM + ONL (8)

The lagrangian function is expressed as follows:

ω = rL (1 − w ) Li + rb Bi − rd (1 − ρ ) Di − rMψ ( Li − (1 − ρ ) Di ) −
C ( Li , Di ) + λ[ Li + Bi − (1 − ρ) Di − ψM − ONL] (9)

We differentiate the lagrangian function with respect to Li , Di , Bi and λ , assuming

that the demand and supply functions for investment funds are inverse functions.

dω dr
= rL (1 − w ) + L (1 − w ) Li − rMψCL + λ (1 − ψ ) = 0 (10)
dLi dLi
24 RESEARCH PAPER 106

dω dr
= rd (1 − ρ ) − a (1 − ρ ) Di + rmψ (1 − ρ )(Cd − λ (1 − ρ )(1 − ψ ) = 0 (11)
dDi dDi

dω
= rb + λ = 0 (12)
dBi

dω
= Li + Bi − (1 − ρ ) Di − ψM − ONL (13)
dX

To capture the loan and deposit elasticities and also the individual bank’s share in the
total loans and deposits, Equations 10 and 11 are multiplied and divided by L and dL
and D and dD , respectively.

Thus, we rewrite Equation 10 and 11 as follows:

dω
= rL ( I − w )φ − rmψ − CL + λ(1 − ψ ) = 0 (10b)
dLi
dω
= rd (1 − ρ )σ + rmψ (1 − ρ ) − Cd − λ (1 − ρ )(1 − ψ ) = O (11b)
dDi

where
1 dL
φ = [I + PL ]
ηL dLi

drL L
ηL = .
dL rL

Li
PL =
L

1 dD
σ = [ −1 + PD ]
ηD dDi

drd D
ηD =
dD rd
Di
PD =
D
AN EMPIRICAL ANALYSIS OF INTEREST RATE SPREAD IN KENYA 25

From Equation 11 λ = −rb , we substitute for λ in Equations 10b and 11b to eliminate
λ.

ri (1 − w )φ − rmψ − Ci − rb (1 − ψ ) = 0 (10c)

rd (1 − ρ )σ + rmψ (1 − ρ ) − Cd + rb (1 − ρ )(1 − ψ ) = 0 (11c)

We derive the rL and rd from equation 9b and 10b to get:

rmψ CL rb
rL = + + (14)
(1 − w )φ (1 − w )φ (1 − w )φ

Cd r ψ r (1 − ψ )
rd = − m − b (15)
(1 − ρ )σ σ σ

Interest rate spread is defined as rL − rd

rmψ CL rb Cd r ψ r (1 − ψ )
rL − rd = + + − + m + b (16)
(1 − w )φ (1 − w )φ (1 − w )φ (1 − ρ )σ σ σ

If we define the marginal cost as linear functions of real deposit and loans,

Cd = Cd 0 + Cd 1D* (17)

Cl = Cl 0 + Cl1L* (18)

Substituting Equations 17 and 18 into Equation 16 we get:

CLO Cdo 1 Cdi

rL − rd = − + CL L* − D* +
(1 − w )φ (1 − ρ )σ (1 − w )φ 1 − ρ )σ

1 1 1−ψ
rmψ (1 + ) + rb ( + ) (19)
σ (1 − W )φ σ
26 RESEARCH PAPER 106

Equation 19 implies that the spread is defined by the operational costs, interest rate
elasticities, reserve requirements, demand and supply of funds, costs of adjustment in
the secondary market, returns on other financial assets, and policy actions.
Assuming Equation 19 is an implicit function, we can analyse the expected direction
of relationship between interest rate spread ( s = rt − rd ) and various determinants
identified in the theoretical and empirical literature. Results of the differential analysis
are given in Appendix A.
AN EMPIRICAL ANALYSIS OF INTEREST RATE SPREAD IN KENYA 27

5. Data

T he data consist of monthly observations of treasury bill rates, commercial bank loans
and deposits, lending rates, deposit rates, inter-bank rates, provision for bad loans, and
liquidity and cash ratios. These data were obtained from the Central Bank of Kenya. The
sample runs from July 1991 to December 1999 for all data seta except the inter-bank rate,
which is only available from April 1993. Estimating recursively a lending and deposit rate
model given by equations 14 and 15 captured interest rate elasticities. The models were
estimated with log level variables to capture long-run trends. Cointegration tests were carried
out to ensure long-run relationships. Regression results are reported in Table 6.
Table 6: Regression results for the lending rate and deposit rate models

Variable Coefficient t-statistic

Lending rate model Regression results Constant -0.7550 -5.0612
Lntbill 0.2298 6.4662
Lnexliq 0.4098 6.5864
Lnloan 0.0439 6.3792
Lncash 0.6902 7.6184
Lndebt -0.4883 -4.6893
R2 0.7478
F-statistic 11.3029(0.0000)
Cointegration results C 0.0002 0.8712
ε t −1 -0.3175 -3.6524
Deposit rate model Regression results Constant -0.5545 -2.2300
Lndeposit 0.0336 1.8847
Lntbill 0.2307 3.3024
Lncash 0.4790 4.7823
Lnexliq 0.3665 4.7885
Lninterbank 0.0273 2.7116
R2 0.7532
F-statistic 12.2042(0.0000)
Cointegration results C -0.0003
ε t −1 -3.4192
Note: In this table we provide regression results of the models used in deriving the elasticities of
deposits and loans to interest rates recursively. The models were estimated using log levels of the
variables to capture the long-run relationship. The Engle and Granger (1987) procedure is used to
test for cointegration. The variables are Lntbill = log treasury bill rate; Lnexliq = log of excess
liquidity measured as the difference between the average and minimum liquidity ratio; Lncash =
log of the cash ratio; Lndebt = log of bad debt provision as a percentage of the total loans; Lnloan
= log of loans advanced; Lninterbank = log of inter-bank rate.
28 RESEARCH PAPER 106

