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Why interest rate spread matters

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This column last week discussed the issue of real interest rate and the interest rate spread. Following that discussion, a lot of readers wanted to know why Malawians should bother about interest rate spreads. What is the relevance to their day to day banking and investment decisions? To answer these questions, it is important to remind each other that the sale of Malawi Savings Bank to FDH Holdings and Indebank to National Bank of Malawi effectively ended the government’s participation in the banking industry. This means that was, probably, one of the last acts of financial liberalisation in Malawi; the gradual liberalisation that started as part of the structural adjustment programmes of the 1980s. The package included decontrolling interest rates and eliminating credit limits. It also entailed considerable institutional reforms, including new laws and regulations governing the financial sector, the restructuring and privatisation of banks, and the adoption of indirect instruments of monetary policy.

The logic was that financial liberalisation would lead to higher growth by increasing the supply of loanable funds through real interest rate increases. The economic logic was that, once real interest rates increase, real saving rates would increase and, therefore, household savings and bank deposits. This logic further assumes that banking system would be more efficient. In this conventional wisdom of banking, it is assumed that banks, as financial intermediaries, play a key role in transforming deposits into financial assets.

One of the major indicators of the efficiency of the banking system is the interest rate spread. In simple terms, the higher the interest rate spread, the more inefficient the banking system in a country. Nevertheless, the main cost of the bank’s activities is interest paid on deposits. In fact, banks achieve the main benefit from the difference between interest paid on deposits and interest received from facilities and loans. In Malawi, this difference (interest rate spread) substantially increased between 1996 and 2015. Between 1980 and 1995, interest rate spreads in Malawi were below 10 percent. Clearly, liberalisation of the market increased them, instead of bringing the rates down. The interest rate spread broke the 10 percent barrier in 1996 when the rates reached 19 percent and fluctuated below the 25 percent level until 2013 when the spread shot up to 27 percent before reaching 33 percent in 2015. In other words, the high interest rate spread is a form of financial taxation on both the depositors and borrowers.

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The high spread rate declares the problems in the regulatory environment of banks and asymmetry of information. Unfortunately, higher spread rates improve profitability of the banking sector, the depth of banking and financial stability with increased tolerance against negative shocks but they are not a good indication of the efficiency of the banking system. High spread rate indicates the low efficiency of the banking system and non-competitive market conditions. As at December 2015, two banks accounted for more than 50 percent of both deposits and capitalisation. The two banks’ share of assets and loans was 47.7 percent and 49.7 percent, respectively. On the other hand, according to them, a high amount of this variable indicates inadequate regulations and high level of information asymmetry and reflects the high risk of banking. In these circumstances, bank instability increases.

Let me admit that it is not the only measure but it is one of the important ones. Others include narrow range of financial products, insufficient capital adequacy ratios, the ratio of non-performing loans to total loans and the way the justice system deals with cases of loan recoveries. If one takes a closer look at these indicators, it becomes difficult to conclude that the banking industry in Malawi is efficient. This is not even taking into consideration the long winding queues in our banking halls and ATM machines that no one seems to think are a problem worth their effort to address— maybe because those who have the power to address these have taken refuge in the fact that they have access to the various executive baking suites of Malawi banks.

Banking is one of the most profitable industries in Malawi. Banks have extraordinary features and special privileges that give them high profitability potential. All economic activities— including productive and unproductive, value adding or non-value adding, socially useful or useless— need access to loans and credit from banks to be successful. Do not doubt the complicity of banks in the infamous Cashgate, which left a negative mark in Malawi. Banks in Malawi are in a position that requires other economic actors to refer to them and their activities are dependent on interaction with other banks. This is an exceptional opportunity for the bank’s profitability. A simple look at the statistics indicates that bank profits have been going up at the same time as interest rates spreads have been increasing. The bank can freely and without social concern allocate or not allocate financial resources to the applicant only in accordance with the logic of profit maximisation. That is why Malawians must discus interest rate spreads as another important indicator of financial importance!

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