DETERMINANTS OF INTEREST RATE SPREAD EVIDENCE FROM

COMMERCIAL BANKS INETHIOPIA

 List of Acronyms and Abbreviations
COFI Cost of financial intermediation
CR Credit risk
GDP Gross domestic product
IMF International monitory fund
INTMC Intimidation cost
INTRCOM Net interest income to total operating income ratio
IRS Interest rate spread
NBE National bank of Ethiopia
NPLS Non performance loans
ROA Return on asset
 Table of content
CHAPTER ONE............................................................................................................................ 1
INTRODUCTION..........................................................................................................................1
Backgroundof the Study..............................................................................................................................1
Statement ofthe problem.............................................................................................................................5
Objectivesof the study.................................................................................................................................6
General Objective.......................................................................................................................................6
SpecificObjectives......................................................................................................................................6
Researchhypothesis.....................................................................................................................................7
Significanceof the study..............................................................................................................................7
Scope ofthe Study.......................................................................................................................................9
Limitationof the study.................................................................................................................................9
Structureof the study...................................................................................................................................9
CHAPTERTWO.......................................................................................................................... 11
LITERATUREREVIEW.............................................................................................................11
Theoretical Framework.............................................................................................................................12
Conceptoffinancialintermediation.............................................................................................................12
Dependant variable...................................................................................................................................13
Determinantsofinterestrate spread.............................................................................................................15
OverviewofCommercialBanks in Ethiopia...............................................................................................23
CHAPTERTHREE...................................................................................................................... 28

RESEARCHMETHODOLOGY................................................................................................ 28
Researchapproachand paradigm...............................................................................................................28
Researchdesign..........................................................................................................................................28
SamplingDesign........................................................................................................................................29
DefinitionandMeasurementof variables....................................................................................................30
DependentVariables..................................................................................................................................30
Independent variables...............................................................................................................................31
DataSourceand Collection.........................................................................................................................32
Contents
CHAPTER ONE................................................................................................................................................5
INTRODUCTION.........................................................................................................................................5
CHAPTER Two.................................................................................................................................................5
INTRODUCTION.........................................................................................................................................5
Theoretical Framework...............................................................................................................................10
 CHAPTER ONE
INTRODUCTION
1.1 Background of the Study
The banking sector plays a fundamental role in economic growth, as it is the basic element in
the channeling of funds from lenders to borrowers. Efficient financial intermediation is an important
factor in economic development process as it has implication for effective mobilization of investible
resources. Consequently, banking sector efficiency plays significant role in an economy. A major
indicator of banking sector efficiency is interest rate spreads, which have been found to be higher in
African, Latin American and the Caribbean countries than in OECD countries (Randall, 1998; Brock
and Suarez, 2000; Chirwa and Mlachila, 2004; Gelos, 2006; Crowley, 2007).

CHAPTER Two
INTRODUCTION
1.2 Times New Roman
Khan & Khan, (2010) states interest rate spread is an indicator of banks efficiency,
similarly Gesang et al, (2014) declare spread as indicator of banks profitability. It is also an
indicator of banking sector illness (Ghoshetal,2008). To be efficient banks should lower interest
rate spread by reducing the cost of lending and also higher the rate of interestexpectedby savers
because, it encourages investors or deficit units to raise funds easily from financialintuitions at a
lower cost in turn facilitates investment and countries economic growth. In theside of fund
mobilization it helps to attract a large amount of funds from excess fund units (savers). Quaden,
(2004) for instance argues that a more efficient banking system benefits the
realeconomybyallowinghigherexpectedreturnsforsaverswithafinancial surplus, and lower
borrowing costs for investing in newprojectsor deficitunits.