Table 7 reports summary statistics for the sample. Our results show tremendous increase
in spread when monetary policy was tightened, reducing marginally when monetary
policy is relaxed. More variability is indicated with the tight monetary policy. This is
explained by the increase in the lending rate with an average of about 9 percentage
points as compared with 2 percentage points for deposit. In addition, treasury bill rates
increased by about 10% and saw excess liquidity that increased with more than 20
percentage points. When monetary policy is relaxed, spread increases marginally with
about 1 percentage point. This is because the deposit rate recorded a 3% decline, while
the lending rate declined by only 1% despite a fall in treasury bill rates by more than 8
percentage points. At the same time, the debt ratio increased, reflecting the growing non-
performing loans, and the inter-bank rate went up by about 4 percentage points. Our
preliminary results thus show that the stickiness of the lending rate downward sustained
the high interest spread. Figures 1 and 2 provide a graphical representation, while Appendix
Table A1 reports the correlation matrix.

Table 7: Summary statistics

Variable Period I Period II Period III

Spread 4.4723 12.4219 13.5202

Lending rate 18.3207 27.7299 26.3473
Deposit rate 13.8484 15.3080 12.8271
Debt ratio 0.0499 0.0798 0.1071
Treasury bill rate 17.4514 27.5780 19.4156
Excess liquidity 0.0245 0.2105 0.1921
Inter-bank rate - 20.7094 16.0000
Growth in real deposits 0.0027 -0.0044 -0.0031
Growth in real loans -0.0074 -0.0052 0.0044

Note: This table reports average values for the specified period. The three periods are:
Period I 1991(7)–1993(3) before tight monetary policy is adopted
Period II 1993(4)–1997(9) when tight monetary policy is in operation
Period III Central Bank relaxes tight monetary policy
AN EMPIRICAL ANALYSIS OF INTEREST RATE SPREAD IN KENYA 29

Figure 1: Trends in deposit rate, lending rate, spread and treasury bill rate

Figure 2: Interest rate spread, average liquidity, minimum liquidity, cash ratio and inter-
bank rate
30 RESEARCH PAPER 106

6. Empirical results

W e first analyse the time series characteristics of the data using the augmented
Dickey–Fuller test. According to this test, a time series Xt is non-stationary if β = 1
in the following autoregressive function:

n
Xt = α o + α1t + βXt −1 + ∑ γ j Xt − j + ε t (20)
j =2

Unit root test results are reported in Table 8. The results indicate the data series to be
non-stationary at levels. Thus, we proceed to test if these variables have a long-run
relationship by testing for cointegration using the Engle and Granger (1987) procedure.
This procedure involves estimating the following model:

yt = α + βXt + ε t

ε t − ε t − 1 = − bε t − 1 + θ t (21)

If b is significantly different from zero, then yt and Xt are cointegrated. Cointegration

results are also reported in Table 8. The results show cointegration between the spread
and the real deposits, real loans, credit risk, cash ratio, and responsiveness of loans to
interest rates. The cointegration factor mimics a profit model where bank profitability is
defined by the nature of the credit market (which is the source of bank income), implicit
tax that squeezes the ability of the bank to earn income, the level of credit risk and the
responsiveness of demand for loans.
With the cointegrating factor we estimate an error correction model that takes the
following general form:

m m
yt = ∑ at − j Xt − j + ∑ b j yt − i + δε t −1 + θ t (22)
j =1 i =1
AN EMPIRICAL ANALYSIS OF INTEREST RATE SPREAD IN KENYA 31

Table 8: Unit root and cointegration results

Unit root test Variable ADF statistic Phillips–Perron

Lending rate -3.1292 -1.7862
Treasury bill rate -3.1741 -2.5964
Bad debt ratio -1.3152 -1.3322
Excess liquidity -2.1296 -1.8758
Inter-bank rate -2.9365 -2.4470
Loan elasticity -1.4128 -2.7536
Deposit rate -3.0720 -1.9812
Real deposits -2.9840 -5.2924
Spread -1.8734 -1.9108
Real loans -1.3747 -0.7790

Cointegrating factor Variable Coefficient t-statistic

Constant 0.3539 1.9347

Bad debt ratio 0.2402 4.0987
Real deposits -0.0828 -3.1449
Real loans 0.0588 3.0773
Cash ratio 0.5881 11.8570
Elasticity of loan 0.1570 3.4074
R2 0.83
F-statistic 20.150(0.0000)

Cointegration test results Constant -0.0003 -0.3677

ε t −1 -0.5200 -5.6014

Note: Unit root test is based on ADF and Phillips–Perron test. Cointegration test uses the Engle and Granger
(1987) approach.

