Determinants of Interest Rates Spreads in Ghana

Introduction

After Ghana's independence – up until the early part of the 1980s – interest rates and prices of a number of commodities were largely independent of market forces (Mensah and Abor, 2012). This was because of government interference in the banking sector; to the extent that, government dictated how much interest rates banks should charge for their loan offerings, thus indirectly eliminating competition and dictating the degree to which banks can become efficient, effective and or even profitable.

Furthermore, government heavily borrowed from the banks. Making matters worse, most of these funds were usually directed towards projects that were deemed more politically expedient than really profitable (Mensah and Abor, 2012). Consequently, the banks became riddled with a lot of bad debts since government couldn’t pay back its loans. This situation adversely affected the Ghanaian economy, with the financial sector being possibly the worse off.  It was therefore no surprise to observe the Ghanaian financial system lacking ability to provide financial services at low cost (Owusu-antwi, 2009), thus triggering the need for reforms in the financial sector during the 1980s and early 1990s.This eventually led to the initiation of two economic programmes by the World Bank in conjunction with the government of Ghana in the country - (1) Economic Recovery Programme (ERP); and the (2) Structural Adjustment Programme (SAP). Under the Economic Recovery Programme (ERP) and the Structural Adjustment Programme (SAP), controls on interest rates were lifted whilst all forms of directed credit was done away with. In a nut shell, governmental control of interest rates may have been one of the major factors if not the major factor of the economic woes of the 1980s.

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In 1987, interest rates became liberalized, thus it was allowed to partially float (Alexander et al., 1995). This was made possible by the abolition of maximum lending rates and minimum deposit rates. Three years later, controls on bank charges and fees were also removed setting the stage for stiff competition within the banking sector. The banking sector was given a further lift when the main instrument of monetary control during ERP which was bank specific credit ceilings was abolished in 1992 and swapped for another (Alexander et al., 1995; Owusu-antwi, 2009). The substitute instrument for money control was indirect and market based and it entailed the weekly auctioning of both 91-Day and 182-Day Treasury Bills and other government and BOG securities, backed up with statutory cash reserve and liquid asset requirements (Alexander et al., 1995). As a result of these series of measures, banks were no longer subject to constraints on how deposits and loans are priced and into which particular sectors of the economy loans are directed. It was not until 2003 that the banking system became fully deregulated with the introduction of the universal banking regime.

In Ghana, as in most countries, regulation rather than competition has defined the structure and range of financial products and services a bank can offer, the types of assets and liabilities it can hold and issue as different kinds of banking institutions licensed to serve a diverse clientele base (Bawumia, Belnye, & Ofori, 2005). There are currently thin lines of difference among them as the products and services rendered by the different bank types have converged over time and emerging non-bank financial institutions now compete with the banks in terms of the provision of similar kind of financial instruments and services. Bank deposits, for example, compete now with other liabilities of financial intermediaries, such as mutual funds. This phenomenon seems to justify the commencement of universal banking in Ghana, whereby banks originally licensed as merchant or development banks can now be issued universal banking licenses with higher paid-up capital. This move was to eliminate the economic costs of maintaining regulatory barriers, which had risen although the barriers had become less effective. The universal banking concept is not only aimed at eliminating the differences due to similarity in bank products/services rendered but also restrictions on branch network of different bank types, as banks become “universal”.

The Ghanaian banking industry is steadily nearing its “carrying capacity.” At present, there are 27 universal banks, 137 rural and community banks, and 58 non-banking financial institutions including finance houses, savings and loans, leasing and mortgage firms in the banking market (PriceWaterCooper, 2014), all jostling for the same customers.

The success or otherwise of any financial system hinges so much on the amount of interest rate banks charge their customers.Interest rate determines the overall financial health of a country, and tends to affect inflation, exchange rate and depreciation. No economy has a single interest rate. In Ghana, for example, the commonly reported interest rates are Bank of Ghana (BoG)' s Policy rate, the Treasury Bill rates, the rates on Bank of Ghana bills, the inter-bank rate, and lending and deposit rates by banks. These rates tend to fluctuate in a similar fashion (Mensah & Abor, 2012).