When banks set higher lending rate by lowering interest rate on deposit this will
encourage banks performance by increasing their profitability. High interest rate spread will
strengthen a countries banking system and capitalization by increasing profitability and
solidifying its financial position by creating additional buffers against negative shocks these
willcontribute much the stability of banks operation (Saunders &Schumcher, 2000; Khrawish et
al,2008and(Gesang,2014)(Ascarya,2010)(Khumaloand,2011)(Konar,2014)(Islams.N.,2015)
(Kalluci;IslamE.R.,2014)Barajasetal,2000).But,discouragesavingandinvestmentdue to increase in
lending interest rate, in turns it creates inefficiency on banks (Randall, 1998;Brock & Suarez,
2000; Chirwa&Mlachila, 2004; Gelos, 2006; Iloska, 2014; Crowley, 2007 andNdung’u&Ngugi,
2000). High interest rate spread could be inimical to economic growth byreducing demand for
bank credit(Taylor and Wijnbergen, 1983). Unstable and high marginshave generally been
attributed to high operating cost, financial taxation, and lack of computationand high inflation
rate (Central bank of Swaziland, 2007). In addition to efficiency the existenceof high interest rate
spread as the major constraint to economic development (Ahokpossi, 2013,Auwalu,2012). High
interest rate spreads also reduce the incentive for economic actors (Hadedetal, 2003).

In connection with researchers this topic is an in sighting area in which most studies have
been conducted on determinants of interest rate spread, there are exhaustive studies examined
this issue in different level. In Africa (Folawewol& Tennant, 2008;Ahokpossi, 2013; Aboagyeet
al.,2008; Akinlo&Olanrewajo, 2012; Quarmyneet al., 2014;Niyimbaniraetal.,2015;Nampewo,
2013;Chirwa et al., 2004;Hinauaya, 2012;Ndung’u &Ngugi, 2000; Ngugi, 2000;Were
&Wambua, 2012;Chelangat &Masturn, 2011;Kiptui, 2014;Maina et al, 2013;

However, literatures in Ethiopia are few in number and not addressed the variables
which are overviewed in empirical studies conducted in other countries. However, data related to
interest rate spread in Ethiopia shows the following facts related to interest rate spread. Crowley,
(2007)using ex ante measure (lending interest rate minus deposit interest rate)the average value
of interest rate spread of Ethiopian commercial banks was 4.53%, and using ex-post measure
(interest income minus interest expense to total asset) IRS is estimated as 2.43%.Data stated by
Folawewo&Teanent, (2009) states that the mean value of interest rate spread ofeast sub-
Saharancountries including Ethiopiaas6.82% using ex-ante measure.This figure isalso shown by
NationalBank of Ethiopia (NBE) in 2012as 6.48% using (ex-ante) measure which is greater than
east African countriesaverage5.48% in sameyearand internationalstandard 5% as sited by
(Aregu, 2014). Therefore, data of interest rate spread using ex-antemeasure in the year 2009 and
2012 reveals the existence of high interest rate spread in Ethiopiacommercial banks. Thisis one
of the reasons the researcher wants toidentify determinantsfactorsofinterest ratespread.
Statementof theproblem
Interest rate spreads remain a subject of debate and continue to pose policy challenges i.e.
policymakers have an interest in promoting banking sectors to be stable and efficient. Stability
clearly requires sufficient banking profitability, while economic efficiency requires banking
spreads that are not too large.A prerequisite to formulate effective banking policies is thus
tounderstand and effectively manage determinant factors of interest rate spread (Demirguc-
Kunt,1999). Now a day, competition in the banking sector has increased over time; these could
entailstrategic policy measures aimed at enhancing effective competition and the ability of small
and medium-sized banks to penetrate the market, as well as measures towards minimizing
interest rate spread. Minimizing interest rate spread is pursuing policies that maximize savings
Ibrahim etal, (2014) & Mettle, (2013). It is also further strengthened by Ferdinand et al, (2015)
as policymakers’ especially monetary authorities should consider the implications of firm
specific factorsthataffectInterest ratespreads inadditionto macroeconomic and industryspecific
factors.