Table 9 reports the reduced form regression results and Appendix Table A2 provides
the parsimonious model. A positive relationship is predicted between the treasury bill
rate and the spread, given the predicted positive relationship between the lending rate
and the treasury bill rate and the negative relationship with the deposit rate. However,
our results show a negative relationship in the short run and no significant relationship in
the long run. The insignificant long run relationship may be attributed to the almost
equal magnitudes in the lending and deposit rates to the treasury bill rate as shown in
Table 6. The negative relationship in the short run reflects the significantly higher decline
in deposit rates as the treasury bill rate declined and the almost insignificant change in
lending rate as shown in Table 7. As a result, the spread increased because as the treasury
bill rate declined, the lending rate did not, indicating the asymmetric response of the
lending rate to the treasury bill rate.
32 RESEARCH PAPER 106

Table 9: Preferred model

Variable Coefficient Standard error

Constant 0.0015 0.0013

Bad debt ratio 0.2760 0.1715
Real deposit 0.0948 0.0320
Excess liquidity -0.1871 0.0868
Inter-bank rate -.0153 0.0450
Elasticity of loan -.0046 0.0135
Treasury bill rate -0.1826 0.0455
Real loans -0.1119 0.0349
Ecm(t-1) -0.8456 0.1745
Seasonal -0.0129 0.0082

Wald test X2 (9)

36.241(0.0000)

This relationship may also be explained by the bank’s attempt to maintain profit
margins faced with a high level of non-performing loans, and declining earnings from
the alternative source (treasury bills). This is supported by the positive relationship between
the spread and bad debt provision, which means that faced with rising credit risk, banks
kept lending rates high as they charged higher risk premiums to maintain their profits.
Inter-bank rates take a negative sign in the short run, while an insignificant relationship
is portrayed in the long run. However, a positive relationship is indicated with the deposit
rate, which would imply that as net borrowers, banks in the long run opted to compete
for more deposits from the public as they would offer lower interest rates compared with
the interest rate charged at the inter-bank market. Banks were net borrowers in the inter-
bank market because of the restrictions at the discount window, the increased implicit
tax following the tight monetary policy and the slow growth in deposits.
The model predicts a positive relationship between the spread and the real loans,
which reflects the positive relationship between the real loans and the lending rate. The
magnitude of the relationship depends on the credit risk and the control the bank has in
the credit market. Increased deposits depress the spread given the positive relationship
between deposits and the deposit rate. However, deposits will reduce the spread by a
greater margin if the financial market is competitive and the implicit tax is low. Our
results show a positive relationship between the spread and the real loans which implies
increased implicit costs, thus the positive relationship between the cash ratio and the
lending rates. Consequently, the spread increases with increased real loans due to the
increase in the lending rate as banks attempt to cover implicit costs by charging a premium
on lending rates. A negative relationship is indicated by the real deposits, as banks
increased their deposits by offering higher deposit rates (see results in Table 6).
Our model predicts a decline in the spread as the market shows high sensitivity to the
interest rate, resulting in a decline (rise) in lending (deposit) rates as the market gains
competitiveness. Our results show a negative relationship in the short run, which does
not imply increased competitiveness in the credit market, but indicates an increase in
deposit rates as banks face high demand for credit with low deposits.
Finally, the cointegrating factor indicates that any distortions that squeeze targeted
profits result in banks’ adjusting the spread upwards.
AN EMPIRICAL ANALYSIS OF INTEREST RATE SPREAD IN KENYA 33

7. Conclusions

T he study aimed to explain the factors determining interest rate spread for Kenya’s
banking sector. For the pre-liberalization period, the minimum and maximum ceilings
on deposit and lending rates set a maximum interest rate spread. Variations in the spread
reflect monetary and fiscal policy actions, where expansionary fiscal policy partly
increased inflationary pressure and the monetary authority responded by tightening the
monetary policy and revising interest rates upwards. During the post-liberalization period,
we expect the spread to narrow to reflect efficiency gains and reduced transaction costs
with the removal of distortionary policies and strengthening of the institutional set-up.
However, Kenya’s experience indicates a widening spread in the post-liberalization period.
Our results show that the interest rate spread increased because of yet-to-be gained
efficiency and high intermediation costs. The increase in spread in the post-liberalization
period stemmed from the failure to meet the prerequisites for successful financial reforms
and the lag in adopting indirect monetary policy tools and reforming the legal system.
Variations in the interest spread are attributable to bank efforts to maintain threatened
profit margins. For example, banks that faced increasing credit risk as the proportion of
non-performing loans went up responded by charging a high risk premium on the lending
rate. High non-performing loans reflect the poor business environment and distress
borrowing, which is attributed to the lack of alternative sourcing for credit when banks
increased the lending rate, and the weak legal system in enforcement of financial contracts.
Fiscal policy actions saw an increase in treasury bill rates and high inflationary pressure
that called for tightening of monetary policy. As a result, banks increased their lending
rates but were reluctant to reduce the lending rate when the treasury bill rate came down
because of the declining income from loans. They responded by reducing the deposit
rate, thus maintaining a wider margin as they left the lending rate at a higher level. Thus
there was an asymmetric response of lending rates to treasury bill rates. High implicit
costs were realized with the tight monetary policy, which was pursued with increased
liquidity and cash ratio requirements. Consequently, banks kept a wide interest rate spread
even when inflationary pressure came down.
We recommend reform of the legal system to enhance the enforcement of financial
contracts. This would work as an incentive for banks to invest in information capital,
thus reducing the information asymmetry problem. Consequently, the proportion of non-
performing loans will be reduced hence lower risk premium attributed to credit risk. In
addition, efforts should be made to revitalize the growth of the economy and to attain
macro stability in order to increase the return on investment and reduce uncertainty.
Furthermore, the development of the capital market is vital to enhance competitiveness.
34 RESEARCH PAPER 106

Fiscal and monetary policy actions should also target development of the financial market.
For example, fiscal discipline is identified as a prerequisite for successful financial
liberalization, while monetary policy using indirect policy tools rather than the reserve
requirement reduces the implicit costs faced by banks. Further stability of macroeconomic
conditions and growth of the economy are imperative for the enhanced performance of
the financial market.
AN EMPIRICAL ANALYSIS OF INTEREST RATE SPREAD IN KENYA 35

Notes
1. Intermediary costs include information costs, transaction costs (administration and
default costs) and operational costs.

