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An analysis of interest rate spread in Nepalese commercial bank

A Research Project Proposal

Submitted to:
School Of Business
Pokhara University


In partial requirement for the degree of
Masters of Business Administration





By:
Uday Kumar Sharma
Roll no: 01/2009



21
th
June, 2011





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CHAPTER I: INTRODUCTION
1.1 BACKGROUND OF STUDY
In any country, economic development hinges critically on patterns and levels of
resource mobilization and allocation. Resources are mobilized through savings,
which, at the level of the macro-economy, pave the way for the allocation of resources
for consumption and investment (Afzal & Nawazish, 2010).

Efficient financial intermediation is an important factor in economic development
process as it has implication for effective mobilization of investible resources.
Consequently, banking sector efficiency plays significant role in an economy
(Folawewo & Tennant, 2008). Major indicator of bank efficiency is interest rate
spread and the difference between lending and deposit interest rates, known as the
interest rate spread (IRS). A high IRS acts as an impediment to the expansion of
financial intermediation necessary for growth and development of an economy. It is
often argued that the higher the IRS, the higher would be the cost of credit to the
borrowers for any given deposit rate. Alternatively, a high IRS could mean unusually
low deposit rates discouraging savings and limiting resources available to finance
bank credit (Mujeri & Younus, 2009).

Nepals controlled interest rate regime was completely abolished on August 31, 1989.
Banks and financial institutions were now given full autonomy to determine their
interest rates on deposits and lending. Although the NRB has given the autonomy to
determine the interest rate, the Bank has been forced to intermittently issue directives
in regard to anomalies in the interest rate determination as there has existed a high
interest rate spread between deposit and lending rates. Therefore, the objective of
interest rate deregulation to lower the financial intermediation cost was not met. The
promulgation of Nepal Rastra Bank Act 2002 attempted to address development in the
financial market. But, the continuing high level of interest rate spread suggested that
greater financial sector development (FD) had not brought efficiency in the financial
system. To address this, NRB attempted to maintain the interest rate spread of
commercial banks at a desired level through using moral suasion only. Additionally,
in the spirit of interest rate deregulation, the provision of interest rate spread of 5.5%
was withdrawn by the NRB in 2003. Since then no such direct or indirect restriction is

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implied as far as determination of interest rate is concerned, although NRB has shown
intermittent concern regarding interest rates.

Since there are no restrictions on lending and deposit rates so banks will invariably
extend credit at high rates for the sake of profit maximization and pay lower returns
on their deposits, hence earning higher spreads. Moreover, if there is a concentration
in banking activities among a few banks, this may lead to an exercise of market power
in order to earn higher margins. Higher margins might also reflect high intermediation
costs and managerial inefficiencies. This acts as a disincentive to both saving and
investment and implies that the banking system is inefficient in performing its role of
effective resource allocation.

Financial systems in most developing and underdeveloped countries are subject to
structural, informational, and institutional inefficiencies that ultimately lead to high
margins between commercial banks lending and borrowing rates. These high spreads
emanate from elevated and volatile lending rates and lead to a higher cost of capital
for borrowers, consequently reducing investments or promoting only short-term high-
risk ventures. The impact of relatively higher banking spreads can be devastating for
businesses with less financial flexibility, especially small and medium enterprises.
Finally, sustained high spreads is a vital indicator of the poor performance of a
financial system and inter alia the inadequacy of banking regulations, and can
ultimately retard economic growth (Afzal & Nawazish, 2010).
To measure the desirable state of efficiency of Nepals banking system, it is critical to
study spreads and net interest margins as they are often used as proxy variables for
measuring the intermediary efficiency of commercial banks

1.2 STATEMENT OF PROBLEM
The banking system, which has major contribution on the financial system in Nepal,
makes the banking system more important. In such a system efficiency of banks is
more important. As banks operate more efficiently, cost will be lowered and funds
will be allocated more efficiently, since more and more lenders and borrowers will
participate. As a result, there will be improvement in the societys welfare. Banks
interest margin or spread can play an important role to lower the social cost of

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financial intermediation and encourage lenders and borrowers contribution to the
financial system (Eralp). It is a long debate between borrowers and bankers that the
margin is to high, and this discourages borrowers to borrow from the banks. The
interest rate is a key variable in the financial system. The interest rate spread, which is
also related to the degree of efficiency of the financial sector, is an offshoot of a
competitive environment. Similarly there are also arguments that high interest rate
spread (IRS) is one of the major factors behind poor economic growth and
development. The interest rate margin provides profit for a bank to continue to remain
in the business. IRS as a measure of bank efficiency and determinant of
intermediation cost and profitability of the banks, thus it is important issue to notify
the determinants of interest rate spread in Nepalese commercial banking system. Thus
this study tries to solve following problems.

1. To what extent bank controlled variable affect the interest rate spread and
margin of commercial bank?
2. How do key macroeconomic variables influence commercial banks spread in
Nepal?

