Effects of Income Diversification and Non-Performing Assets on Interest Rate Spread in the Kenyan Banking Sector

Abstract

Various structural changes intended to lower interest rate spread were initiated by the Central Bank of Kenya (CBK) since interest rate liberalization in early 1990s, but as documented in various Monetary Policy Statement issues and acknowledged by the Industry players and policy makers, interest rate spread remained high. High interest rate spread denotes intermediation inefficiencies leading to disincentive to investment through poor reallocation of resources and lowers effectiveness of economy’s monetary tools. Nevertheless, commercial banks continued had undergone a lot of changes characterized by new business models anchored on enhanced technologies and innovativeness. While only a few studies had been conducted in this subject, none captured the post economic crisis period in a broad way. Further, income diversifications, a product of commercial bank evolution in the period under study, received little attention. Under Kenya Banks’ Reference Rate initiated by CBK in consultation with Kenya Bankers Association (KBA) to improve transparency in loan pricing, risk premium was a major component of price of loans. As such, this study sought to establish the trend of non-performing assets provisions as a component of interest rate spread and the effect of non-performing assets and income diversification on interest rate spread using quarterly bank-specific, industry specific and macroeconomic data between 2004 and 2014. Interest spread decomposition model and random effect regression analysis were used to meet the objectives. Hausman test was used to discriminate between random and fixed effect panel regression analysis. Apart from the variables Risk Appetite and Market Concentration that were stationary at first difference, the rest were stationary at level. Interest spread decomposition indicated a low loan loss provisions component between 2009 and 2013 and a general spread range of between 1.0 and 1.5 percent. Non-interest income, a measure of income diversification, accounted for 5 percent of spread on average. Regression results indicated a 0.11 percent fall in spread following a 1 percent increase in the proportion of non-interest income to total income. Relationship between spread and nonperforming assets was positive but insignificant. Positive relationship also existed with respect to market concentration and operational costs. On the other hand, increased illiquidity in commercial banks reduced spread. The study recommends focus on operational efficiency, income diversification, market competition, reduced return’s appetite and scaled credit information sharing.