Are bank interest rate spreads too high? A simple model for decomposing spreads

Viewpoint The World Bank February 1996 Note No.67 Are Bank Interest Rate Spreads Too High? A simple model for decomposing spreads F Montes-Negret In the first seven months of 1995, average bank spreads in Ukraine ranged from 46 percentage and Luca Papi points to 84 percentage points (table 1). The size of these spreads might suggest that banks en- joyed a wide profit margin. But inflation was high in Ukraine, and its banking system had large stocks of nonperforming loans. Using a simplified model to make a "quick and dirty' estimate of the spread banks need to achieve a positive real return on equity, this Note shows that nominal spreads in Ukraine were on average below breakeven. The model can be adapted for use for any country or for any bank or group of banks. Specifying the model should comprise a liquidity risk premium "re- warding" banks for transforming more liquid An important task for bank analysts is to assess assets (deposits) into less liquid assets (loans), the efficiency of bank intermediation. A good an information premium for banks' compara- place to start is the size of interest rate spreads- tive advantage in selecting and monitoring the difference between lending and deposit rates projects and borrowers, and a premium for con- (ex ante spreads). In theory, this difference trolling and managing risk. In reality, it is a com- plicated business to assess whether these premiums-and therefore the spreads-are too TABLE I COMMERCIALElANK INTEREST RATES AND SPREADS N , high or too low for efficient intermediation. This TE MEAA ESD E Note approaches the question from a method- : ; UKRAINE, 1995 (percentj f ological perspective, using a highly simplified model and applying international parameters for Average Average Spread bank performance as a benchmark. The model Month endakg rate deposit rate (simple differencel is a static one based on quite restrictive assump- tions, and it manipulates simple accounting iden- tities without any consideration of the strategic Jantuary 220.7 144.9 7&9 behavior of market participants. There are three February 212.9 128.9 80 groups of critical variables (see box for the deri- March 189.6 112.6. 77.0 vation of the formula): April 152.8 882 64.6 * The prevailing policy parameters (reserve re- May 122.2 61.0 61.2 quirements and their remuneration, if any; Jun -0 :91 141.8 5 59.1 ; taxes; and the capital-asset ratio). - Julyne8t6: 35A 412 501 * The operating condition of the banks (oper- -uly 81.6 3. E ating costs, targeted real return on equity, and share of nonperforming loans). Scaaw:etatioaal Bank of Ukraine, SIHetiJI 7 * The rate of inflation (and the related deposit interest rates). EL] Financial Sector Development Department Vice Presidency for Finance and Private Sector Development  Are Bank Interest Rate Spreads Too High? The iTanrebep6fli~rpreenWveba1dtstImt sses,taasLt.The model assumes a simplified balance sheet in ixonontJtins(WLindreewest)n&t4bouweitfunii4~which loans and reserves are the only assets and depositslflhtndcapital Ri. ~~~~there are no liquidity reserves or other invest- ments by banks. It assumes that banks target a (1Lt+rL