IMPACT OF MACROECONOMIC

DETERMINANTS ON INTEREST RATE SPREAD

IN SRI LANKA

(Special Reference to Commercial Bank Sector)

By

S.M.Gunawardana

MF/2009/2356

Department of Accounting and Finance

February 2014

Dissertation Presented to the Faculty of Management and Finance

of University of Ruhuna

in Partial Fulfillment of the Requirements for the Degree of

Bachelor of Business Administration

 Acknowledgement

Firstly, I would like to convey my sincere gratitude to my research supervisor

Ms.T.A.N.R Jayarathne, Lecturer of the Department of Accounting and Finance,
University of Ruhuna. The guidance, enthusiasm and all support provided throughout
this endeavor is highly appreciated.

I would like to make my heartfelt gratitude to Dr.Manjula K.Wanniarachchige, Head,

Department of Accounting and Finance, University of Ruhuna, for his supervision,
educational support and good advice. He provides me with helpful comments which
results in developing a better and vital understand of the subject.

Finally, I express my heartfelt gratitude to my friends, parents and family members

who are behind me throughout my life as well for helping me for the successful
completion of everything of this study.

i
 Dedication

This Dissertation is dedication to my family members for their kindness, devotion and
endless support which gave me much more courage.

ii
 Table of content

Acknowledgement ...................................................................................................................... i
Dedication .................................................................................................................................. ii
Table of content ........................................................................................................................ iii
List of Tables .............................................................................................................................. v
List of Figures ............................................................................................................................ vi
List of Acronyms....................................................................................................................... vii
Declaration .............................................................................................................................. viii
Certification .............................................................................................................................. ix
Abstract ...................................................................................................................................... x
1 CHAPTER 01 ....................................................................................................................... 1
INTRODUCTION .......................................................................................................................... 1
1.1 Background of The Study ........................................................................................... 1
1.2 Banking Sector Structure in Sri Lanka ........................................................................ 1
1.3 Interest Rate Spread .................................................................................................. 2
1.4 Research Problem ...................................................................................................... 3
1.5 Research Question and Objectives ............................................................................ 4
1.6 Methodology.............................................................................................................. 4
1.7 Significance of The Study ........................................................................................... 5
1.8 Limitations of the study ............................................................................................. 6
1.9 Summary and Chapter Organization.......................................................................... 6
CHAPTER 02 ............................................................................................................................... 7
LITERATURE REVIEW .................................................................................................................. 7
2.1 Introduction ............................................................................................................... 7
2.2 What is Interest Rate Spread ..................................................................................... 7
2.3 Determinants of Macroeconomics ............................................................................ 8
2.4 Summary .................................................................................................................. 13
CHAPTER 03 ..................................................................................................................... 14
METHODOLOGY ....................................................................................................................... 14
2.5 Introduction ............................................................................................................. 14
2.6 3.2 Conceptual Framework .................................................................................. 14
2.7 Rationalization of the variables ............................................................................... 15
2.7.1 Dependent Variable ......................................................................................... 15

iii
 2.8 Development of Hypotheses ................................................................................... 18
2.9 Methodology............................................................................................................ 18
2.10 Data Analysis ............................................................................................................ 18
2.11 Summary .................................................................................................................. 19
CHAPTER 04 ..................................................................................................................... 20
DATA PRESENTATION AND ANALYSIS ...................................................................................... 20
3.1 Introduction ............................................................................................................. 20
3.2 Data Presentation .................................................................................................... 20
3.3 Data Analysis ............................................................................................................ 21
3.3.1 Descriptive Statistics ........................................................................................ 21
3.3.2 Variance Inflation Factor (VIF) ......................................................................... 23
3.3.3 Regression Analysis .......................................................................................... 24
3.4 Summary .................................................................................................................. 27
CHAPTER FIVE .................................................................................................................. 28
CONCLUSION AND RECOMMENDATIONS................................................................................ 28
4.1 Introduction ............................................................................................................. 28
4.2 Conclusion ................................................................................................................ 28
4.3 Recommendations ................................................................................................... 30
4.4 Suggestion for Future Researches ........................................................................... 31
REFERENCES ..................................................................................................................... 32
Annexure .......................................................................................................................... 34

iv
 List of Tables

Table 4.1 Descriptive Statistics……………………………………………22

Table 4.2 Collinearity Diagnostics…………………………………………23

Table 4.3 Results of the Equation I………………………………………..24

Table 5.1 Conclusion of Regression Result……………………………….29

v
 List of Figures

Figure 1.1 Conceptual Frame Work…………………………………………5

Figure 3.1 Conceptual Framework………………………………………….14

Figure 4.1 Interest Rate in Recent Past – Sri Lanka………………………...20

vi
 List of Acronyms

BR Bank Rate

CPI Consumer Price Index

EXR Exchange Rate

GDP Gross Domestic Production

GDPpc Per Capita Gross Domestic Production

INF Inflation Rate

IRS Interest Rate spread

LCB Licensed Commercial Bank

LSD Licensed Specialized Bank

NSD National Saving Directorate

SCALE Banking Sector Development

SRR Statutory Reserve Requirement

SSA Sub Saharan African

TBR Treasury Bill Rate

US United State

vii
 Declaration

I hereby declare that this dissertation is my own work and effort and that, to the best
of my knowledge and belief, it contains no material previously published or written
by another person nor material which has been accepted for the award of any other
degree or diploma of the university or other institute of higher learning, except where
due acknowledgment has been made in the text.

Signature of the student : _______________________________

Name of the student : S.M.Gunawardana________________

Registration number of the student: MF/2009/2356___________________

Date : 10th February 2014________________

viii
 Certification

This is to certify that this dissertation submitted by S.M.Gunawardana

(MF/2009/2356) in partial fulfillment of the requirement for the Degree of Bachelor
of Business Administration in Accounting at the Faculty of Management and Finance
of the University of Ruhuna is a record of the own work carried out by the student
under my supervision. This dissertation has been submitted with my approval.

____________________________

Supervisor

Ms.T.A.N.R. Jayarathne

Department of Accounting and Finance

Faculty of management and Finance

University of Ruhuna

____________________________

Head

Dr.Manjula K. Wanniarachchige

Department of Accounting and Finance

Faculty of management and Finance

University of Ruhuna

ix
 Abstract

This study gives emphasis on the macroeconomic determinants of Interest Rate

Spread in Sri Lanka commercial bank sector. Based on the literature, focus of this
study has been placed on five macroeconomic determinants of interest rate spreads in
the commercial banking sector. Accordingly the variables are inflation rate, Bank
Rate, Banking Sector Development, Exchange rate and Treasury bill rate. Study used
in the Central Bank of Sri Lanka annual data from 1983 to 2012 are analyzed by using
Regression model. Result of the study concluded that inflation rate, Bank Rate,
Banking Sector Development, and Exchange rate have significant relationship with
Interest Rate spread in Sri Lanka.

Key Words;CommercialBanking Sector, Interest Rate Spread, Macroeconomic

Determinants

x
 1 CHAPTER 01

INTRODUCTION

1.1 Background of The Study

Economic development of a country essentially depends on patterns and levels of

resource mobilization and allocation. Resources are mobilized through savings,
which, at the macroeconomic level, way for the allocation of resources for
consumption and investment. The banking system and the financial system more
generally, is a key pillar in any economy to reallocate funds from agents with a
surplus to those with a deficit.

