Pakistan's Banking Industry: Interest Spread, Inelastic Deposit Supply, and Mergers

Topics: Bank, Interest rate, Central bank Pages: 20 (6255 words) Published: March 11, 2013
Banking: Interest spread, inelastic deposit supply and Mergers


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


Idrees Khawaja Research Associate Pakistan Institute of Development Economics Islamabad

Correspondence Address Idrees Khawaja, Research Associate Pakistan Institute of Development Economics, Islamabad. (e-mail:


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


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...

References: Allen, Linda (1988). “The Determinants of Bank Interest Margins: A Note.” Journal of Financial and Quantitative Analysis 23, 231–235. Angbazo, Lazarus (1997). “Commercial Bank Net Interest Margins, Default Risk, Interest-Rate Risk, and Off-Balance Sheet Banking.” Journal of Banking and Finance 21, 55–87. Austin, John V, 2002 The Role of Supervisory Authorities in Connection with Bank Mergers. Berger, Allen N. and Hannan, Timothy H., “The Price-Concentration Relationship in Banking” Review of Economics and Statistics, May 1989, 71,291-9 Barajas, A., R. Steiner, and N. Salazar, 1999, “Interest Rate Spreads in Banking in Colombia, 1974–96,” IMF Staff Papers, Vol. 46, pp. 196–224. Berananke, B. and Alan Blinder, 1992, “Credit, Money, and Aggregate Demand,” American Economic Review, 82, 901-21 Bernanke, Ben, and Mark Gertler (1989). “Agency Costs, Net Worth, and Business Fluctuations.” American Economic Review 79, 14–31. Claessens, S., and L. Laeven, 2004, “What Drives Bank Competition? Some International Evidence,” Journal of Money Credit and Banking, Vol. 36, pp. 563–83. Freidman, Milton, and Anna Schwartz, 1963, “A Monetary History of United States, 1867-1960” Princeton N.J.: Princeton University Press. Hannan, T., and J.N. Liang, 1993, “Bank Commercial Lending and the Influence of Thrift Competition,” Finance and Economics Discussion Series 93–39 (Washington: U.S. Board of Governors of the Federal Reserve System). Ho, T., and A. Saunders, 1981, “The Determinants of Bank Interest Margins: Theory and Empirical Evidence,” The Journal of Financial and Quantitative Analysis, Vol. 16, proceedings of 16th Annual Conference of the Western Financial Association, pp. 581–600. 17
Mishkin, Frederic S, 1995, “Symposium on the Monetary Transmission Mechanism”, Journal of Economic Perspectives, 9(4), 3-10. Panzar, J.C., and J. N. Rosse, 1987, “Testing for Monopoly Equilibrium,” Journal of Industrial Economics, Vol. 35, pp. 443–56. Peria, M.S., and Mody, How Foreign Participation and Market Concentration Impact Bank Spreads: Evidence from Latin America, Journal of Money, Credit, and Banking, Vol. 36, No. 3 Romer, C. and Romer D. “Does Monetary Policy Matter? A new Test in the Spirit of Friedman and Schwartz,” NBER Macroeconomic Annual, 1989, 4, 121-170. Samuel and Valderrama, “The Monetary Policy Regime and Banking Spreads in Barbados,” IMF Working Paper, WP/06/211.
Annexture-A Banks included in the study
1 2 3 4
Allied Bank of Pakistan Askari Bank Limited Al-Habib bank Limited My Bank Limited
5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29
First Woman Bank Habib Bank Limited Alfalah Bank Limited Metropolitan Bank Limited Muslim Commercial Bank National Bank of Pakistan Prime Bank Limited Soneri Bank Limited Union Bank Limited United Bank Limited Faysal Bank Limited Bank Of Punjab Khyber Bank Limited PICIC Commercial Bank AL-Baraka Limited ABN Amro Ameriacn Express Bank Oman Bank Limited Tokyo Bank Citi bank Deutsche Bank Habibk bank A.G. Zurich Hong-Shinghai bank Rupali Bank Standard Charterd Bank
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