The interest rate spread has been one of the most prominent measures of banks efficiency
Beck,(2006). It indicates how efficiently banks perform the r intermediation role on mobilization
funds from excess fund units and allocation of raised funds to deficit units. Large interest rate
spreads are deemed to be unfavorable to economic growth, as they act as a disincentive to private
investment and otherwise constraint to sub optimal levels through affecting banks efficiency. In
efficiencies in intermediation may emerge from structural problems: lack of adequate
competition, scale diseconomies due to small market size or high fixed operating costs, the
existence of regulatory controls, perceived market risks and the unsoundness of banks Grenade,
(2007). Similarly, low interest rate spread also affects banksstability. To mitigate the problems
arises from high or low interest rate spread commercial banks should identify determinant
factors. According to Doliente, (2003) these factors may vary from country tocountryor region to
regions.
 In Ethiopia, the banking sector plays a dominant role in the financial sector, particularly
with respect to mobilization of savings and provision of credit, but the interest rate spread is high
as compared to East African countries average and international standards as cited by Aregu,
(2014). While empirical studies in the area are at toddler stage, few scientific researchers
conducted to the knowledge of the researchers. As a result, the researcher is motivated to
examine determinant factors of banks interest rate spread. Meanwhile, Aregu, (2014) tries to
address some of the variables that affects interest rate spread such as credit risk, liquidity
risk,operating cost, concentration, reserve requirement, interest rate volatility, non interest
income, return on asset, management quality, real GDP, exchange rate volatility, financial
developmentand inflation. The researcher also suggests that further studies must be done using
additionalexplanatory variables. In general, the researcher tries to add and test new variable that
explains interest rate spread which is tested in other countries and gives relevant relation with the
explained variable but not in Ethiopia such as, credit risk, bank size, net interest income as a ratio
of total income, Administrative expense.

Objectives of the
study 3
General Objective

The general objective of this study is to examine the determinants of commercial banks
interest rate spread evidence from commercial banksof Ethiopia.

SpecificObjectives

Thisstudytriesto achievethefollowingspecificobjectives;
1. To examine the effect of credit risk in Ethiopian commercial banks interest rate spread.
2. To identify the relationship between return on asset and banks interest rate spread.
3. Toexaminetheeffectof administrativeexpenseonbanksinterestratespread.
4. To explain banks size and their effect on interest rate spread.

Research hypothesis

In order to attain the above mentioned broad objectives, the following null hypotheses are
designed.
 H0: There is not a significant relationshipbetweencreditriskandbanksIRS.
H0: There is no a significant relationship between return on asset and banks IRS.
H0: There is no a significant relationship between administrative expense and banks IRS.
H0:ThereisnosignificantrelationbetweennationalbankdirectiveandIRS.
H0: There is no a significant relationship between bank size and Banks IRS.

Significance of the study

 The study will be contribute towards policy makers to see the significance of bank
specific factors in determination of interest rate this in turn initiate to devise
measures, enact new proclamations, directives and procedures in relation to
interest rate spread determination and to promote investment and countries
economic growth

 It also helps to build the efficiency of commercial banks and assuring profitability
(stability) that enhances free computation to penetrate the market, this would
benefit both the existing and newly emerged commercial banks and their potential
savers and borrowers.
 The paper helps as initial for commercial banks to identify the effects of risks
associated with lending and deposit interest rate variation and explore internal and
industry driven strategies to militate against the draw backs of interest rate spread.

Scope of the Study

The study will cover the time span from (2022-2023) and conducted on both government
owned and private owned commercial banks whose main office is located in Addis Ababa. All
commercial banks are included in the study. Even bank spread have determined by different
industry specific and macroeconomic factor the study tries to test bank (firm) specific factors.
The study also substantiated using secondary data (documentary analysis) with a Quantitative
and explanatory research approach.
CHAPTER Four LITERATUREREVIEW
Theoretical Framework
1.3 Concept of financial intermediation

Financial intermediation is defined as a process of channeling funds from surplus sectors

of the economy towards the deficit sectors of an economy. The institutions that perform this
function are known as financial intermediaries. Banks are the most popular financial
intermediaries in the world. The cost of performing intermediary services is termed as the cost of
financial intermediation (COFI). As financial intermediaries, banks play a crucial role in the
operation of most economies. The efficiency of financial intermediation can also affect economic
growth. Crucially, financial intermediation affects the net return to savings, and the gross return
for investment. The spread between these two returns mirrors the bank interest rate spread, in
addition to transaction costs and taxes borne directly by savers and investors. This suggests that
bank interest spreads and net interest margin can be interpreted as an indicator of the efficiency
(Levine,1996)and indicator of profitability(Gesanget al, 2014) of banking system.