Similarly, investment depends on banking credit and the primary lending

system, which enables investors to borrow for the purpose of investing in real capital
to enhance existing businesses or establishing new businesses. In this way, banking
credit contributes to the generation of economic activity and eventually leads to
higher national income and growth.
Therefore, all economic players, including households, businesses, and the
public sector, are sensitive to the efficient flow of resources from surplus to deficit
units. Analysis of resource transfer through the operations of the banking system,
therefore, has to contend with the price structure prevailing in the credit market. The
strong correlation of banking system stability with the economic growth and
development of a country has only recently been noted. Supervisory authorities
around the world are driven to ensure the safety and soundness of their respective
financial systems so that they can play an active role in the economic development of
their country.

1.2 Banking Sector Structure in Sri Lanka

According to Central bank of Sri Lanka the banking sector accounted for 56.4% of
financial system assets at end of 2012 and comprises Licensed Commercial Banks

1
(LCBs) and Licensed Specialized Banks (LSBs). The distinction between LCBs and
LSBs lies in the scope of activities they can undertake. LSBs are licensed to conduct
specialized banking business and are not authorized to accept demand deposits and
deal in foreign currency. At end of 2012, there were 33 licensed banks including 24
LCBs and 9 LSBs.

1.3 Interest Rate Spread

Sri Lanka as a developing country requires an efficient and energetic commercial

banking and financial systems that ensures efficient and effective functioning of
economy. A key indicator of financial performance and efficiency is the interest rate
spread (IRS). The difference between the rates at which banks lend money to
borrowers and the rates they are paying to depositors are generally known as the
interest rate spread.

According toInternational Monetary Fund, International Financial Statistics

and data files, Interest rate spread is the interest rate charged by banks on loans to
private sector customers minus the interest rate paid by commercial or similar banks
for demand, time, or savings deposits. The terms and conditions attached to these
rates differ by country, however, limiting their comparability.

IRS affects many macroeconomic variables. The study conduct in Bangladesh

(Mujeri and Younus, 2009) identifies several determinants of high IRS in the banking
sector in Bangladesh. The analysis shows that the statutory reserves requirements
(SRR) and the high National Savings Directorate (NSD) certificate rate contribute to
higher interest rate spreads in the banking sector in Bangladesh.

Thus, by undertaking the current research, the researcher is interested in

identifying the macroeconomic determinants of interest rate spread in Sri Lanka.
Based on data availability, focus has been placed on the industry and macroeconomic
determinants of interest rate spreads in the banking sector. Accordingly the variables
are, Inflation Rate (the annual percentage change in the CPI), Bank Rate (the rate at
which the Central Bank grants advances to Commercial Banks for their temporary
liquidity purposes), Banking Sector Development (ratio of commercial bank assets to

2
GDP), Exchange rate (Annual percentage change of US dollar exchange rate), and
Treasury Bill rate (interest rate of 3 months treasury bills).

1.4 Research Problem

IRS is an important indicator on level of efficiency of a banking system and it reflects

profit maximizing ability of the financial intermediaries. Interest rate spread (IRS) is
the difference between interest rate charged by banks on loans to prime customers and
the interest rate paid by commercial or similar banks for demand, time, or savings
deposits. It plays major role in economic growth by determining saving and
investment. Interest rate spreads indicate how efficiently banks perform their
intermediation role of savings mobilization and allocation. If this spread is large, it
works as a barrier to the expansion and development of financial intermediation.

A study carried out in Jamaica (Tennant and Folawewo, 2008) has concluded
that narrower spreads can have definite economic benefits. The study tested
determinants of banking sector interest rate spreads in 33 low and middle income
countries.

High IRS higher the cost of credit and discourage savings. Higher cost of
credit restricts the access of potential borrowers to credit market.High IRS is
represents higher cost to borrowers and investors.According to prior researches IRS is
tend to widen in developing countries. Also it acts an obstacle to the expansion of
financial intermediation necessary for growth and development of an economy.

Bandaranayake,n.d, investigated the Central Bank of Sri Lanka continuously

expresses its concern on IRS in the recent past times. This IRS is higher than other
south Asian countries. Specially, small business, household enterprises and rural
industries economy wide effect of reducing feasible investment opportunities. Thus, it
is important to identify the macroeconomic determinants of IRS to maintain
applicable IRS.Therefore, researcher involved to search macroeconomic determinants
in Sri Lankan banking sector for filling this knowledge gap.

3
1.5 Research Question and Objectives

The Researcher develop main research question. Therefore the Question behind this
study is as follows.
What is the impact of macroeconomic determinants for Interest Rate Spread in
Sri Lanka commercial banking sector?

As per the problem Statement identified in previous section, following general

objective and specific objectives can be identified for which the present study is
devoted upon.

General Objective

 Main objective of the study is to identify the macroeconomic determinants

of IRS in Sri Lankacommercial banking sector

Specific Objectives

1.5.1.1 To identify current trends in Sri Lankan IRS.

1.5.1.2 To measure the relationship between IRS and each macroeconomic

determinant identified.

1.5.1.3 To suggest recommendation to improve efficiency of financial system in

Sri Lanka

1.6 Methodology

This study was conducted using annual data from the Sri Lanka LCB Financial
Statistics for the years 1983 – 2012 according to central bank of Sri Lanka (CBSL).
Thus study, identifying the macroeconomic determinant affecting IRS in Sri Lanka
commercial banking sector, was an analytical in nature. Analytical research primarily
concern with testing hypothesis, specifying and interpreting relationship by analyzing
information already available. The main objective of this study was that identify

4
determinant affecting IRS in Sri Lanka using already available data obtain from
various data source. Therefore this study was an analytical study in nature.

Macroeconomic Variable

 Bank Rate

 Exchange Rate
Interest Rate Spread
 Treasury Bill Rate

 Inflation Rate

 Bank Sector Development

Figure1.1: Conceptual Frame Work

1.7 Significance of The Study

Sri Lanka is a developing country and its banking sector as a financial intermediary
plays major role in financial sector in Sri Lanka. Interest Rate Spread is the main
determinant of the efficiency and sound financial banking and financial system.
Moreover, it is of the essence that regulatorsstudy potential business combination in
the banking industry for these can repeal existing competitive conditions and increase
bank interest spread.

According to Central Bank of Sri Lanka 2012,The services sector, which is

the largest sector in the economy contributing 58.5 per cent to the GDP, grew by 6.5f
per cent in 2012. The banking, insurance and real estate sub sector grew by 6.9 per
cent in 2012. The banking sector is the dominant player in the financial sector
accounting for 70.6 per cent of the total assets of the financial sector.

Sri Lankan commercial banking interest spreads have sustained around 4.1%
and is exact to widen on the back of deposit rates falling ahead of lending rates. Due
to the dominance of unquoted state sector banks the net interest margin has squeezed
to around 4.1% due to the faster reduction in lending rates over the deposit rates.
However the scenario in the private quoted commercials banks is quite contrary with
the interest spreads widening to around 6% due to a faster reduction in deposit rates
ahead of the lending rates. This study results are more important to financial policy

5
makers. Becausemain effect on economic development of their policy decisions.Also
Government can control barriers for correct policy decisions. More ever Central Bank
of Sri Lanka can supply security for the entire banking sector as like as controller of
the all the banks.

Therefore the study is carried out to identify the macroeconomic determinants

of interest rate spread in Sri Lankan banking sector. The results are important to
commercial bank managers that the typically high spreads in developing countries are
caused by factors outside of their control and also have important policy implications.