2. Edwards (1984), Mirakhor and Villanueva (1993), and Montiel (1995) indicate
macroeconomic and financial stability and fiscal discipline as prerequisites for
successful financial liberalization.

3. The CBK attributed the widening spread to inflationary expectations that kept the
lending rates high; inadequate competition where four banks controlled over 70%
of the deposit; and loans market; excess demand for loans in the midst of low
deposits, inefficient operations of the banks; increased non-performing loans;
monetary and fiscal policy actions; and profitability of the banks (Central Bank of
Kenya, Monthly Economic Review, September 1995: 4–6).

4. For a successful shift the following procedure is expected: Excess liquidity is

absorbed first, using the reserve requirement to sterilize the excess liquidity
accumulated with credit control regime. Then, credit controls and interest controls
are removed and efforts made to foster growth of money and government securities
market. An open market type operation in the form of auctions of government
short-term securities is introduced, and because the reserve requirement is a
disincentive in the intermediation process, the ratio is reduced to allow the
operations with securities to sterilize any excess liquidity (Alexander et al., 1995).

5. The cash ratio was first introduced in 1971 at 5%, then rescinded in 1972, and
reintroduced in 1978 at 4%, to be rescinded again in 1981 and reintroduced in
1986 at 6%. The main aim was to reduce the banks’ free cash base and hence curb
their capacity to give loans and advances. With no interest paid, reserve
requirements served as an implicit tax on commercial banks (except for a short
period of time when the banks paid an interest 5%, i.e., December 1995 to May
1996, aiming to achieve a decline in interest rate levels). Cash ratio was extended
to the NBFIs from July 1995.

6. This was an agreement made by the CBK to buy back at short notice earmarked
treasury bills sold to the bank, such that there is temporary withdrawal of liquidity
from banks and the situation normalized with the CBK buying back the treasury
36 RESEARCH PAPER 106

bills or reserves through the REPO. Thus the REPO provided participants with an
alternative channel for either borrowing or lending. At the moment the REPO is
agreed between the CBK and commercial banks with treasury bill paper.

7. As a lender of last resort the CBK revised the lending and rediscount rates; overnight
lending rate on the Lombard facility (window 1), which was a cheaper facility,
was set at 3 percentage points above the treasury bill rates from June 1997, down
from 4% in November 1996. Interest rate on rediscount and overnight loans
(window 2) was reduced to 5% in June 1997, from 6% in November 1996.

8. By 1996, the financial system had 51 commercial bank, 23 NBFIs, 5 building

societies, 39 insurance companies, 3 reinsurance companies, 10 DFIs, a capital
market, 13 forex bureaus, and 2,670 savings and credit cooperative societies (Ngugi
and Kabubo, 1998). This changed to 53 banks, 11 NBFIs, and 4 building societies
and mortgage finance companies in 1999.

9. This ratio is very small, implying that individual depositors make heavy losses in
case of bank liquidation, and the large depositors are penalized more.

10. This is the risk that the value of financial liabilities will fluctuate in response to
change in market rates

11. Accounting methods:

Interest received (IR)
(-) Interest paid (IP)
= Interest margin
+ Other income net (IO)
= Gross earning margin (GM)
(-) Operating costs (OC)
= Net earnings margins
+ Net (other credit) (OCR)
= Net profit before tax (PBT)

So that
IR - IP + OI = GM = OC + PBT - OCR

12. To introduce interest rate risk in his model Zarruk (1989) assumed that a bank is a
quantity setter in the deposits market, thus facing a perfectly elastic supply of
deposits. Given a maturity period of less than one period, deposits are rolled over
at the prevailing unknown one-plus deposit rate so that the bank faces fixed rate
loans and variable rate of deposits. This exposes the bank to interest rate risk.
Gheva et al. (1992) capture the risk factor by assuming the bank engages in money
market activities. They assume that a bank sets the rates of both deposits and
loans and the volumes are left to be set by public demand for credit and supply of
AN EMPIRICAL ANALYSIS OF INTEREST RATE SPREAD IN KENYA 37

deposits. Interest rates are set at the beginning of the period and at that point
volumes are uncertain. At the end of the period the bank resorts to the secondary
market for adjustment borrowing from the central bank or commercial banks or
reduces its indebtedness. Ho and Saunders (1981) explain that banks face interest
rate risk with assumed long-term maturity of deposits and loans and the uncertainty
over transaction arrivals as they hold unmatched portfolios of deposits and loans
at the end of the period and the short-term rate of interest changes. Wong (1997)
also introduced interest rate risk in his model by assuming a bank is a quantity
setter in deposits and faces a perfectly elastic supply. While the deposit rate is
variable, the loan rate is fixed within the period so that the bank is exposed to
interest rate risk.
38 RESEARCH PAPER 106

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Caprio, G., Jr. 1996. “Banking on financial reform? A case of sensitive dependence on
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Cukierman, A. and Z. Hercowitz. 1990. “Oligopolistic financial intermediation, inflation
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Ho, T.S.Y. and A. Saunders. 1981.”The determinants of bank interest margin: Theory
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Kimura, J. 1998. “Financial structures for sustainable growth”. Paper presented during
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of Banking and Finance, 13: 797–810.
 40