The rationale for the existence of financial intermediaries and their contribution in
economic development can be classified into three main categories. These include information
problems (theory of asymmetric information), transaction costs and risks (financial services) and
regulatory factors (agencytheory).Theprimaryreasonforfinancialintermediationisinformational
asymmetries between participants of financial system. There could be ex-ante asymmetries that
would lead to adverse selection, interim ones, causing moral hazards and ex-post, warranting
need for audit or other costly monitoring or enforcement mechanisms. Financial intermediaries
are expected to mitigate these explicit and implicit costs. Leland & Pyle, (1977) demonstrate that
financial intermediaries reduce a symmetric cost by acting as information sharing coalitions.
Diamond & Dybvig,(1983)proposed financial intermediation as risk absorption capacity for
depositors against idiosyncratic shocks that would negatively impact heir solvency. Diamond,
(1984) advocates the role of financial intermediaries as monitoring agents on behalf of surplus
units, where households will place deposits with intermediaries who in turn would extend credit
to deficit units and monitor their activities.

The existence of transaction costs is the second reason (in fact exogenous) for evolution of
financial intermediation. The financial institutions would act on behalf of lenders and borrowers
and exploit economies of scale ands cope. The transaction costs would include monetary costs
Tobin, (1963) and search costs, monitoring and audit costs Benston & Smith,(1976). The
intermediaries would transform financial claims of depositors to advances portfolio while
maintaining liquidity and diversification. This would enhance efficiency, while mitigating
transaction costs, between borrower and lender which are difficult to achieve in absence of
financial intermediaries (Holmstrom & Tirole, 2001). Therefore, with role of intermediation,
savers and investors are likely to interact optimally at considerable low cost with more effective
screening and monitoring of current and expected default risk.

The third justification of financial intermediaries relates to their role to regulate money
creation and financing of an economy (Fama, 1980 & Merton, 1995). The inherent risks and
concerns of solvency ina financial system require the monetary and prudential supervision that is
not possible in direct interaction of savers and investors. Although, regulatory supervision of
financial intermediaries is expensive but the potential benefits that emanate in form of safety for
depositors are immense and considered as main economic rent extracted from monitoring and
control (Matthews&Thompson, 2005).
Dependant variable Interest rate spread

Interest rate spread is a payment for services in the intermediation process like loan
screening and monitoring, deposit mobilization, management of payment services and
information asymmetry and other relevant costs between interest rate paid to savers and interest
charged from borrowers (Harunn, 2011). Spread is captured as fees charged for intermediation
services on both deposit and loan mobilization (Auwalu,2012). It reflects the additional cost of
borrowing related to intermediation activities performed by banks in linking borrowers with the
ultimate fund lenders (Khrawish et al, 2008). Interest rate spread (IRS) is also described as the
difference between lending interest rate and deposit interest rate. It is generally regarded as a
considerable barrier to the expansion and development of financial intermediation. This often
discourages potential savers with low returns on deposits and limits for financing potential of
borrowers, thereby reducing feasible investment opportunities and the potential growth of the
economy(Barajas et al., 1999, and Ndung’u & Ngugi, 2000).Robinson, (2002) highlights that;
loan rates charged by commercial banks can be separated into two major components. One is the
interest rate paid to depositors and the other rate is risk premium. IRS can also be explained as
the difference between average interest rate earned on interest earning assets or loans and
average interest rate paid on deposits (Jayaraman & Sharma, 2003), the difference between bank
lending and deposit rates (Sologoub, 2006).