1.8 Limitations of the study

Using secondary data obtained from different sources such as annual reports and web
based databases carries out this study. Therefore in behaviorally, there were some
disadvantages of secondary data when it was compared with primary data such as less
reliability, less accuracy, bias etc. Measurements of some variables change time to
time. (E.g. Inflation Rate – Base year of Colombo consumer price index is change).
This study covered only data year between 1983 and 2012. Data before 1983 time
period and data after the 2012, had not been used for this study. When applying some
mathematical model for analysis the result the validity of result created by these
techniques were depend on range of date and time period. Large number of data and
time period enrich the strangeness of result.

1.9 Summary and Chapter Organization

The first chapter involved giving introduction on the topic, significance of the
carrying out such research and the brief introduction on banking sector in Sri
Lanka.Next chapter is going to explain the theoretical and empirical base of the study

The study has divided into four chapters. Chapter one includes the problem
statement with a brief description of the problem situation, Conditions or the
background of the problem situation, relevance of the study and objectives of the
study. Chapter two basically covers the literature review and the related body of
knowledge in the said area of study. It is an in depth study of existing literature on this
topic. Ideas of previous Researches are examined under this chapter. Observed
variables that are investigating and graphical representation of the relationship of
these variables are presented under the third chapter.

6
 CHAPTER 02

LITERATURE REVIEW

2.1 Introduction

This chapter concluded the theories related with IRS and the literature review will
examine the determinants of Interest Rate Spread.

2.2 What is Interest Rate Spread

According to Alfred Marshall, the interest rate is the price paid for the use of capital.
This rate of interest is determined by the equilibrium formed by the interaction of the
aggregate demand for capital and its future supply. As said by Taussig, the interest
rate is determined at the level where the marginal productivity of capital equals the
marginal installment of saving (www.cliffsnote.com).

According to Keynes, the interest rate definitely influences the marginal

propensity to save. This savings is also linked to the level of income. Hence it is
concluded by Keynes that the rate of interest should be at a point where the demand
curve for capital at different interest rates intersects the savings curve at a fixed
income level(www.cliffsnote.com).

According to the Effectsof financial sector reforms in Sri Lanka

(edirisooriya,2007) interest spread or interest margin of banking institutions which is
the difference between interest income and interest expenditure is one of the
commonly used measures to evaluate benefit from financial sector reforms.
Theoretically, interest margin or spread declines as competition between banks gets
pace and momentum.

According to framework of McKinnon and Shaw, the interest rate is positively

associated with the savings, investment and economic growth. They assumed an

7
increase in interest rates stimulates savings; especially bank deposits and there by
provides more invest able funds thus leading to economic growth.

Perera and Bandaranayake (2012) carried out an empirical investigation on

market concentration and pricing behavior of Sri Lankan banks and the study
concluded that Sri Lankan banking sector regulators should closely watch banks with
larger loan and deposit shares because they operate with higher interest margins.
These banks may be exploiting their dominant presence and geographical reach to
charge higher spreads.

2.3 Determinants of Macroeconomics

Numbers of studies have been carried out in search of determinants of Interest Rate
Spread. Regardless of the widespread implementation of costly financial sector
reform programs in the developing world, banking sector in many developing
countries is still characterized by persistently high interest rate spreads. (Tennant and
Folawewo, 2008)

A study on Market concentration and pricing behavior of Sri Lankan banks

(Perera et.al, 2012) investigated whether market concentration in Sri Lankan banking
sector allows banks to extract higher interest spreads after controlling for other bank
specific and external factors. This is the first such study on Sri Lanka’s banking
sector. The findings of the study reveal that the dominant Sri Lanka banks may be
compensating for their inefficiency by charging relatively higher interest spreads.

Poke and Graeme (2007) conducted a study on The Term Spread and GDP
Growth in Australia to determine the degree to which the Australian term spread can
forecast real GDP growth. The results suggest that the term spread has been useful for
forecasting cumulative real GDP growth.

Obamuyi (2009) investigated the relationship between real interest rates and
economic growth in Nigeria from 1970 to 2006. The results show that there exist a
unique long-run relationship between interest rates and economic growth. The
researcher concluded that the relationship between investment and growth in Nigeria

8
may not allow for optimal benefits from interest rate reforms in the country. The
important condition for promoting economic growth, therefore, is for the government
to formulate and implement financial policies that enhance investment friendly rate of
interest and take into consideration those other factors which negatively affect
investment in the country.

According to Ndung and Ngugi (2000) narrow interest rate spread is important
to maintain a stable macroeconomic environment and thus reduce credit risks and also
need to minimize implicit taxes like reserve and cash ratios, complemented by fiscal
discipline to reduce the demand for financing budget deficit with low cost funds.

Perera et.al (2012) emphasis that state owned banks should also draw
regulatory attention for extract higher interest margins, possibly, as compensation for
their high operational inefficiency levels. Moreover, it is of the essence that regulators
study potential business combination in the banking industry for these can repeal
existing competitive conditions and increase bank interest spread.

A study carried out by Hemachandra (2009), on the topic of Interest Rate as a

Policy Instrument, have explained that interest rate have included as a monetary
policy instrument in many countries. Sri Lanka too, uses interest rates as one of its
policy instruments to achieve the objectives of the Central Bank. In this study, the
relationships between policy rates and other macroeconomic variables are identified
and empirical estimations are carried out to find out to what extent the interest rates
could be used to manage macroeconomic variables, based on which some policy
implications are suggested. The objective of this paper is to evaluate to what extent
the interest rate is responsible in managing price stability and other macroeconomic
variables in Sri Lanka.

A study carried on Bangladesh (Mujeri and Younus, 2009) analysis shows that
IRS is significantly influenced by operating costs and classified loans for state owned
commercial banks and specialized banks while inflation, operating costs, market share
of deposits, statutory reserve requirements, and taxes are important for the private
commercial banks.

9
 Grenade (2007) carried out a trend analysis of commercial banks’ interest rate
spreads in the Eastern Caribbean Currency Union (ECCU) over the period 1993 with
employing panel data techniques to measure the relevance of micro and macro factors
in determining commercial banks’ interest rate spreads over the period. The results
indicate that the observed spreads can be attributed to the high level of market
concentration, high operating costs and non-performing loans and the central bank’s
regulated savings deposit rate.

Demirguc-Kunt and Huizinga (1998) cited by Tennant and Folawewo,(2010)

note that the macroeconomic variables typically thought to be determinants of interest
rate spreads include inflation, growth of output, and money market real interest rates.
Real per capita GDP (GDPpc) should have a similar effect on IRS, as it is included as
a general index of economic development.

According to Mujeri and Younus (2009) interest rate spread (IRS) affects
many macroeconomic variables. The study carried out in Bangladesh identifies
several determinants for higher the IRS in the banking sector in Bangladesh. The
analysis shows that statutory reserves requirements, the high National Savings
Directorate certificate interest rates, inflation, operating costs, market share of
deposits contribute to higher interest rate spreads in the banking sector in Bangladesh.
The analysis in terms of bank groups shows that operating costs and classified loans
significantly influences interest rate spreads.