Banks are major players in the growth and development of any country’s economy. For instance, the financial sector’s contribution to GDP grew from 4.5 % in 2002 to 6.3 % in 2007 (Owusu-antwi, 2009). One of the ways they influence the economy is through financial intermediation; they channel funds from surplus to deficit actors (Njuguna et al., 2000). Financial intermediation is not without its risks as funds loaned out to business people and organizations may eventually become bad debts making the bank incur a loss as a result; hence, the need for interest rate spread – a vital component of lending rates. The interest rate spread is essentially a bank’s reward/profit for bearing the risk associated with given out depositors’ funds to a loan applicant for investment into his/her business for a certain period of time. It must be noted that the borrower does not only pay for the interest rate spread but also for the deposit rate, together termed lending rate.

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In simple terms, lending rates are basically a function of both deposit rates and interest rate spread. The deposit rate is the interest rate paid on savings of depositors, whereas the interest rate spread is the difference between the lending rate and the deposit rate. The more effective and efficient a bank is, the narrower the spread between lending and deposit rates. Unfortunately in Ghana, high net interest rate spreads is becoming the order of the day in the banking sector, as Ghana has been noted overtime as one of the countries with persistently highest interest rate spreads globally (Aboagye et. al, 2008; Bawumia et al, 2005; Buchs and Mathisen, 2005; Gockel and Mensah, 2006;Owusu-antwi, 2009; Kwashie & Kyereboah-coleman, 2013), suggesting the possibility of high cost inefficiencies in the financial sector. This thus beg the question of what exactly are the factors determining interest rate spreads in the country, considering the fact that the Ghanaian banking industry has been deregulated.

These implications of banking sector inefficiency have triggered several debates in developing countries about the determinants of banking sector interest rate spreads. Studies have shown that there is a general view amongst some stakeholders that high interest rate spreads are caused by the internal characteristics of the banks themselves, such as their tendency to maximize profits, while many others argue that the spreads are imposed by the macroeconomic, regulatory and institutional environment in which banks operate. These debates can only be resolved through an objective and quantitative analysis of the determinants of the banking sector interest rate spreads in Ghana.

Available data from literature on determinants of interest rate spreads can therefore be grouped into three categories: bank-specific, bank-industry or market structure and macroeconomic factors (Ngugi, 2001; Chirwa and Mlachila, 2002). Both bank-specific and bank-industry factors constitute microeconomic variables.

Bank-Specific Determinants of Interest Rate spreads

Firstly, bank-specific determinants of interest rate spreads are those factors intrinsic to banks and these may range from non-performing loans (NPLs), excess liquidity, overhead costs, market share to ownership of banks, credit risk, liquidity risk, returns on assets, noninterest income, operating cost, management quality (Rusuhuzwa, Karangwa, & Nyalihama, 2016; Asmare, 2014). Findings from a study carried out to assess the impact of bank ownership type on interest rate spreads of banks in developing countries revealed that foreign owned banks tended to have larger interest rate spreads when compared to locally owned banks (Demirgüc-Kuntand & Huizinga, 1998), an indication that ownership type plays a role in determining interest rate spreads. Elsewhere, foreign ownership was found to be insignificant in determining interest rate spreads in fourteen South American countries (Gelos, 2006). In Belize, market share and NPLs have been implicated as core determinants of interest rate spreads (Perez, 2011).  Furthermore, excess liquidity has been found to be responsible for increasing interest rate spread in Belize (Perez, 2011).

The foregoing data clearly suggest that determinants of interest rate spreads may vary from country to country and even from region to region (Gelos, 2006); thus buttressing the need to pin-point the exact determinants of interest rate spreads in a country like Ghana. Research has also shown that high interest rate spreads in the Kenyan financial sectors is due in part to the market shares of the different banks. Operating expenses and credit risk have been linked to widening interest rate spreads in Kenya (Rebei, 2014).

Industry-Specific Determinants of Interest Rate Spreads

Secondly, industry-specific factors affecting interest rates spreads include competition, bank concentration and reserve requirement (Asmare, 2014). Herfindahl–Hirschman index (HHI) is used as proxy for industry concentration. The higher the HHI, the greater the level of market power in the hands of a few banks. With such market power in the hands of a few banks, there is the probability of these players colluding to 'fix' interest rates spreads, thereby leading to lowered competition in the banking sector (Afzal, 2011; Ahokpossi, 2013).   

Macroeconomic Determinants of Interest Rate Spreads

Macroeconomic factors play a pivotal role in determining the interest rates spreads amongst the commercial banks. Inflation and GDP growth rate are some macroeconomic factors that affect the setting of interest rates by banks (Mbao, Kapembwa, Mooka, Rasmussen, & Sichalwe, 2014). Inflation as a macroeconomic factor is crucial in interest rates spreads determination. Banks are usually very responsive in incorporating changes in inflation to their lending rates as opposed to deposit rates (Mensah & Abor, 2012). In Ghana, it's been observed that positive linkages exist between inflation rates and net interest margins, an indication that improvements in the macroeconomic environment with regards to lower inflation rates is an important prerequisite of lower net interest margins (Aboagye et al., 2005; Bawumia et al., 2005).

