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Banking Sector Interest Rate
Spread in Kenya
Njuguna S. Ndung’u and Rose W. Ngugi
Macroeconomic and Economic Modelling Division
Kenya Institute for Public Policy Research and Analysis
KIPPRA Discussion Paper No 5
March 2000
Interest rate spread in Kenya
KIPPRA in brief
The Kenya Institute for Public Policy Research and Analysis
(KIPPRA) is an autonomous institute whose primary mission is to
conduct public-policy research leading to policy advice and capacity
building. KIPPRA’s mission is to produce consistently high-quality
analysis of key issues of public policy and to contribute to the
achievement of national long-term development objectives. It aims to
influence the decision-making process positively through effective
dissemination of recommendations resulting from analysis and
through training to build capacity in the public sector. KIPPRA
therefore produces a body of well-researched and documented
information on public policy. In the process it assists in formulating
long-term strategic perspectives. KIPPRA serves as a centralized
source from which the government and the private sector may obtain
information and advice on public-policy issues.
Published 2000
Щ Kenya Institute for Public Policy Research and Analysis
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PO Box 56445, Nairobi, Kenya
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ISBN 9966 949 04 6
The Discussion Paper Series results from KIPPRA research and
policy activities. They disseminate results and reflections from
ongoing research activities of the institute’s programmes. The papers
are not externally refereed and are disseminated to inform and invoke
debate on policy issues. Any opinions expressed, the findings,
interpretations, views and policy suggestions are entirely those of the
author or authors and do not necessarily reflect the views of the
institute.
KIPPRA acknowledges generous support by the European Union (EU), the
African Capacity Building Foundation (ACBF), the United States Agency for
International Development (USAID), the Department for International
Development of the United Kingdom (DfID) and the Government of
Kenya (GoK).
Printed by Paretto Agencies, Moktar Daddah Street, P.O. Box 73585, Nairobi, Kenya
Abstract
A key indicator of financial performance and efficiency is the spread
between lending and deposit rates. If this spread is large, it works as an
impediment to the expansion and development of financial intermediation.
This is because it discourages potential savers due to low returns on deposits
and thus limits financing for potential borrowers. This has the economywide
effect of reducing feasible investment opportunities and thus limiting
future growth potential. It has been observed that large spreads occur in
developing countries due to high operating costs, financial taxation or
repression, lack of a competitive financial/banking sector and
macroeconomic instability. That is, risks in the financial sector are high.
Financial reforms and liberalization should improve efficiency in the
intermediation process. This implies that the spread will decline over time
as liberalization is accomplished and the financial sector develops. But in
Kenya, financial liberalization seems to have led to a widening interest rate
spread. The main factors that appear to propel this are distortions in the
loans market, institutional impediments and the policy environment. This
paper presents empirical support for these views and argues that
disequilibrium in the loans market is a major factor in driving the spread
and has substantial feedback effects, which reflect persistence of the
disequilibrium. Institutional and policy factors impact on transaction costs
and compound the effects of risks and uncertainty in the market, thus
exacerbating the spread.
To narrow interest rate spread, it is important to maintain a stable
macroeconomic environment and thus reduce credit risks. There is also a
need to minimize implicit taxes like reserve and cash ratios, accompanied
by fiscal discipline to reduce the demand for financing budget deficit with
low-cost funds. Banks should perform more intermediation/screening