Efficient financial intermediation is an important factor in economic development process

as it has implication for effective mobilization of resources. Consequently, banking sector
efficiency plays significant role in an economy. A wide deposit to lending rate margin is not only
indicative of banking sector inefficiency; it also reflects the level of development of the financial
sector. Quaden, (2004) argues that amore efficient banking system benefits there al economy by
allowing higher expected returns for savers with a financial surplus, and lower borrowing costs
for investing in new projects that need external finance. An increase in the inefficiency of banks
increases these intermediation costs, and thereby increases the fraction of savings that is ‘lost’ in
the process of intermediation. This ultimately reduces lending, Investment and economic growth.

These implications of banking sector inefficiency have spurred numerous debates in

developing countries about the determinants of banking sector interest rate spreads. Studies have
shown that there is a pervasive view amongst some stakeholders that interest rate spreads are
caused by the internal characteristics of the banks themselves, such as their tendency to
maximize profits In an oligopolistic market, while many others argue that the spreads are
imposed by the macroeconomic, regulatory and institutional environment in which banks
operate. These debates can only be resolved through objective, quantitative analysis of the
determinants of banking sector interest rate spreads in developing countries like Ethiopia.

Researchers have attributed the existence of high IRS in developing countries

toseveralfactors,suchashighoperatingcosts,financialrepression,lackof competition and market
power of a few large dominant banks enabling them to manipulate industry variables including
lending and deposit rates, high inflation rates, high risk premiums informal credit markets due to
widely prevailing perception relating to high risk for most borrowers, and similar other factors
(Aryeetey et al.,1997;Barajas et al.,1999; Hanson & Rocha, 1986;Smirlock, 1985;Mujeri &
Islam, 2008). Same study made by Randall, (1998); Gelbard &Leite, (1999), and Brock& Rojas-
Suarez, (2000) show that interest rate spreads in Sub-Saharan Africa, Latin America and the
Caribbean are wider than in OECD countries.

Priorstudiesthatexaminedeterminantsofbankinterestratespreadsgenerallyusevariables that
fall in three categories (1) individual bank-specific factors such as operating or administrative
costs, risk aversion, non-performing loans, return on asset, structure of the balance sheet, non-
interest income or non-core revenues, bank size, liquidity ratio of a bank, banks personnel costs
among others; (2) factors specific to the banking industry such as the degree of competition, for
instance, be indicated by market concentration, regulatory requirements such as minimum core
capital requirements, statutory reserve requirements or regulated minimum deposit rates; and, (3)
macroeconomic indicators which include growth rate or the real Gross Domestic Product(GDP)
and inflation rate etc.

The empirical evidence on the role of bank specific and industry specific variables in the
determination of interest rate spread in generally supports the theory. For example, studies
suchasPerez,(2011)inBelize;Claeys&Vennet,(2004)inEurope;Gelos,(2006)inLatinAmerican;
Hossa in,(2010) in Bangladesh; and Dabla& Floerkemeier, (2007) in Armenia. On the other end,
Eita, 2012; Khawaja & Din, 2007; Chirwa & Mlachila, 2002; Afanasieff,
LhacerandNakane,2002;Demirgüc-Kunt&Huizinga,1999pointoutthatthemacro-economic
environment has a significant effect on determination of interest rate spreads.

Determinants of interest rate spread

As afore mentioned above different researchers using different models and variables tries
to explain the determinants of interest rate spread. This research uses credit risk, return on asset,
risk aversion, bank size, net interest income as ratio of total income, administrative expense, off-

Balance sheet activity, banks personnel costs and directive enacted by national bank of Ethiopia
in 2010 as dummy variable. Listed variables and explanations and results obtained by prior
literatures are stated as follows.

Credit risk

Credit risk is the most important factor in determining interest margin in high income
countries (Hyeon et al, nd). It is a measure of differences in credit quality across countries. High
ratio indicates poor quality of loans and higher the risk and also reflects differences in
provisioning regulations. Poor enforcement of credit rights, fragile legal setting and inadequate
information on borrowers expose banks to credit risk (Khumaloand et al, 2011). Straka,
(2000)and Wheaton et al.,(2001) have expressed credit risk as the end result of some trigger
event which makes it no longer economically possible for a borrower to continue offsetting a
credit obligation. Though there are various definitions of credit risk, one outstanding concept
portrayed by almost every definition is the probability of loss due to default. However, a lot of
divergences emerge on defining what default is, as this is mainly dependent on the philosophy
and/or data available to each model builder. Liquidation, bankruptcy filing, loan loss (or charge
off), non performing loans (NPLs) or loan delayed in payment obligation, are mainly used terms
as synonym to default risk.