Eliana and Cardoso (n.d) carried out a study on Seigniorage, Reserve

Requirements and Bank Spreads in Brazil and the paper suggests that reducing
reserve requirements and directed credit could reduce bank spreads and net margin.
This experience suggests that these measures can only succeed if supported by
adequate fiscal policy. Gertler et.al (1991) carried out a study on Interest Rate
Spreads, Credit Constraints, and Investment Fluctuations. In this paper, they have
presented a simple framework that incorporates a role for interest spreads in models
of investment fluctuations. The result shows that fluctuations in agency costs
significantly affect the timing of investment. In addition, the findings explain the
significance of widening interest rate spreads for predicting output declines in post
war time series.
10
 Bank of Zambia (2010) carried out a survey on how commercial banks
determine lending interest rates in Zambia taking all the commercial banks and the
survey results indicated that the interbank rate, which is expected to influence the
policy rate, is not a significant input in the determination of the lending base rates.
Economic conditions and in this case inflation was found to be directly taken into
account in the determination of base lending rates. The result infers that the
commercial banks’ base lending rates seem to be sticky downwards in response to
declining Treasury bill yield rates. Therefore, suggests that achieving the required
return on equity and covering operational costs are, among other factors, more
important factors in the determination of base lending rates. Although banks set the
base lending rates and announce these rates in the market, it is generally expected that
the actual lending rates given on loans and advances differ considerably from the base
rates. Furthermore, the survey highlighted that there are qualitative factors such as
high default risk and large information asymmetries that contribute to high lending
rates.

Randall (1998) has examined Interest rate spread in the Eastern Caribbean and
the finding of the study suggested the scale diseconomies in commercial bank,
Reserve requirement, provision for loan losses and share of loan going to the public
sector have significant effect on the interest rate spread. Randall inclusion the
additional variables showed that macro policy variables, such as public sector
domestic borrowing, discount rates and Treasury bill rates, are commonly perceived
to impact on commercial bank spreads.

Tennant and Folawewo (2008) investigated the significant of 9 market and

macroeconomic variables by using empirical data of 33 developing countries
including Sri Lanka and the study emphasis that only 4 variables are
significantdeterminant of interest rate spread. Those are statutory reserve requirement,
inflation rate, bank rate and public sector crowding out.

Folawewo and Tennant (2008) carried out a study attempt to analyze the
determinants of spreads between banks’ deposit and lending rates in SSA countries
from market and macroeconomic view points, using a dynamic panel data estimation
11
technique. 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. 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 of
economic development, and population size are important determinants of interest
rate spreads in SSA (Sub-Saharan African) countries. This result has an important
implication in terms of policy design in the region.

Ndung and Ngugi (2000) emphasis that the minimal levels of reserve
requirement ratios will ensure the lending rates are kept down in a study carried out in
Kenya.This study analyzed factors behind the widening interest rate spread following
interest rate liberalization in Kenya. The survey of indicators shows that market
fundamentals and institutional factors influence interest rate spread. Disequilibrium in
the loans market is a major factor in driving the widening of interest rate spread.
There are also feedback effects from the other fundamentals to the loans market. The
factors that drive the interest rate spread are availability of deposits, alternative
investment channels for banks and the ease of portfolio adjustment at the end of the
period. Study also concluded that some institutional factors like micro market
structures and policy actions explain substantial variations in interest rate spread.
Performance in the loans market reflects a macroeconomic environment in which
stability serves to reduce the risk premium and ensure positive returns for investment,
thus reducing the credit risk.

Afzal and Mizra (2010) investigate the determinants of Interest Rate Spreads
in Pakistan’s commercial banking sector and they find out 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.

A study on determinants of lending interest rates and interest rate spreads

carried out by Georgievska et.al (2011) and concluded that the decrease in the costs of
financing will certainly cause a decrease in the price of loans, although this factor has

12
a relatively weaker influence than expected. In addition, the rise in the central bank
bill rate has a considerable effect in the rise of the lending rates, as expected.

Chortareas et.al (2006) carried out a data endowment analysis on Competition,

Efficiency and Interest Rate Margins in Latin American Banking andproduce
evidence suggesting that competitive markets result in lower spreads. The result of the
study shows that the degree of capitalization increases spreads, while economic
growth contributes to their reduction. As the results for the macroeconomic variables,
coefficient of the exchange rate is statistically significant in four cases only and
theirdegree is generally low. The exchange rate effect on interest rate spread is
positive for Paraguay and Peru but negative for Chile and Venezuela. They find that
the inflation rate is statistically significant and positive in Venezuela. Finally, GDP
growth, when significant, is negative as is in Argentina and Chile.

Thornton (n.d) investigated on the Discount Rate and Market Interest Rates
and finds out that the market interest rates are influenced by numerous factors that
affect the supply of and demand for credit. One of these factors is the discount rate.
The impact of the discount rate on market rates varies with the Federal Reserve’s
operating procedures.

2.4 Summary

This chapter included the theories related with IRS and the literature review will
examine the determinants of Interest Rate Spread. There are many theories related
with interest rate spread and no of research emphasis the importance of undertaking
the study on determining interest rate spread in Sri Lanka.

13
 3 CHAPTER 03

METHODOLOGY

2.5 Introduction

This chapter is devoted to explain the developed conceptual framework and

methodology of the study, in order to identify the macroeconomic determinant on
Interest Rate Spread (IRS). To arrive at a conclusion of the study, it is needed to
gather and analyze the required data. Under the research methodology, this chapter
describes the dependent and independent variables, developed models and data
analysis methods.

2.6 3.2 Conceptual Framework

Macroeconomic Variables

 Bank Rate

 Inflation Rate

 Treasury Bill Rate

Interest Rate Spread
 Exchange Rate

 Banking Sector
Development

Figure 3.1: Conceptual Frame Work

14
2.7 Rationalization of the variables

This paper examines the determinants of banking sector interest rate spreads in Sri
Lanka. The study has used the determinants from previous studies to guide the choice
of independent variables.
.

2.7.1 Dependent Variable

Interest Rate Spread

Interest rate spread is the interest rate charged by banks on loans to prime customers
minus the interest rate paid by commercial or similar banks for demand, time, or
savings deposits. The study has examined the spreads for the commercial banking
sector as a whole. This allows for the use of actual interest rate data in the calculation
of spreads, and gives a better understanding of the broad state of efficiency of
financial intermediation in the country.

Therefore the banking sector interest rate spreads (IRS) are calculated as:

IRS = Average Commercial Bank Lending Rate – Average Commercial Bank Deposit
Rate

3.3.1 Independent Variables

The set of independent variables includes variables that might possibly explain the
dynamics of banking spreads in Sri Lanka. These are explained in detail below.

 Inflation Rate

Inflation rate is continually increasing price level. Continually mean, minimum 10

years.Another word, Inflation rate is a term used in economics which refers to the rise
in prices of goods or services over a given time period. Inflation as measured by the
consumer price index reflects the annual percentage change in the cost to the average

15
consumer of acquiring a basket of goods and services that may be fixed or changed at
specified intervals, such as yearly.

The inflation rate is consistently and highly significant in model. As expected,

there is a positive relationship between inflation and banking sector spreads, but the
coefficient for the inflation rate is low, suggesting that anti-inflationary measures will
have to be stringent if they are to cause appreciable reductions in interest rate spreads.
(Tennant and Folawewo, 2010)

 Treasury bill Rate

Treasury bill is short-term security instrument. Meaning of short term is usually less
than one year, typically three months. It was issued by government as a primary
instrument for regulating money supply and rising funds via open market operations.
Issued through the country's central bank, T-bills commonly pay no explicit interest
but are sold at a discount, their yield being the difference between the purchase price
and the par-value. This yield is closely watched by financial markets and affects the
bank interest rates. Although their yield is lower than on other securities with similar
maturities, T-bills are very popular with institutional investors because, being backed
by the government's full faith and credit, they come closest to a risk free investment.

