Banking Industry of Pakistan

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Banking: Interest spread, inelastic deposit supply and Mergers

By

Musleh-ud Din Chief of Research Pakistan Institute of Development Economics Islamabad

and

Idrees Khawaja Research Associate Pakistan Institute of Development Economics Islamabad

Correspondence Address Idrees Khawaja, Research Associate Pakistan Institute of Development Economics, Islamabad. (e-mail: khawajami@yahoo.com)

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Banking: Interest spread, inelastic deposit supply and Mergers By Musleh-ud Din and M. Idrees Khawaja1 Abstract Interest spread of the Pakistan’s banking industry had been on the rise for the last two years. The persistent increase in spread discourages savings and investments besides this casts doubt on the effectiveness of bank lending channel of monetary policy. Given the implications of raise in spread, this study examines the determinants of interest spread. We found that inelasticity of deposit supply is the main driving force behind the rising interest spread however industry concentration does not exercise influence upon the spread. One reason for inelasticity of deposits supply to the banks is the absence of alternate options for the savers. The on-going merger wave in the banking industry will further limit the options for the savers. Given the adverse impact of banking mergers on competitive environment, we argue that to maintain a reasonably competitive environment, merger proposals be subjected to review by an antitrust authority with the State Bank retaining the veto over merger approval.

1. Introduction Interest spread of the banking sector has been on an upward course during the last few years. During 2005 the average interest spread of the banking sector has increased by 2.14 percent. Interest spread being the difference between what the bank earns on its assets and what it pays on its liabilities, the increase in the spread implies that either the bank’s creditor/depositor or the bank’s borrower or a mix of both stand to loose. Bank lending channel is an important channel of monetary policy transmission mechanism. The channel works like this: With a commitment to market based monetary policy the central bank influences the yield on Treasury bills (T.bill hereafter) that in turn affects the deposit and lending rates of banking industry2. The change in these rates influences the cost of capital that in turn affects the level of consumption and investment in the economy. If the pass-through of the changes in yield on T.bill rate to the deposit and lending rate is asymmetric then this changes the spread, for better or worse, depending upon the nature of asymmetry. If the increase in spread is due to lower return Authors are: Chief of Research and Research Associate at Pakistan Institute of Development Economic (PIDE), Islamabad. 2 For discussion on channels of monetary policy, see Mishkin (1995) 1

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to depositors than this discourages savings, alternatively if it is due to higher charge on loans, investment decisions are affected. In either case the increment in spread has an adverse bearing upon the effectiveness of bank lending channel of monetary policy and has therefore important implications for the economy3. Samuel and Valderrama (2006) argue that wide bank spreads in Barbados may have contributed to low rates of private investment and economic growth. According to Peria and Mody (2004) in developing countries, the impact of increase in spread could be severe as the capital markets are relatively less developed and a sizable percentage of agents depend on banks for their financial needs. Thus the lack of alternate avenues of financial intermediation aggravates the adverse impact of increase in spread. Therefore it is important to study the determinants of Interest spread. We found inelasticity of deposits supply to the banks to be the main determinant of interest spread. Industry concentration, for which the evidence in literature is mixed, does not appear to influence interest spread of...
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