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.