1.3 FOCUS OF THE STUDY
Most of the financial institutions in Nepal are profit motivated. These organizations
survive who can make profit in the long- run. The profit for these organizations is the
interest spread between sources and uses of funds. The focus of this study is to
examine the influencing factors of interest rate spread and net interest margin in
Nepalese commercial banks taking 17 commercial banks as sample. Interest rate is
believed as one of the most important factors for the development of financial
institutions and financial system as a whole. This study also attempts to analyze the
interest rate spread and its relationship with bank specific as well as macroeconomic
variables. Since interest rate is the main subject of study. Here impact of interest on
core banking business has been focused.
1.4 OBJECTIVES OF THE STUDY
We know that interest rate is important in financial market in collecting the funds and
lending the loans, so determination of interest rate is also important function of
financial market. This study tries to fulfill following objective:

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

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

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CHAPTER II: LITERATURE REVIEWS
There is an exhaustive body of literature on the determinants of banking spreads both in
developed and developing economies. Since Nepal is a developing economy, we will focus
mainly on literature from similar countries. Here is some reviews of different article and paper
investigated in similar topic by different investigator.

Maudos and Solis (2009) have investigated the determinants of net interest income in the
Mexican banking sector for the period 1993 to 2005. Their sample consists of 43 commercial
banks with 289 annual observations of unbalanced panel data. They observe high interest
margins approximately 5% for Mexico vis--vis international standards. They consider various
explanatory factors to explain the behavior of banking spreads, including operating costs,
volatility of interest rates, implicit interest payments, quality of management, noninterest
income, credit risk, degree of risk aversion, market risk, transaction size, liquidity, cost to gross
income, GDP growth, and inflation rate. The reported results reflect that, except for liquidity, all
other variables are significantly related to interest rate spreads. They conclude that high Mexican
spreads are a function mainly of average operating costs and market power while noninterest
income, despite having increased over the years, has a low economic impact.

Folawewo and tennant (2008) have investigated the determinants of spreads between banks
deposit and lending rates in Sub-Saharan African (SSA) countries from market and
macroeconomic view points, using a dynamic panel data estimation technique for period of 1988
to 2005. Using annual data covering 33 countries, the results obtained from the paper suggest
that different market and macroeconomic policy variables play significant role in explaining
variations in IRS in the region. Among others, the paper show that the extent of government
crowding out in the banking sector, public sector deficits, discount rate, inflationary level, level
money supply, reserve requirement, level economic development, and population size are
important determinants of interest rate spreads in SSA countries.


Afanasieff, Lhacer and Nakane (2005) have investigated the determinants of Bank Interest
Spread in Brazil Using a panel data of 142 Brazilian banks for the February 1997-November
2000 period, the two-step approach due to Ho and Saunders (1981) is advanced by Ho and

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Saunders (1981) to uncover the influence of bank characteristic variables: a) number of
employees; b) the ratio of non-interest bearing deposits to total operational assets; c) the ratio of
interest bearing funds to total earning assets; d) operating costs; e) bank liquidity; f) the ratio of
service revenues to total operational revenues; g) the bank net worth; and h) bank leverage as
well as macroeconomic influences as the main explanatory factors of the bank spread in the
country. The vector of macroeconomic variables contains the estimated volatility of the market
interest rate, the inflation rate, and the output growth rate. The result shows that large banks
charge higher interest spreads. The ratio of non-interest bearing deposits to total operational
assets (nibd) affects positively the interest spread. The ratio of interest-bearing funds to earning
assets (ibf) is negative in equation (5). Operating costs (opc) act to increase the bank interest
margin. The expected negative sign for liquidity (liquid), however, is not confirmed. The ratio of
service revenues to operational revenues (servr) is found to have a positive impact on the interest
spread. The coefficient on bank net worth (netw) is negative, as expected. An increase in bank
leverage (lever) is associated with higher interest margins due, probably, to higher solvency risk.
These results suggest that microeconomic do not seem to be a major determinant of interest
spreads in Brazil.

Afzal and Mirza (2010) have analyzed the determinants of interest rate spreads and margins in
Pakistans commercial banking sector in the post-transition period (20042009), using an
exhaustive set of macro- and firm-level variables to analyze their impact on intermediary
efficiency. The result shows that there is strong evidence that bank size explains interest rate
spreads. Similarly, operational efficiency, asset quality, liquidity, risk absorption capacity and
GDP growth are found to be important determinants of banking spreads. There is negative
relationship between deposit market share and spread. Similarly the negative relationship
between spreads and loans per employee and the positive relationship with performing loans per
employee clearly indicates that employee efficiency would count if asset quality were
maintained. There is evidence of deposit market share and deposit market concentration,
establishing the presence of an interest-sensitive deposit market. The paper suggests that there is
no evidence found to support the impact of interest rate volatility and financial development
indicators on banking spreads.