Appendix A: Model results

Table A1: Correlation matrix

Spread Tbill rate Real loans Inter-bank rate Excess liquidity Bad debt Cash ratio Loan elasticity Deposits Lending

Spread 1
Treasury bill rate -0.1803 1
(0.070)
Real loans 0.4138 -0.4399 1
(0.000) (0.000)
Inter-bank rate -0.6704 0.8936 -0.3763 1
(0.000) (0.000) (0.001)
Excess liquidity 0.6853 0.2010 -0.0837 -0.1122 1
(0.000) (0.043) (0.403) (0.319)
Bad debt ratio 0.6266 -0.1787 0.4003 -0.4246 0.5637 1
(0.000) (0.072) (0.000) (0.000) (0.000)
Cash ratio 0.8655 -0.0256 0.0514 -0.3829 0.7387 0.3545 1
(0.000) (0.799) (0.608) (0.000) (0.000) (0.000)
Loan elasticity 0.6221 -0.6968 0.9232 -0.5451 -0.4513 0.4153 -0.0736 1
(0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.517)
Real deposits 0.5769 -0.4072 0.9471 -0.4381 0.1868 0.4699 0.2701 0.9124 1
(0.000) (0.000) (0.000) (0.000) (0.060) (0.000) (0.006) (0.000)
Lending rate 0.7097 0.3425 -0.0553 0.3198 0.7474 -0.2082 0.7954 -0.2939 0.1576 1
(0.000) (0.000) (0.581) (0.004) (0.000) (0.036) (0.000) (0.008) (0.114)
Deposit rate -0.2333 0.6809 -0.5777 -0.7063 0.1907 -0.4860 0.0489 -0.6240 -0.4825 0.5192
(0.018) (0.000) (0.000) (0.000) (0.055) (0.000) (0.626) (0.000) (0.000) (0.000)
RESEARCH PAPER 106
AN EMPIRICAL ANALYSIS OF INTEREST RATE SPREAD IN KENYA 41

Table A2: Parsimonious model

Variable Coefficient t-statistic

Constant 0.0011 1.133

Spread (t-3) 0.2540 3.078
Bad debt ratio(t-1) 0.2059 1.638
Real deposit(t-1) 0.0707 3.202
Excess liquidity -0.1396 -2.243
Inter-bank rate -0.1141 -3.736
Elasticity of loan(0) 0.2860 -4.079
Elasticity of loan(t-1) -0.1229 -1.950
Elasticity of loan(t-4) -0.1665 -2.898
Treasury bill rate(t-3) -0.1363 -4.468
Real loans(0) -0.0240 -2.735
Real loans(t-1) -0.0594 -3.144
ECM(t-1) -0.6308 -6.749
Seasonal(t-1) -0.0100 -3.713
Seasonal(t-2) -0.0085 -3.065
Seasonal(t-7) 0.0044 1.635

R2 0.6416
F-statistic 6.4906(0.0000)
σ 0.0058
DW 2.18
RSS 0.0019
42 RESEARCH PAPER 106

Appendix B: Derivation of the

partial derivatives
1. Spread and treasury bill rate

ds 1 1−ψ
a) = + (1)
drb (1 − w )φ σ

drL 1
b) = (2)
drb (1 − w )φ

drd − (1 − ψ )
c) = (3)
drb σ

2. Spread and inter-bank rate

ds 1 1
a) =ψ( + ) (4)
drm (1 + w )φ σ

drL ψ
b) = (5)
drm (1 − w )φ

drd −ψ
c) = (6)
drm σ
3. Spread and volume of loans

ds CLI
a) = (7)
dL*
(1 − w )φ

drL CL1
b) = (8)
dL*
(1 − w )φ
AN EMPIRICAL ANALYSIS OF INTEREST RATE SPREAD IN KENYA 43

4. Spread and volume of deposits

ds −Cd 1
a) = (9)
dD *
(1 − ρ )φ

drd Cd 1
b) = (10)
dD *
(1 − ρ )σ

5. Spread and performing loans

ds C +r
a) = − L 2b (11)
d (1 − w ) (1 − w ) φ

drL − r ψ + CL + rb
b) = m (12)
d (1 − w ) (1 − w )2 σ

6. Spread and power in loan market

ds − CL + rb
a) = (13)
dφ (1 − w )φ 2

drL − rmψ + CL + rb
b) = (14)
dφ (1 − w )φ 2

7. Spread and power in deposit market

ds 1 Cd
a) = 2[ − ψrm − rb (1 − w )] (15)
dσ σ (1 − ρ )

drd 1 Cd
b) = 2[ − ψrm − rb − rb (1 − ψ )] (16)
dσ σ (1 − ρ )