Bank of Zambia (2010) carried out a survey on how commercial banks

determine lending interest rates in Zambia taking all the commercial banks and the
survey results indicated thatthe commercial banks’ base lending rates seem to be
sticky downwards in response to declining Treasury bill yield rates. Consequently it
has effect on IRS.

 Bank Rate

The Bank rate is the rate charged by central banks when commercial banks borrow
from them. The rate at which the Central Bank grants advances to Commercial Banks
for their temporary liquidity purposes is Bank Rate.

16
 Much of the recent economic literature suggests that the discount rate is no
longer an important monetary policy tool for many countries. However, a study
(Tennant and Folawewo, 2010) results suggest that whether or not the government as
a means of controlling the money supply is using the bank rate, it is undoubtedly an
important factor in determining the size of the banking sector interest rate spreads.

 Banking Sector Development

The Banking sector in Sri Lanka accounted for 56% of financial system assets at end-
2012 and comprises Licensed Commercial Banks and Licensed Specialized Banks
(Central Bank of Sri Lanka 2012).The members of the banking system and the
functions they typically perform include, commercial banks that take deposits and
make loans, investment banks which specialize in capital market issues and trading,
and national central banks that issue currency and set monetary policy.

In the study development of banking sector measured by using proxy

measurement. Ratio of commercial bank assets to GDP is used to measure the
development of banking sector.Randall (1998) has examined Interest rate spread in
the Eastern Caribbean and the finding of the study suggested the scale diseconomies
in commercial bank sector have significant effect on the interest rate spread

 Exchange rate

The price of one country's currency expressed in another country's currency. In other
words, the rate at which one currency can be exchanged for anotheran advantage to a
floating exchange rate is the fact that it tends to be more economically efficient.
However, floating exchange rates tend to be more volatile, depending on the
particular currency. Study uses the annual percentage change in US dollar exchange
rate.

The result of the study on IRS conducted by Chortareas et.al (2006) for the
macroeconomic variables, coefficient of the exchange rate is statistically significant in
four cases only and their degree is generally low. The effect the exchange rate on
interest rate spread is positive for Paraguay and Peru but negative for Chile and
Venezuela.

17
2.8 Development of Hypotheses

This study observes the effects of the macroeconomic determinant affecting Interest
Rate Spread (IRS) in Sri Lanka.With the purpose of achieve the objectives of the
study, several hypotheses can be established.

In order to identify the relationship between independent and dependent variables

generalized hypotheses would be,

H0: There is no significant affecting between Macroeconomic determinants and

IRS

H1: There is a significant affecting between Macroeconomic determinants and IRS

2.9 Methodology

Secondary Data obtain from various data sources have analyzed using Regression
Model. Main data sources are annual report of Central Bank of Sri Lanka and World
Bank web site. Annual data is used in the study over the time period of 1983 to 2012.

2.10 Data Analysis

With the objective of identifying the macroeconomic determinant affecting IRS in Sri
Lanka commercial banking sector, ordinary least square regression analysis model is
used. Following model is used to discover the macroeconomic determinant affecting
IRS in Sri Lankan commercial banking sector.

Linear equation is developed using above mentioned variables

Y = β0 + β1 X1 + β2 X2 +………+ βnXn

IRS = β0 + β1 INF + β2 BR +β3TBR + β4 EXR +β5SCALE +U

18
Where,

IRS - Interest rate spread (Deference between Average Commercial Bank

Lending Rate and Average Commercial Bank Deposit Rate)

INF - Inflation Rate (the annual percentage change in the CPI)

BR - Bank Rate (This is the rate at which the Central Bank grants advances to
Commercial Banks for their temporary liquidity purposes)

TBR - Treasury Bill Rate (3 months)

SCALE - Banking Sector Development (Ratio of commercial bank assets to GDP)

EXR - Exchange rate (Annual percentage change in US dollar exchange rate)

U - Residual Error

β0 and β1…- parameters

2.11 Summary

This chapter explains the developed conceptual framework and methodology of the
study, in order to identify the macroeconomic determinant on IRS. Types of data
used is secondary data obtain from Central Bank of Sri Lanka 1983-2012 data sources
is used in the study. Regression model is employed to data analysis.

19
 3 CHAPTER 04

DATA PRESENTATION AND ANALYSIS

3.1 Introduction

This chapter is devoted to present the data collected from various data source. Also
this chapter is intended to elaborate the statistical tests and interpretations of the
results of the analysis with the objective of become aware about the data and also this
chapter facilitates to check the stated hypotheses of this study to draw the final
conclusion regarding the research problem by providing necessary information. Using
tables, graphs and statistical measurements does these data presentation and analysis.

3.2 Data Presentation

25.00

20.00

15.00
Depot Rate
10.00 Lending Rate

5.00

0.00
1983

1987

1991
1981

1985

1989

1993
1995
1997
1999
2001
2003
2005
2007
2009
2011

Figure 4.1:Interest Rate in Recent Past – Sri Lanka

Source; Central Bank of Sri Lanka Data 1981-2012

20
Interest Rate Spread is the difference between commercial bank lending rate and
deposit rate. Figure 4.1 shows the 1981-2012 annual average lending rate and deposit
rate of commercial banking sector in Sri Lanka. It indicates that IRS in Sri Lanka is
highly fluctuating in recent past.

As Figure 4.1 shows interest rate spread of Sri Lanka’s commercial banks
have been declining since the mid-1990s. However, since 2002, bank interest spread
has begun to increase again. This change is somewhat confused. According to CBSL
recent information’s researcher identified two reasons for those changes. First, even
though the Central Bank of Sri Lanka has reduced the official interest rate
continuously from 2001-2003.Therefore commercial banks have not given the full
benefits of reduced rates to consumers. Second, one was rapid credit growth due to
low interest rate and the market dominance of two largest state owned commercial
banks have not helped in reducing interest spread. This situation banks to earn more
interest income.

Currently IRS situation is it is decline step by step. The major reason for this
decline is the competition among commercial banks. A study carried out Effectsof
financial sector reforms in Sri Lanka (edirisooriya,2007) included the two largest
banks’ assets level has a declining trend since 2000 due to increase pressure from
other domestic private banks and foreign banks.

3.3 Data Analysis

3.3.1 Descriptive Statistics

Prior to estimation process of the equation, all the variable concerned have been tested
for stationary process using Regression model.

Descriptive statistics illustrates the average and the standard deviation of

different variables of the study. As well as minimum and maximum values of
variables support to get an idea about maximum and minimum value that a one by one
variable. Table 4.1 shows the descriptive statistic values.

21
 Table 4.1: Descriptive Statistics

Variables N Minimum Maximum Mean Std. Deviation

INF 30 .58 22.56 10.2927 5.01192
BR 30 10.00 25.00 15.3333 2.86878
EXR 30 -2.21 16.07 6.3390 4.86597
SCALE 30 15.98 53.89 36.4547 12.49285
TBR 30 7.25 21.30 14.0480 4.14386
IRS 30 -6.64 8.38 2.9943 4.37509
Valid N
30
(list wise)

Source: SPSS output from Central Bank of Sri Lanka Annual Reports, 1983-2012

The Average (Mean) value of the IRS is 2.99% and its standard deviation is 4.37%.It
means the value of IRS can be deviate from mean to positive and negative sides by
4.37%.The maximum value of IRS 8.38% and minimum value is -6.64%.When
considering the average value of IRS selected commercial bank sector that are
favorable position by IRS.
SCALE is presenting percentage of commercial bank assets in gross domestic
product. In here it’s about 36.45% average values and standard deviation is 12.49%
value. Minimum value is 15.98% and maximum is 53.89%.Hence this is indicator
how much percentage include in GDP as a commercial bank assets. It helps to get a
clear idea about bank and financial sector development.
According to table average Inflation rate of commercial bank sector
10.29%and standard deviation is 5.01%.The maximum value of INF is 22.56% and
minimum is 0.58%.This representing what the impact of INF for IRS selected period.
Because Inflation rate is a term used in economics which refers to the rise in prices of
goods or services over a given time period.
When considering the BR of the commercial bank sector its take 15.33%with
standard deviation value 2.86%.The maximum is 15.00% and minimum is 10.00%.
Bank rate an important factor in determining the size of the banking sector interest
rate spreads. Cause of it is using control the money supply.