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CHAPTER III: RESEARCH METHODOLOGY
3.1 INTRODUCTION
Research methodology is a systematic way to solve the research problem. In other words,
research methodology describes the methods and process applied in the entire aspect of the
study. Research methodology refers to the various sequential steps ( along with a rational
of each step) to be adopted by a researcher in studying a problem with certain objectives in
view. Thus the overall approach to the research is presented in this chapter.
This chapter consists of research design, sample size and selection process, data collection
procedure and data processing techniques and tools.
3.2 RESEARCH DESIGN
A research design is the specification of methods and procedures for acquiring the
information needed. It is the overall operational pattern of framework for the project that
stipulates what information is to be collected from which sources and by what procedures.
The research design followed for this study is both inferential and descriptive. To analyze the
interest rate and spread historical data is analysed.
3.3 POPULATION AND SAMPLE
Since the research topic is about interest rate, all the Commercial Banks of Nepal are the
population of the study. The population for the study comprises 31 commercial banks. Out of
them 17 commercial banks are taken as sample on the base on given sampling criteria to draw
the conclusion about population.
All Banks should established before 2005
The sample data from 2005-06 to 2009/10 (five years).
Data on balance sheets and income statements should be available.




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3.4 SOURCES AND NATURE OF DATA
This study mainly based on secondary data. To show the relation between variables involved
secondary data are used. The sources of secondary data have been collected from published
annual reports, published bulletins and prospects of concerned organizations, various
publications of Nepal Rastra Bank, various thesis and various papers, journals, magazines
and websites.
3.5 DATA COLLECTION PROCEDURE/ TECHNIQUE
Secondary data on annual reports of concerning organizations, interest rate structure of such
organizations and introductory profiles of the institutions are collected by visiting the
respective organizations and from their web sites. Some secondary data of sample
organizations and Nepal Rastra Bank s regulation upon them are collected from the NRB
websites as well as visiting NRB office when required.
3.6 DATA PROCESSING AND PRESENTATION
Data collected for the study are presented in various forms. Most of the secondary data are
presented in tabular form and some graphical presentation is also used. Since the primary
data collected are more subjective they are presented in tables and graphs and conclusions have
been drawn. So far as the computation is concerned; it has been done with the help of scientific
calculator and computer software Programme.
3.7 DATA ANALYSIS TOOLS
The basic descriptive statistics like Mean, Standard Deviation, Coefficient of variation,
Coefficient of Correlation, Co-efficient of multiple determinations and t-test will be used to
analyze the data collected for this study. Further financial tools like Ratio analysis will be used to
analyze the proportion between several factors.



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Econometric model
The empirical test is concerned with the determinants of interest rate spread and interest rate
margin of Nepalese commercial bank. We use bank specific variable and macro-economic
variable as an independent variable to run regression over interest rate spread and NIM. The
econometric model for regression is

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


Where IRSit is interest rate spread for bank i at time t. Five bank specific variable and two
macro-economic variable has been taken as independent variable: TA represent total assets,
NII/TA represent non-interest income over total assets. ROA represent return on assets. OH/TA
represents overhead cost over total assets. TC/TA represents Total cost over total assets. NPL/TL
represent non-performing loan over total loan. CAR represent capital adequacy ratio. I represent
inflation whereas gGDP is indicator of GDP growth rate.
Further ues alternative definition of Spread for robustness and run a regression of same
independent variable on Net Interest Margin.

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

Where, NIM is net interest margin for bank i at time t.







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References
Afzal, A., & Nawazish, M. (2010). The Determinants of Interest Rate Spreads in Pakistan's
Commercial Banking sector. CREBWorking Paper No. 01-10 .
Eralp, B. (n.d.). Determinants of Net Interest Margin and Spread in north Cyprus Bank Market:
The Preliminary Findings.
Folawewo, A. O., & Tennant, D. (2008). DETERMINANTS OF INTEREST RATE SPREADS IN
SUB-SAHARAN AFRICAN COUNTRIES: A DYNAMIC PANEL ANALYSIS.
Mujeri, M. K., & Younus, S. (2009). An Analysis of Interest Rate Spread in the Banking Sector
in Bangladesh. The Bangladesh Development Studies .
Maskay, N. M. & Pandit, R. (2009).NRB Working Paper: Interest Rate Pass- through in Nepal,
NRB Research department (S. n. NRB/WP/5)
Maudos, J. & Solis, L. (2009). The determinants of net interest income in the Mexican banking
system: an integrated model

Shrestha M.K. & Bhandari D.B.(2008). Financial Markets & Institutions. Kathmandu: Asmita
Books Publishers and Distributors.
Wolf, K.H. & Pant, P.R. (2005). A Hand Book for Social Science Research and Thesis
Writing. Kathmandu: Buddha Academy.
Website: www.nrb.org.np