Effects of High Interest Rate Spread on the Banking Sector

Interest rate spread is defined as the difference between the average interest rate earned on the interest earning assets like loans and average interest rate paid on deposits.

The interest rate spread affects the capability of the banks to transact business because high interest rate spread means that borrowers of funds are being charged high interest rates on loans thus in the process decreasing their demands for all the loanable funds.

This also implies that savers are getting low interest rates on their savings and thus can reduce the supply of loanable funds, as they can channel their funds to other activities and all these affect the performance of the banks in the economy.

Kenya at the moment has a relatively high interest rates spread as compared to those rates prevailing in developed countries. Despite the so called ongoing financial reforms in the financial sector in an effort to reduce these rates and in the process enhance competition, the interest rate spread instead of narrowing down has been growing each and every coming day.

What does high interest rates mean to the economy of the country? High interest rate spread means that the banks are charging high interest rates on loans thus in the process decreasing their loan customer base. This also indicates that savers are paid low interest rates on their savings and hence reduce the supply of the loanable funds.

This trend of the increasing interest rate spread has significant implications for the banking industry and the implications flow all the way down to the common man in the streets.

The Central Bank of Kenya through its monetary policy committee always sets the ceiling lending interest rates by directing the banks to fix their lending interest rates at a rate of four basis points above its lending rate.

According to the Central Bank of Kenya Act 2000, banks nominal interest rates need to be pegged on the 91-days Treasury bill rates by maintaining a constant margin between the lending rates and the deposit rates. The act further recommends that depositors be pad at 70% of the 91-days Treasury bill rate, while lending would be at 4% above the 91-days Treasury bill rate and this leaves the banks with no option other than try and adhere to the CBKs regulations.