22
 EXR is the annual percentage change in US dollar exchange rate. In here it’s
about 6.33% and standard deviation is 4.86%.The higher value of EXR is 16.07%and
minimum value is -2.21%.

3.3.2 Variance Inflation Factor (VIF)

This measures the relationship of all the independent variables simultaneously. In

practice all VIF are greater than 1 and lower than to 10. If VIF less than 1 or greater
than 10 is indicate there is Multicorllinearity problem.

Table 4.2 shows the VIF and Tolerance of each variable. In here the tolerance value is
measures the influence of one independent variable to all other variables.

Table 4.2 Collinearity Diagnostics

Model Collinearity Statistics

Tolerance VIF
1 (Constant)
INF .814 1.229
BR .934 1.071
EXR .909 1.100
SCALE .669 1.494
TBR .646 1.548

Source: SPSS output from Central Bank of Sri Lanka Annual Reports, 1983-2012

According to this study every macroeconomic variable VIF value are greater than 1
and lower than to 10.In here researcher could identify there is no multicorllinearity
problem.

23
3.3.3 Regression Analysis

Table 4.3: Results of the Regression Analysis

Variable Coefficient(B) Probability

Constant -17.408 0.002**

BR 1.1086 0.000***
EXR -0.230 0.076*
INF -0.219 0.099*
SCALE 0.114 0.054*
TBR 0.235 0.187
R – Squared = 0.582 (F=6.685, P=.000)
Adjusted R – Squared = 0.495

***significant at 1% **significant at 5% * significant at 10%

Source: SPSS output from Central Bank of Sri Lanka Annual Reports, 1983-2012

As in regression analysis, the coefficient of determination (R2) measures the

proportion of the total variation in the dependent variable that is explained by the
variation in the independent variables or explanatory variable in the regression. R –
Squared represents the explanatory power of the model and the result shows that the
model has explained 0.582 of IRS. Hence it signals, that is able to explain, that the
selected variables have higher explanatory power of the regression model of variance
in IRS. When the R- squared value is very close to one, we identify that regression
analysis is very strong as well as when the R- squared value is very close to zero, we
identified that more relevant independent or explanatory variables should be included
in to regression. R – Squared of the model is 0.582 and it concluded that BR, EXR,
INF and SCALE explain significant portion of the changes in IRS.

The F, Statistic in the table shows that the set of independent variables were
generally contributes to the variance in the dependent variables. And there was
statistically significant effect between IRS and the set of
variables(BR,EXR,SCALE,INF,TBR).Because of the P value (.000) is greater than
0.05 and its shows the overall model was statistically significant to predict the

24
outcome. Therefore the F, statistically significant at a level of <0.05, it is assumed that
there is a linear relationship among the variables.

When considering the results of the equation, one can see that TBR has higher
value of probability and they are not significant even 10% significant level. It can be
concluded that TBR has an insignificant impact on determining IRS.

IRS = β0 + β1 INF + β2BR + β3TBR + β4 EXR +β5 SCALE +U

IRS =-17.408-0.219(INF)+1.1086(BR)+0,235(TBR) -0.230(EXR) +0.114(SCALE)
+231.993

When analyzing the results one can see that the probability value of BR is less
than 0.001 depicting that the null hypothesis of no significant influence is rejected and
it has a significant impact on the determination of IRS in the case of Sri Lanka. As per
the regression output, one percent change in the BR will exact 1.1086 percent positive
change in IRS.

The rate at which the Central Bank grants advances to Commercial Banks for
their temporary liquidity purposes is Bank Rate. Thus, bank rate is cost of funds
commercial banks’ point of view. Therefore they will increase lending rate of
commercial banks thus, Interest Rate spread.

Much of the recent economic literature suggests that the discount rate is no
longer an important monetary policy tool for many countries. However, a study
(Tennant and Folawewo, 2010) results suggest that whether or not the government as
a means of controlling the money supply is using the bank rate, it is undoubtedly an
important factor in determining the size of the banking sector interest rate spreads..

As per the result of the equation, it is clear that probability value of EXR is
less than 0.05, depicting that the null hypothesis of no significant influence is rejected
and it has a significant impact on the determining IRS. As per the regression output,
one percent change in the EXR will exact 0.230 percent negative change in IRS.

Relationship between EXR and IRS is expected to be positive in countries

with freely-floating exchange rates. As the result of the study on Competition,

25
Efficiency and Interest Rate Margins in Latin American Banking carried out
byChortarea et.al (n.d) the exchange rate effect on net interest margin is negative for
Chile and Venezuela.
Increase in Exchange rate discourage import and encourage export. It makes
friendly environment to domestic producers, especially small and medium scale
business. Investment is goes up and it accelerates economic growth and then reduces
IRS.

In accordance with the result, probability value of INF is 0.099 and null
hypothesis of no significant impact on IRS can be rejected in 10% significant level. It
can be concluded that one percent change in INF exact 0.219 percent negative change
in IRS.

Macroeconomic instability cause and effect of banking sector performance.

Inflation is associated with a high interest margin as it creates uncertainty and
therefore raises the risk premium charged.Higher inflation might be expected to lead
to higher inflation adjusted spreads if it causes banks to charge a risk premium,
Regressing adjusted spreads on inflation yielded the result that an additional points of
inflation was associated with about a half point decline in the inflation-adjusted
spread with high significance. Similarly, low output prices and a slowdown in
production and economic activity generally reduce the value of assets for collateral,
and therefore the credit worthiness of borrowers diminishes. This pushes banks to
charge higher lending rates to cover for default risk. In an environment where the
exchange rate is volatile and the interest rates are sticky downward, expectations of
exchange rate depreciation will result in higher lending rates. This widens the spread.

As per the regression output, SCALE is concern the probability value 0.054
and can be rejected null hypothesis of no significant impact at 10% significant level,
and the coefficient of SCALE is 0.114. It can be concluded that SCALE has a positive
significant impact on determining IRS.

Banking sector development measures the overall size of the banking sector
and is correlated with growth in GDP. Lower developing of the banking system may
reflect a lower level of efficiency in intermediation activity, leading to higher spreads.
26
Higher bank assets to GDP could indicate a more developed banking sector with more
diversity of services and more profit-oriented banks which could lead to higher
average interest income. It could be associated with more competition or greater
efficiency which could lead to lower spreads.

Regression coefficient implies that when independent variables were zero,

impacts of the constant variables on the dependent variables. The probability of
constant is 0.002 thus, one can conclude that there are more significant variables
should be included the model and they make negative effect on IRS. Constant
coefficient is -17.408.

3.4 Summary

This chapter has discussed the results of the analysis done by using obtained data on
dependent and independent variables with established model and methodology in
chapter four. This chapter identified the determinant of Interest Rate Spread and kind
of relationship between IRS and each determinant identified.

