AbstractThis study is based onidentifying whether the inflation and the growth rate which are themacroeconomic factors affect the interest rate spread in commercial banks ofSri Lanka. When compared to other South Asian countries, Sri Lanka isconsidered to have a slightly high interest rate spread. Even though the banksin Sri Lanka have been developed over the recent years, the interest rate spreadremains high. Therefore, it is very crucial to understand what causes the highinterest rate spread. Based to the previousliteratures, two main macroeconomic factors were identified which are theinflation and the growth rate. The secondary data will be used for this study.
Relevant information about the interest rate spread will be obtained from thepublished annual reports of selected banks for the time period from 2011 to2016. Regression analysis will be used in this study to identify the impact ofinflation and growth rate on interest rate spread. This whole study willprovide the users with clear information regarding the impact of themacro-economic variables which are the inflation and the growth rate oninterest rate spread. 1. Research Background Commercial banksfacilitate the individuals and business entities in order to meettheirfinancial needs in both domestic and international trade. Hence,commercial banking and financial sector contributes immensely in the economycovering varioussectors.Commercial banks’provides a favourable environment for depositors and borrowers and it helps thefinancial markets to perform effectively.
The commercial banking sector of SriLanka had been developed since 1977 with the open economy.Interest component is themain source of income in commercial banks which is the main criteria whichdecides the cost of funds, transaction cost of lending and the risk. Banksmaintain deposits from various customers at different interest rates and inreturn lend money to its customers for various purposes.The banking sector in acountry is vital for the economy since the banks interest rate highly affectsthe economy of a country. A higher interest rate signifies that the economy isinefficient. The level of growth and the development in an economy depends onthe lending and the deposit rates of commercial banks. (Folawewo, A. O.
,& Tennant, D. ,2008)According to (Dumi?i?,M., , T. , 2013)if a bank has a high interest rate spread,the economic development of a country may decrease, investments of a countrywill get reduced and ultimately the whole economy will have a negative effect.On the other hand it states that if the interest rate spread is low, it willaffect the economy in a favourable way.There is a high costassociated with the commercial banks in Sri Lanka. According to (Gelos, R. G.
2009), thebanks tend to increase the interest rate spread in order to maintain theprofitability. Therefore, the reason for the high interest rate spread in SriLanka might be because of the high cost. Most of the researches have statedthat fact including the above stated study.According to (Crowley,J. 2007),another factor that might be the reason for the high interest rate spread isthe uncertainty that the banks face because of the volatility of the economy.There is a risk involved for the banks due to the changes in the economy suchas the changes in the exchange rates. Therefore, the banks tend to increase theinterest rate spread.
Commercial banks earnsuper profits due the high cost of intermediation or interest rate spreadsupported by the cost of other business sectors. The effectiveness of financialintermediaries relies on interest spread. Therefore, banks are considered asone of the main contributors in most economies. Considering theseliteratures, it is crucial to find out what affects the interest rate spreadand the reasons for the high interest rate spread in an economy. Also, it isneeded to find out what is the reason for the gap between the lending and thedeposit rate.Literature reveals that thereare many factors which affect the interest rate spread in commercial bankingsector of Sri Lanka. (Khan, B., 2010).
Thosefactors are divided into bank characteristics, macroeconomic indicators,financial structure variables and regulatory variables. This study aims tounderstand how the macro economic factors affect the interest rate spread incommercial banking sector of Sri Lanka. In this study, it expects to test theimpact of inflation and growth rate on interest rate spread in commercialbanks. 2. ResearchProblem, Research Question and Objectives2.
1 Research ProblemMost of the developingcountries tend to have a high interest rate spread. When compared to otherSouth Asian countries, Sri Lanka is considered to have a high interest ratespread and it will negatively affect the economy of the country. This prohibitsthe future investors in investing in new projects which in turn will adverselyaffect the development of the economy. Even though the bankingsector of Sri Lanka has been growing over the recent years, the interest ratespread remains high. Therefore, it is very important to understand the factorsthat affect the interest rate spread in commercial banks.
There are only fewresearches which have been conducted regarding this in Sri Lanka when comparedwith other Asian countries. Therefore, this represents a gap for furtherstudies in related to interest rate spread in commercial banks of Sri Lanka. This study of “Impact ofmacroeconomic factors on interest rate spread” expects to fill up this gap byproviding information which helps to identify whether the inflation and theeconomic growth rate can be a reason for the high interest rate spread in thecommercial banks of Sri Lanka.