8. Spread and available reserves

ds Cd
a) = (17)
(1 − ρ ) (1 − ρ )2 σ

drd Cd
b) = −[ (18)
d (1 − ρ ) (1 − ρ )2 σ
44 RESEARCH PAPER 106

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Paper 1.
Real Interest Rates and the Mobilization of Private Savings in Africa, by F.M. Mwega, S.M. Ngola and N.
Mwangi, Research Paper 2.
Mobilizing Domestic Resources for Capital Formation in Ghana: The Role of Informal Financial
Markets, by Ernest Aryeetey and Fritz Gockel, Research Paper 3.
The Informal Financial Sector and Macroeconomic Adjustment in Malawi, by C. Chipeta and M.L.C.
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The Effects of Non-Bank Financial Intermediaries on Demand for Money in Kenya, by S.M. Ndele,
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A Macroeconomic-Demographic Model for Ethiopia, by Asmerom Kidane, Research Paper 7.
Macroeconomic Approach to External Debt: The Case of Nigeria, by S. Ibi Ajayi, Research Paper 8.
The Real Exchange Rate and Ghana’s Agricultural Exports, by K. Yerfi Fosu, Research Paper 9.
The Relationship between the Formal and Informal Sectors of the Financial Market in Ghana, by E.
Aryeetey, Research Paper 10.
Financial System Regulation, Deregulation and Savings Mobilization in Nigeria, by A. Soyibo and F.
Adekanye, Research Paper 11.
The Savings-Investment Process in Nigeria: An Empirical Study of the Supply Side, by A. Soyibo,
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Links between the Informal and Formal/Semi-Formal Financial Sectors in Malawi, by C. Chipeta and
M.L.C. Mkandawire, Research Paper 14.
The Determinants of Fiscal Deficit and Fiscal Adjustment in Côte d’Ivoire, by O. Kouassy and B.
Bohoun, Research Paper 15.
Small and Medium-Scale Enterprise Development in Nigeria, by D.E. Ekpenyong and M.O. Nyong,
Research Paper 16.
The Nigerian Banking System in the Context of Policies of Financial Regulation and Deregulation, by A.
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European Economic Integration and the Franc Zone: The Future of the CFA Franc After 1996. Part I:
Historical Background and a New Evaluation of Monetary Cooperation in the CFA Countries, by
Allechi M’Bet and Madeleine Niamkey, Research Paper 19.
Revenue Productivity Implications of Tax Reform in Tanzania by Nehemiah E. Osoro, Research Paper 20.
The Informal and Semi-formal Sectors in Ethiopia: A Study of the Iqqub, Iddir and Savings and Credit
Cooperatives, by Dejene Aredo, Research Paper 21.
Inflationary Trends and Control in Ghana, by Nii K. Sowa and John K. Kwakye, Research Paper 22.
Macroeconomic Constraints and Medium-Term Growth in Kenya: A Three-Gap Analysis, by F.M.
Mwega, N. Njuguna and K. Olewe-Ochilo, Research Paper 23.
The Foreign Exchange Market and the Dutch Auction System in Ghana, by Cletus K. Dordunoo,
Research Paper 24.
Exchange Rate Depreciation and the Structure of Sectoral Prices in Nigeria under an Alternative Pricing
Regime, 1986–89, by Olu Ajakaiye and Ode Ojowu, Research Paper 25.
Exchange Rate Depreciation, Budget Deficit and Inflation–The Nigerian Experience, by F. Egwaikhide,
L. Chete and G. Falokun, Research Paper 26.
Trade, Payments Liberalization and Economic Performance in Ghana, by C.D. Jebuni, A.D. Oduro and
K.A. Tutu, Research Paper 27.
Constraints to the Development and Diversification of Non-Traditional Exports in Uganda, 1981–90, by
G. Ssemogerere and L.A. Kasekende, Research Paper 28.
AN EMPIRICAL ANALYSIS OF INTEREST RATE SPREAD IN KENYA 45

Indices of Effective Exchange Rates: A Comparative Study of Ethiopia, Kenya and the Sudan, by
Asmerom Kidane, Research Paper 29.
Monetary Harmonization in Southern Africa, by C. Chipeta and M.L.C. Mkandawire, Research Paper 30.
Tanzania’s Trade with PTA Countries: A Special Emphasis on Non-Traditional Products, by Flora
Mndeme Musonda, Research Paper 31.
Macroeconomic Adjustment, Trade and Growth: Policy Analysis Using a Macroeconomic Model of
Nigeria, by C. Soludo, Research Paper 32.
Ghana: The Burden of Debt Service Payment under Structural Adjustment, by Barfour Osei, Research
Paper 33.
Short-Run Macroeconomic Effects of Bank Lending Rates in Nigeria, 1987-91: A Computable General
Equilibrium Analysis, by D. Olu Ajakaiye, Research Paper 34.
Capital Flight and External Debt in Nigeria, by S. Ibi Ajayi, Research Paper 35.
Institutional Reforms and the Management of Exchange Rate Policy in Nigeria, by Kassey Odubogun,
Research Paper 36.
The Role of Exchange Rate and Monetary Policy in the Monetary Approach to the Balance of Payments:
Evidence from Malawi, by Exley B.D. Silumbu, Research Paper 37.
Tax Reforms in Tanzania: Motivations, Directions and Implications, by Nehemiah E. Osoro, Research
Paper 38.
Money Supply Mechanisms in Nigeria, 1970–88, by Oluremi Ogun and Adeola Adenikinju, Research
Paper 39.
Profiles and Determinants of Nigeria’s Balance of Payments: The Current Account Component, 1950–88,
by Joe U. Umo and Tayo Fakiyesi, Research Paper 40.
Empirical Studies of Nigeria’s Foreign Exchange Parallel Market I: Price Behaviour and Rate Determi-
nation, by Melvin D. Ayogu, Research Paper 41.
The Effects of Exchange Rate Policy on Cameroon’s Agricultural Competitiveness, by Aloysius Ajab
Amin, Research Paper 42.
Policy Consistency and Inflation in Ghana, by Nii Kwaku Sowa, Research Paper 43.
Fiscal Operations in a Depressed Economy: Nigeria, 1960-90, by Akpan H. Ekpo and John E. U.
Ndebbio, Research Paper 44.
Foreign Exchange Bureaus in the Economy of Ghana, by Kofi A. Osei, Research Paper 45.
The Balance of Payments as a Monetary Phenomenon: An Econometric Study of Zimbabwe’s Experience,
by Rogers Dhliwayo, Research Paper 46.
Taxation of Financial Assets and Capital Market Development in Nigeria, by
Eno L. Inanga and Chidozie Emenuga, Research Paper 47.
The Transmission of Savings to Investment in Nigeria, by Adedoyin Soyibo, Research Paper 48.
A Statistical Analysis of Foreign Exchange Rate Behaviour in Nigeria’s Auction, by Genevesi O. Ogiogio,
Research Paper 49.
The Behaviour of Income Velocity in Tanzania 1967–1994, by Michael O.A. Ndanshau, Research Paper
50.
Consequences and Limitations of Recent Fiscal Policy in Côte d’Ivoire, by Kouassy Oussou and Bohoun
Bouabre, Research Paper 51.
Effects of Inflation on Ivorian Fiscal Variables: An Econometric Investigation, by Eugene Kouassi,
Research Paper 52.
European Economic Integration and the Franc Zone: The Future of the CFA Franc after 1999, Part II,
by Allechi M’Bet and Niamkey A. Madeleine, Research Paper 53.
Exchange Rate Policy and Economic Reform in Ethiopia, by Asmerom Kidane, Research Paper 54.
The Nigerian Foreign Exchange Market: Possibilities for Convergence in Exchange Rates, by P. Kassey
Garba, Research Paper 55.
Mobilizing Domestic Resources for Economic Development in Nigeria: The Role of the Capital Market,
by Fidelis O. Ogwumike and Davidson A. Omole, Research Paper 56.
Policy Modelling in Agriculture: Testing the Response of Agriculture to Adjustment Policies in Nigeria,
by Mike Kwanashie, Abdul-Ganiyu Garba and Isaac Ajilima, Research Paper 57.
Price and Exchange Rate Dynamics in Kenya: An Empirical Investigation (1970–1993), by Njuguna S.
Ndung’u, Research Paper 58.
46 RESEARCH PAPER 106