27
 4 CHAPTER FIVE

CONCLUSION AND RECOMMENDATIONS

4.1 Introduction

This chapter presents the conclusion of the study based on analyzed data and an
overall summary of the study. In addition to that, this chapter consisted with
recommendations of the study with suggestions for future researches on determinant
of Interest Rate Spread.

4.2 Conclusion

This study investigated on the variables affecting Interest Rate spread in Sri Lanka.
The main objective of the study is to identify the macroeconomic determinants of IRS
in Sri Lankan commercial banking sector. In achieving this objective, there are some
specific objectives have been formed. Those are, to identify current trends in Sri
Lankan IRS, to measure the relationship between IRS and each determinant
identified, to be aware of economic impact of IRS and to suggest recommendation to
improve efficiency of financial system in Sri Lanka.

This study carried out to identify the macroeconomic determinants of Interest

Rate Spread in Sri Lanka. Based on the conclusions of prior research and availability
of data, focus ofthis study has been placed on five macroeconomic determinants of
interest rate spreads in the banking sector. Accordingly the variables are, inflation
rate (the annual percentage change in the CPI), Bank Rate (the rate at which the
Central Bank grants advances to Commercial Banks for their temporary liquidity
purposes), Banking Sector Development (ratio of commercial bank assets to GDP),
Exchange rate (Annual percentage change of US dollar exchange rate), and Treasury
Bill rate (interest rate of 3 months treasury bills).

28
 According with the regression results Treasury bill rate has insignificant
relationship with Interest Rate Spread in Sri Lanka even 10% significant level.
Therefore the model was redeveloped excluding that variables. As further, researcher
could identify that the inflation rate changes have not direct affected of Interest Rate
Spread in Sri Lanka. A study carried out by Hemachandra (2009), on the topic of
Interest Rate as a Policy Instrument, have explained that Inflation increased along
with other factors such as depreciation of foreign exchange rates as proxy by dollar
rate in the equation. The dollar rate in the equation tested is highly significant in
explaining inflation of the country

According to result of the regression analysis the effect of those four variables
on Interest Rate Spread can be calculated as follows.

Table 5.1: Conclusion of Regression Result

Expected type
Variable (H1)of the Significant/ Type of the
Relationship Insignificant Relationship
Inflation rate Positive Significant Negative
Banking Sector development Negative Significant Negative
Bank Rate Positive Significant Positive
Exchange Rate Positive Significant Negative
Treasury Bill Rate positive Insignificant Positive

Source; Authors Preparation

Result of the study concluded that all variable in the model have explained
more than 58% of the changes in IRS and each determinant have the significant effect
on Interest Rate Spread in Sri Lanka. Also it can be concluded that there are more
significant variables should be included the model and they make negative effect on
IRS. Relevant to the study could identify selected determinants were correlate each
other. Because gets in that variable one by one those doesn’t apparent expected
results exclusive of BR.

29
 Relevant to the study researcher expected to identify money market current
trends. According to the study, The CBSL, since November 2004, has been
implementing a tight monetary policy. Because as one of the measures to control
rising inflation. The interest rate corridor was revised upward starting from November
2004 following which market interest rates also increased.

The researcher analysis average deposit rate included the commercial bank
sector average deposit rate, fixed deposit rate and saving deposit rates. As further
lending rate was included average prime and normal lending rates. According to this
IRS economic players can get an idea about economic direction. Hemachandra
(2009), conducted a study on The Interest Rate as a Policy Instrument have to
determine the estimations weighted average deposit rates, fixed deposits rates and the
savings deposits rates are responsible in determining total deposits of the banks.
Therefore, rather than policy rates, interest rates are important determinants of
financial savings commercial bank deposits in the country. The coefficients for
weighted average deposit rates, fixed deposit rates and savings deposit rates are
significant in explaining the behavior of total deposits of the country.

4.3 Recommendations

Banking and financial sector of a country is main pillar of economic development of

the country. Financial sector should performed efficient manner in order to achieve
such development. Interest Rate Spread is used to measure the efficiency of banking
and financial system. Therefore moderate level Interest Rate Spread is important in
economic development.

Interest Rate Spread is relatively higher than the regional countries. It acts as
an obstacle to development in Sri Lanka. Identifying the determinants of Interest Rate
Spread is important to maintain Interest Rate Spread moderate level.

According to the result of the study Bank rate is the most affected determinant
of Interest Rate Spread in Sri Lanka. To maintain less interest rate spread policy
makers should be responsive when deciding monetary policy rates. Inflation rate and
exchange rate are cause to determine Interest Rate Spread in Sri Lanka. Therefore

30
macroeconomic stability should be sustained through well-established fiscal policy
and international trade policy. Macroeconomic stability is essential for successful
financial liberalization process, thus policy actions should be taken to ensure
sustainable growth of the economy. Stability of key prices, including the exchange
rate, commodity prices and interest rates, is crucial. This will stimulate high
investment returns and reduce the credit risk, consequently reducing the risk premium
tagged on loan interest rate.

Government should establish strengthen the institutional framework, and

regulatory and legal framework. It will enhance stability in the financial sector and
reduce costs of capital to investors. It should also help to strengthen the supervisory
and monetary control role of the Central Bank and will avoid the current conflict
between monetary and fiscal This also allows the financial sector to gain stability and
thus reduce risk to investors. Enhancing enforcement of contracts would also reduce
risk premium in the financial sector.

4.4 Suggestion for Future Researches

The study would give some suggestions to future researches. This study carried out
using macro level data. One could carry out a study on Interest Rate spread using
micro level data.

Investigate the effect of Interest Rate spread on GDP growth is another important
topic.

A study can be carried out on determinants of Interest Rate spread using Central Bank
of Sri Lanka data. Another researcher could carry out using panel data within South
Asian region and cross sectional analysis is important to make comparison among
countries.

31
 5 REFERENCES

Annual Report. Central Bank of Sri

Lanka.(1983,1988,1992,1996,2000,2004,2009,2012)

Afzal, A., & Mirza, N. (2010). The Determinants of Interest Rate Spread in Pakistan's
Commercial Banking Sector. CREB Working Paper No. 01-10, Centre for Research
in Economics and Business and Lahore School of Economics.

Bank of Zambia. (2010). Survey on How Commercial Banks Determine Lending

Interest Rate in Zambia.

Cardoso, E. (n.d.). Seigniorage, Reserve Requirement and Bank Spreads in Brazil.

Central Bank of Sri Lanka - Interest Rates. (2012). Retrieved from www.cbsl.gov.lk:
http://www.cbsl.gov.lk/htm/english/_cei/ir/

Chortareasa, G., Garza-Garcíab, J., & Girardonec, C. (n.d.). Competition, Efficiency

and Interest Rate Margins in Latin American Banking.

Crowley, J. (2007). Interest Rate Spreads in English-Speaking African Countries.

International Monetary Fund.

Financial Stystem Stability Review, Central Bank of Sri Lanka. (2011,2013).

Folawewo, A., & Tennant, D. (n.d.). Macroeconomic and Market Determinants of

Banking Sector Interest Rate Spreads: Empirical Evidence from Low and
Middle Income Countries.

Georgievska, L., Kabashi, R., Trajkovska, N. M., Mitreska, A., & Vaskov, M. (2011).
Determinants of lending interest rates and interest rate spreads. Bank of
Greece.

Grenade, K. (2007). Determinants Of Commercial Banks Interest Rate Spreads: Some

Empirical Evidence From The Eastern Caribbean Currency Union. Eastern
Caribbean Central Bank.