Furthermore, a number of studies have been conducted showing that inflation is a key determinant of interest rates spreads (Chirwa and Mlachila, 2004; Beck and Hesse, 2009). A study by Beck and Hesse (2009) reported the incidence of higher interest rates spreads in Ugandan banks in response to inflation rates rise. This is confirmed by the work of Chirwa and Mlachila (2004) in Malawian banks.

Interest Rate Spreads in Ghana

Bawumia, Belnye, & Ofori (2005) concede that market concentration in Ghana is a major problem and greatly hinders efficiency in the financial sector. They also observed that high market concentration dampens competition. Attempting to unearth the determinants of interest rate spreads in the country; they found that market share appeared to be probably the most important variable in accounting for the variability in interest rate spreads in Ghana. This perhaps is why there is minimal or non-existent price competition in the banking space. High operating costs, non-performing loans and the existence of liquidity reserves were also observed to be significant in explaining wide interest rate spreads. It must be noted however, that the effect of non-performing loans and the liquidity reserve was found to be not as significant as operating costs and market share.

Elsewhere, Mensah & Abor (2012) reported that asset size, degree of concentration in the banking industry, level of capital held by banks, reserve requirement and the level of inflation were key to determining interest rate spreads in Ghana.

Problem Statement

Despite general consensus amongst economists that when a country liberalizes its financial system, economic growth and development can be assured and that there will be an upsurge of loanable funds into banks by virtue of real interest rate (Bawumia et al., 2005). However, after many years down the line in post-liberalization Ghana, interest rate spreads continue to spin out of control, making cost of access to finance either too expensive or burdensome for businesses. So what went wrong? Ghana has over the years been identified as one of the countries with the highest interest rate spreads in the world (Aboagye et. al, 2008; Bawumia et al, 2005; Buchs and Mathisen, 2005; Gockel and Mensah, 2006).

Despite the macroeconomic stability chalked by Ghana in recent times, public opinion hold that there is stunted growth in the private sector because businesses are ‘bleeding’ under the weight of excessive lending rates. It is important therefore to investigate the factors accounting for this rather unpleasant situation. Indeed, if Ghana is to attain a stable and efficient banking system, an investigation into the study of the determinants of interest rate spreads cannot be overlooked.

When the spread between lending and deposit interest rates is too large, it is generally regarded as a considerable impediment to the expansion and development of financial intermediation, as it discourages potential savers by virtue of low returns on deposits (Ndung'u and Ngugi, 2000) and limits financing for potential borrowers, thus reducing feasible investment opportunities and therefore the growth potential of the economy (Valverde et al, 2004). It is therefore imperative that studies be conducted to ascertain the factors accounting for the high interest rate spreads in the Ghanaian banking sector.

Objectives

The main objective of this study was to investigate the determinants of interest rate spreads within the banking sector of Ghana.

Key Findings

Bank lending rates in Ghana rose especially after 2009, despite the deregulation exercise. A lending rate low of 21.24 % was registered in 2008, with respect to the period 2006-2008. However, this rate was short-lived as it began to rise again.

Drawing upon the standardized beta coefficients though insignificant (p> 0.05), the following model can be put forward: IRS = 0.1Markt_Share + 0.326NPL – 0.061Comptn. From the equation, it can be deduced that as market share increases by a factor of 1, IRS will go up by a factor of 0.1; whereas in the case of non-performing loans, NPL, an increase in 1 point will trigger an increment of 0.326 points in the IRS. However, with regards to competition, when there is an increment of 1 point, IRS responds by a decline of -0.061.

The coefficient of determination, R-square was found to be a whopping 97.6 %, implying that the variables under consideration vis-à-vis monetary policy rate, exchange rate, inflation rate and GDP accounted for a massive 97.6 % of the variation in the interest rate spread and it was significant (F change > sigf. F change). This implied that post-deregulation period, the most important determinant of interest rate determination may likely be factors outside the control of the banks i.e. macroeconomic factors. This presents a rather unpleasant situation for the banks, because it makes planning difficult.

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Researcher: C.A.M.
This post was a thesis review.
 

References

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