Exchange Rate Policy and Inflation: The Case of Uganda, by Barbara Mbire, Research Paper 59.
Institutional, Traditional and Asset Pricing Characteristics of African Emerging Capital Markets, by Ino
L. Inanga and Chidozie Emenuga, Research Paper 60.
Foreign Aid and Economic Performance in Tanzania, by Timothy S. Nyoni, Research Paper 61.
Public Spending, Taxation and Deficits: What Is the Tanzanian Evidence? by Nehemiah Osoro, Research
Paper 62.
Adjustment Programmes and Agricultural Incentives in Sudan: A Comparative Study, by Nasredin A. Hag
Elamin and Elsheikh M. El Mak, Research Paper 63.
Intra-industry Trade between Members of the PTA/COMESA Regional Trading Arrangement, by Flora
Mndeme Musonda, Research Paper 64.
Fiscal Operations, Money Supply and Inflation in Tanzania, by A.A.L. Kilindo, Research Paper 65.
Growth and Foreign Debt: The Ugandan Experience, by Barbara Mbire, Research Paper 66.
Productivity of the Nigerian Tax System: 1970–1990, by Ademola Ariyo, Research Paper 67.
Potentials for Diversifying Nigeria's Non-oil Exports to Non-Traditional Markets, by A. Osuntogun, C.C.
Edordu and B.O. Oramah, Research Paper 68.
Empirical Studies of Nigeria’s Foreign Exchange Parallel Market II: Speculative Efficiency and Noisy
Trading, by Melvin Ayogu, Research Paper 69.
Effects of Budget Deficits on the Current Account Balance in Nigeria: A Simulation Exercise, by Festus
O. Egwaikhide, Research Paper 70.
Bank Performance and Supervision in Nigeria: Analysing the Transition to a Deregulated Economy, by
O.O. Sobodu and P.O. Akiode, Research Paper 71.
Financial Sector Reforms and Interest Rate Liberalization: The Kenya Experience by R.W. Ngugi and
J.W. Kabubo, Research Paper 72.
Local Government Fiscal Operations in Nigeria, by Akpan H. Ekpo and John E.U. Ndebbio, Research
Paper 73.
Tax Reform and Revenue Productivity in Ghana, by Newman Kwadwo Kusi, Research Paper 74.
Fiscal and Monetary Burden of Tanzania’s Corporate Bodies: The Case of Public Enterprises, by H.P.B.
Moshi, Research Paper 75.
Analysis of Factors Affecting the Development of an Emerging Capital Market: The Case of the Ghana
Stock Market, by Kofi A. Osei, Research Paper 76.
Ghana: Monetary Targeting and Economic Development, by Cletus K. Dordunoo and Alex Donkor,
Research Paper 77.
The Nigerian Economy: Response of Agriculture to Adjustment Policies, by Mike Kwanashie, Isaac
Ajilima and Abdul-Ganiyu Garba, Research Paper 78.
Agricultural Credit Under Economic Liberalization and Islamization in Sudan, by Adam B. Elhiraika and
Sayed A. Ahmed, Research Paper 79.
Study of Data Collection Procedures, by Ademola Ariyo and Adebisi Adeniran, Research Paper 80.
Tax Reform and Tax Yield in Malawi, by C. Chipeta, Research Paper 81.
Real Exchange Rate Movements and Export Growth: Nigeria, 1960–1990, by Oluremi Ogun, Research
Paper 82.
Macroeconomic Implications of Demographic Changes in Kenya, by Gabriel N. Kirori and Jamshed Ali,
Research Paper 83.
An Empirical Evaluation of Trade Potential in the Economic Community of West African States, by E.
Olawale Ogunkola, Research Paper 84.
Cameroon's Fiscal Policy and Economic Growth, by Aloysius Ajab Amin, Research Paper 85.
Economic Liberalization and Privatization of Agricultural Marketing and Input Supply in Tanzania: A
Case Study of Cashewnuts, byNgila Mwase, Research Paper 86.
Price, Exchange Rate Volatility and Nigeria’s Agricultural Trade Flows: A Dynamic Analysis, by A.A.
Adubi and F. Okunmadewa, Research Paper 87.
The Impact of Interest Rate Liberalization on the Corporate Financing Strategies of Quoted Companies
in Nigeria, by Davidson A. Omole and Gabriel O. Falokun, Research Paper 88.
The Impact of Government Policy on Macroeconomic Variables, by H.P.B. Moshi and A.A.L. Kilindo,
Research Paper 89.
AN EMPIRICAL ANALYSIS OF INTEREST RATE SPREAD IN KENYA 47