2.2 ResearchObjectivesThe main objective ofthis study is to find out the impact of macroeconomic factors on interest RateSpread in select Commercial Banks in Sri Lanka.2.3 Research QuestionsIn relating to the abovementioned objectives, the following research question is set to be answered bythe study. What is the impact of macroeconomic factors on interest rate spreadin commercial banks in Sri Lanka? In regarding to the above mentioned mainquestion the following sub questions have been identified. 1. Whatis the impact of inflation on interest rate spread in select commercial banksin Sri Lanka?2. Whatis the impact of growth rate on interest rate spread in select commercial banksin Sri Lanka?3.
Significanceand Limitations of the study This study expects tounderstand the impact of macroeconomic factors on interest rate spread incommercial banks. The findings of this study will be a help to many differentusers. It helps the government to develop economic policies relating to bankingindustry and ultimately reduce the interest rate spread. Further,the commercialbanks in any country can use this study to determine a fair lending rate andthis will help the banks to attract more customers. Thereby, it supports to theeconomic development of a country since many customers have access to loanfacilities. The students who are doing higher studies can use this study as asource of information. Finally, this study can be used as a reference forrelated studies that are being conducted and this intends to contribute immenselyto the body of knowledge.As the limitations, thedata which is needed to calculate the interest rate spread of the individualbanks might be difficult and time consuming.
Some banks might not like toprovide the datasince it will reveal its internal information such as anyinternal weakness. If there are internal weaknesses within the banks, theymight try to hide that fact by manipulating the data. These are the limitationsthat might be there when doing the research. 4.
LiteratureReview 4.1 IntroductionThemacro economy is a comprehensive design of the entire economic environment, foran example it can include the economy of a particular country. The macroeconomy consists of many variables such as inflation, growth rate, Treasurybill rate etc.
Insimple terms interest rate means the extra amount that is being charged onborrowed or lent money which is calculated for a period of time. In the presentcontext licensed banks engage in this activity with an aim of gaining profits.The rationale behind interest rates is to give timely value for the money.
Banks accept deposits from its customers and an interest is being paid on thedeposited value. On the other hand when banks lend loans and money to itscustomers, an interest rate is charged from the customer. Hence, the gap thatis being created between the deposit rate and the lending rate is termed as theinterest rate spread. 4.2 Interest RateSpreadAccordingto Crowley (2007), he says that interest rate is the money that is being paidby the borrower of the certain sums of money for which they have borrowed froma bank or a financial institution.
Further, if a person gives one shilling tosomeone to pay back in another one year time, the lender would expect and extrabenefit other than the lent amount. Moreover, Brock & Rojas (2000) hadstated that, interest rate spread is determined by the difference that occursbetween the income of such interest deducted from the expenses incurred on suchinterest rate. Another crucial aspect that needs to be determined is that dueto the high competition that is taken place in the market place it has resultedin a lowering of the interest rate spread. Furthermore, according to Quaden(2004) he states that, ‘higher expected returns for savers with a financialsurplus, and lower borrowing costs for investing in new projects that needexternal finance. Hence, when the interest spread rate is increased it wouldnot motivate prospective savers because of the low amount of returns theyobtain with regard to deposits. Furthermore, Valverde (2004), points out thatthe inefficiency that is connected with amount to extra costs and it wouldresult in reducing the savings, which in return would have adverse effects uponlending, investment as well as the economic growth of a country.
4.3 Inflation(Englishspeaking africa, 2007) has stated that when the inflation changes in a country,it makes the interest rate spread to become high because of the risk premiumthat banks need to charge. Further, it has pointed out from its results that inthe country of English speaking Africa, the change in the inflation does notaffect the interest rate spread significantly.
Someexperts argue that the result of macroeconomic stability is the ability to maintaina low rate of inflation. When there is a high inflation rate it imposesnegative impacts on the economy and it creates adverse results to each andevery part of the economy, thus every country’s objective is to maintain a lowinflation rate. The inflation will impact the entire banking system as well.The effect of inflation on the banking sector has to be determined with theextra costs incurred by banks. According to Athanasoglou et at (2006), hebrings up an interesting point where he states that when an economy of aparticular country is matured enough the future growth of inflation can fairlybe forecasted, whereby it would enable the financial institutions and banks tocontrol and monitor their expenses and costs in a timely and a proper manner.Accordingto (pacific island,2015), the high inflation of a country represents theuncertainty of the economy and it forces the banks to increase the interestrate spreads in order to cover up the inflation cost.
But it has found thatthere is only a small effect to the bank interest rate spreads by the inflation.