The determinants of banking sector interest rate spreads in Zambia
Banda, Charles Masili
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Financial intermediation is essential for economic development. The consensus is that Zambia needs a stable and efficient banking system in order to finance both private and public investment and expenditures. The effectiveness of the banking system in channelling funds from surplus to deficit actors is often gauged by examining the spread between lending and deposit rates and by assessing the degree of operational efficiency of the banking industry. Although Zambia has made some progress since the deregulation of its banking system, interest rate spreads remain absolutely high. When the spread between lending and deposit interest rates is too large, it is generally regarded as a considerable impediment to the expansion and development of financial intermediation, as it discourages potential savers with low returns on deposits and limits financing for potential borrowers, thus reducing feasible investment opportunities and therefore the growth potential of the economy. However, Zambia's experience indicates a widening spread in the post-liberalization period. This research will therefore contribute to fill the knowledge gap by examining why interest rate spreads are still persistently high in Zambia despite successful financial reforms. The aim of this study has been to investigate the levels and trends in interest rate spreads, to document the key macroeconomic and market determinants of interest rate spreads and to provide policy options that would help to narrow the interest rate spreads so as to enhance the efficiency of the Banking Sector and hence economic growth and development of Zambia. In particular, the study investigates the effects of inflation, exchange rate volatility, reserve requirements and discount rates on interest rate spreads. The study uses Ordinary Least Squares to estimate the Log-Linear regression model to explain the main determinants of interest rate spreads in Zambia. Quarterly time series data is used from 1995 to 2008 and it was collected from the Bank of Zambia. The Dickey- Fuller and Augmented Dickey- Fuller Tests were performed to determine if the variables were stationary and to determine their order of integration. To avoid spurious results, a cointegration analysis using the Johansen Maximum Likelihood ratio test was done to determine whether the variables are cointegrating. The loglinear empirical model was estimated by Ordinary Least Squares using EViews econometric Package. To ensure that the model was adequate and that consistent and unbiased parameter estimates were obtained, various diagnostic tests were conducted. The study checked and corrected for violations of the standard assumptions of the regression analysis. The Ramsey RESET test was also conducted to ensure that model was correctly specified. The study found exchange rate volatility and inflation rate to be statistically insignificant. Hence the government should not use them in an attempt to influence interest rate spreads as such policies are bound to fail. However, the study found the lag of the interest rate spread, the discount rate and reserve requirements to be positive and statistically significant. Hence policies targeting these are likely to be more effective at reducing the persistently high interest rate spreads.