External Debt and Economic Growth in Sub-Saharan African Countries: An Econometric Study, by
Milton A. Iyoha, Research Paper 90.
Determinants of Imports in Nigeria: A Dynamic Specification, by Festus O. Egwaikhide, Research Paper
91.
Macroeconomic Effects of VAT in Nigeria: A Computable General Equilibrium Analysis, by Prof. D. Olu
Ajakaiye, Research Paper 92.
Exchange Rate Policy and Price Determination in Botswana, by Jacob K. Atta, Keith R. Jefferis, Ita
Mannathoko and Pelani Siwawa-Ndai, Research Paper 93.
Monetary and Exchange Rate Policy in Kenya, by Njuguna S. Ndung'u, Research Paper 94.
Health Seeking Behaviour in the Reform Process for Rural Households: The Case of Mwea Division,
Kirinyaga District, Kenya, by Rose Ngugi, Research Paper 95.
Trade Liberalization and Economic Performance of Cameroon and Gabon, by Ernest Bamou, Research
Paper 97.
Quality Jobs or Mass Employment, by Kwabia Boateng, Research Paper 98.
Real Exchange Rate Price and Agricultural Supply Response in Ethiopia: The Case of Perennial Crops,
by Asmerom Kidane, Research Paper 99.
Determinants of Private Investment Behaviour in Ghana, by Yaw Asante, Research Paper 100.
An Analysis of the Implementation and Stability of Nigerian Agricultural Policies, 1970–1993, by P.
Kassey Garba, Research Paper 101.
Poverty, Growth and Inequality in Nigeria: A Case Study, by Ben E. Aigbokhan, Research Paper 102.
The Effect of Export Earnings Fluctuations on Capital Formation in Nigeria, by Godwin Akpokodje,
Research Paper 103.
Nigeria: Towards an Optimal Macroeconomic Management of Public Capital, by Melvin D. Ayogu,
Research Paper 104.
International Stock Market Linkages in Southern Africa, by K.R. Jefferis, C.C. Okeahalam, and T.T.
Matome, Research Paper 105.
© 2001, African Economic Research Consortium.

Published by: The African Economic Research Consortium

P.O. Box 62882
Nairobi, Kenya

Printed by: The Regal Press Kenya, Ltd.

P.O. Box 46116
Nairobi, Kenya

ISBN 9966-944-39-7
Contents
List of tables
List of figures
Abstract

1. Introduction 1

2. Financial sector development 3

3. Literature review 14

4. Modelling interest rate spread 19

5. Data 27

6. Empirical results 30

7. Conclusions 33

Notes 35
References 38
Appendixes 40
List of tables

1. Trends in interest rates, monetary aggregates and

macroeconomic variables 4
2. Minimum capital requirements for financial institutions
(Ksh millions) 8
3. Conversion of NBFIs to commercial banks 11
4. Institutions liquidated, debt collected and deposits paid
by deposit protection fund (DPF) 12
5. Performance of the banking sector (%) 13
6. Regression results for the lending rate and deposit rate models 27
7. Summary statistics 28
8. Unit root and cointegration results 31
9. Preferred model 32

List of figures

1. Trends in deposit rate, lending rate, spread and treasury bill rate 29
2. Interest rate spread, average liquidity, minimum liquidity,
cash ratio and inter-bank rate 29
Abstract

Financial reform predicts achievement of efficiency in the intermediation process and

reduced transaction costs, which is proxied by a narrowing wedge between the lending
and deposit rates. Kenya’s experience shows a rise in interest rate spread during the
financial reform and subsequent financial liberalization process, which suggests the failure
to meet the prerequisites for successful financial liberalization. Interest rates were
liberalized amidst inflationary pressure, declining economic growth, financial instability,
the failure to sustain fiscal discipline and lack of proper sequencing of the shift to use
monetary policy tools. At the micro level, our results show that when the profit margin is
threatened, banks sustain a widening spread. Faced with a rising credit risk due to distress
borrowing and poor macroeconomic conditions, banks charge a higher risk premium on
their lending rate. The accumulation of non-performing loans results from a weak legal
system and a poor business environment that squeezes the profit margin, and banks respond
by increasing the lending rate. Policy actions also affect the spread. An asymmetric
response is indicated with the treasury bill rate where lending rates increase with the
treasury bill rate, and become sticky downward when the treasury bill rate declines.
Further, increased implicit costs that accompany tight monetary policy sustain a widening
spread even when inflationary pressure is reduced. Thus a widening interest rate spread
indicates inefficiency in the intermediation process and rising costs of intermediation.