32
Hemachandra, W. M. (n.d.). Interest Rate as a Policy Instrument – Recent Experience
of Sri Lanka. Central Bank of Sri Lanka.

Heon Kim, D., & Hamilton , J. (1999). A re-examination of the predictability of the
yield spread for real economic activity.

K., B. S. (n.d.). Issues Relating to Interest Rate Spread in Commercial Banking

System of Sri Lanka.

Leng, Y. K. (2011). Economic Outlook Sri Lanka. RAM Holdings Berhad.

Monthly Bulletin. Central Bank of Sri Lanka. (2010, 2011,2013).

Mujeri, M., & Younus, S. (2009). An Analysis of Interest Rate Spread in the Banking
Sector in Bangladesh. The Bangladesh Development Studies Vol. XXXII.

Ndung’u i, N., & Ngugi, R. (2000). Banking Sector Interest Rate Spread in Kenya.
Macroeconomic and Economic Modelling Division, Kenya Institute for Public
Policy Research and Analysis.

Obamuyi, T. M. (2009). An investigation of the relationship between interest rates

and economic growth in Nigeria, 1970 - 2006. Journal of Economics and
International Finance Vol. 1(4),, pp. 093-098,.

Randall, R. (1998). Interest rate Spread in the Eastern Caribbean. International

Monetory Fund.

Retrieved from www.cliffsnote.com: http://www.cliffsnote.com/study_guide (2012)

Sri Lanka - Country Profile - 2012. (2012). Retrieved from www.indexmundi.com:

http://www.indexmundi.com/sri_lanka/.

Sri Lanka / Data. (2012). Retrieved from databank.worldbank.org.

Tennant, D., & Folawewo, A. (2008). Determinants of Interest Rate Spreads in Sub-
Saharan African Countries: A Dynamic Panel Analysis. the 13th Annual
African Econometrics Society Conference,. Republic of South Africa.

Wells, G., & Poke , J. (2007). The Term Spread and GDP Growth in Australia. School
of Economics and Finance.

33
 6 Annexure

Year IRS BR EXR INF SCALE TBR

1983 -5 16.9 13 13.05 40.5 13
1984 -6.64 20.3 13 8.12 41.43 12
1985 -3.93 0.58 11 6.78 36.78 14
1986 -0.64 6.91 11 3.15 38.42 11.5
1987 -1.7 7.57 10 5.09 36.95 13.31
1988 -0.81 10.11 10 8.02 23.1 15.77
1989 -3.26 10.92 14 13.33 24.93 18.86
1990 -6.42 21.06 15 11.14 24.92 18.1
1991 5.56 10.62 17 3.27 24.07 17.41
1992 5.94 9.84 17 5.94 25.74 19.33
1993 6.43 9.88 17 10.25 23.81 17.67
1994 5.03 10.77 17 2.26 26.75 18.09
1995 5.91 9.3 17 3.72 26.93 18.73
1996 5.9 10.91 17 7.84 25.98 19.26
1997 3.64 9.02 17 6.74 23.64 17.45
1998 5.46 9.31 17 9.25 20.66 9.97
1999 5.61 4.16 16 9.6 18.53 12.01
2000 6.99 7.27 25 9.02 15.98 11.79
2001 8.38 13.66 18 16.07 53.89 17.77
2002 3.95 11.81 18 7.02 52.66 12.92
2003 3.68 6.31 15 0.9 49.82 9.92
2004 4.86 7.58 15 4.84 49.16 7.43
2005 5.93 11.64 15 -0.69 51.99 7.25
2006 7.14 10.02 15 3.4 53.08 10.1
2007 6.69 15.84 15 6.46 50.03 12.76
2008 7.54 22.56 15 -2.07 44.16 21.3
2009 3.11 3.46 15 6.1 46.13 17.33
2010 3.04 6.22 15 -1.63 45.8 7.73
2011 3.25 6.71 15 -2.21 48.25 8.68
2012 4.19 7.54 15 15.41 49.55 10
Annexure A

Data Table

34
 40
60

0
20

10
20

-10
10
20
30

0
10
20
30

0
1983 1983 1983
1986 1983
1987 1987
1989 1987
Annexure B

1991 1991
1992 1991
1995 1995 1995 1995
1999 1998 1999 1999

BR

INF
2003 2001
EXR

2003 2003

SCALE
2007 2004 2007 2007
2007
2011 2011 2011
2010

BR

INF
Categorical Graph of the Variables

SCALE
EXR

35
 TBR
30
20
10
TBR
0
1983
1987
1991
1995
1999
2003
2007
2011
Annexure C

Y =β0 + β1 X1 + β2 X2 +………+ βnXn

IRS = β0 + β1 INF + β2BR + β3TBR + β4 EXR +β5 SCALE

Sample: 1983- 2012

Included observations: 30

Result of the Regression Model for Banking Sector Development

IRS=1.858+0.031(SCALE)

Variable Coefficient Std. Error t-Statistic Prob.

SCALE 0.031 0.066 0.473 0.640

R-squared 0.008 Mean dependent var 2.9943

Adjusted R-squared 0.028 S.D. dependent var 4.3705

36
Result of the Regression Model for Banking Rate

IRS=-11.632+0.954(BR)

Variable Coefficient Std. Error t-Statistic Prob.

BR 0.954 2.8687 4.242 .000

R-squared 0.391 Mean dependent var 2.9943

Adjusted R-squared 0.369 S.D. dependent var 4.3705

Result of the Regression Model for Inflation Rate

IRS=4.537-0.150(INF)

Variable Coefficient Std. Error t-Statistic Prob.

INF - 0.150 0.163 -0.922 .364

R-squared 0.029 Mean dependent var 2.9943

Adjusted R-squared 0.005 S.D. dependent var 4.3705

37
Result of the Regression Model for Exchange Rate

IRS=4.361-0.216(EXR)

Variable Coefficient Std. Error t-Statistic Prob.

EXR -0.216 0.065 -1.307 .202

R-squared 0.057 Mean dependent var 2.9943

Adjusted R-squared 0.024 S.D. dependent var 4.3705

Result of the Regression Model for Treasury Bill Rate

IRS=2.787+0.015(TBR)

Variable Coefficient Std. Error t-Statistic Prob.

TBR 0.015 0.200 0.074 .941

R-squared 0.000 Mean dependent var 2.9943

Adjusted R-squared -0.036 S.D. dependent var 4.3705

38
Annexure D

Regression result of the Equation I

Sample: 1983- 2012

Included observations: 30

Variable Coefficient Std. Error t-Statistic Prob.

C -17.408 5.131 -2.391729 0.0257

BR 1.086 .208 5.213 .000
EXR -.230 .124 -1.852 .076
INF -.219 .128 -1.717 .099
SCALE .114 .056 2.023 .054
TBR .235 .173 1.358 .187

R-squared 0.582 Mean dependent var 2.9943

Adjusted R-squared 0.495 S.D. dependent var 4.3750

39
Annexure E

Result of Regression Analysis

Normal P-P Plot of Regression Standardized Residual

Dependent Variable: IRS

1.0

0.8
Expected Cum Prob

0.6

0.4

0.2

0.0
0.0 0.2 0.4 0.6 0.8 1.0

Observed Cum Prob

40
Annexure F

Result of Regression Analysis

Histogram

Dependent Variable: IRS

6
Frequency

Mean =5.31E-16
0 Std. Dev. =0.91
N =30
-2 0 2

Regression Standardized Residual

41