Commercial Banks allude to the fact that persistent credit risk mainly buoyed by the
blatant lack of accurate information on borrowers’ debt profile and repayment history; could
Bethe causal factor for determining Interest rate Spreads. Timely and accurate information on
borrowers’ debt profile and repayment would reduce information asymmetry between borrowers
and lenders. This was expected to enable banks among other things lower credit risk and Interest
rate Spreads and hence, contribute to financial deepening in the economy. Moreover, high and
inflexible interest rate spreads are indicative of the existence of perceived market risks (Mugume
&Ojwiya, 2009).

Nampewo, (2013) studies the determinants of the interest rate spread of the banking
sector in Uganda using time series data for the period (1995–2010).The study applies the Engle
and Granger two-step procedure to test for co integration between dependantvariableandnon-
performingloans.Resultsshowthatinterestratespreadispositivelyexplained by non-performing
loans. Same result was indicated by Grenade, (2007); Ngugi, (2000); Kasmanet al., (2010);
Hossain, (2010); and Aregu, (2014); Afzal & Mirza, (2010); Gounder & Sharm,(2011); Auwalu
and Entrop et al, (2012) ; Gasang et al, Ben et al, Konar & Kimondo, (2014);Islam & Suarez,
(2010) and Trung & Dan, (2015). Banks with higher ratio of non-performing loans to total loans
faces higher credit risk, which is likely to be reflected in the changing
ofhighermargin(Kalluci,2009).Thehighercreditriskthehigherthepricingofloansandadvances to
cover likely losses (Were & Wambua, 2014). The higher the NPL the wider theinterest rate
spread (Samaliya & Knakunga, nd). On the other side, few researchers revealed thatcredit risk
has negatively affect interest rate spread such as Drakos, (2003) in FSU countries andRandall,
(1998); Willium, (2007); Brock & Suarez, (2000); Ghosh et al, (2001); Fungacova
&Poughosyan, (2009); Ascarya & Yumanti, (2010); Azeez & Gamage, (2013) and Plakalovic
&Alihodzic,(2015).Still some researcher argued that credit risk plays minimal role
indetermination of interest rate spread Mannasoo, (2012), Matheri, (2009). Whereas, Ahokpossi,
(2013) in SSA; Siddiqui, (2012) in Pakistan; Moore & Craigwell, (2000) and Perez, (2011)
inBelize, announce there is a significant relation between credit risk and interest rate spread.
Similar attempt was made by Beck et al, (2010); Maudos et al., (2004) and Tarus et al., (2012) to
investigate the determinants of interest rate spreads, credit risk as explanatory variable.

Return on assets
Return on asset explains the overall profitability of a bank emanating from the asset
portfolio both advances and investments. In order to improve profitability the bank will seek to
increase net interest income by increasing interest margin. The bank will also raise interest
margin to cover increase in operating cost thus, the increase In return on asset will encourage
banks to raise interest margin (Gesang et al, 2014). High profitability and soundness of the bank
can be attributed to its consistently high interest margin as well (Konar, 2014). Profitability
measured through the return on asset ratio is in a positive association with net interest margin
(Reharjo et al, 2014). It is another effective measure for evaluating performance of a bank‘s
management. A bank with higher profitability, otherwise, can afford to charge lower spreads.

However, on the contrary banks with higher ROA could result in higher spreads with
better performance of interest sensitive assets. Siddiqui,(2012)estimates interest rate spread in

Pakistan based on individual bank specific factors using return on assets after payment of tax as a
percent of average assets. Similarly, Norris & Floerkemeier, (2007) revealed that return on
assetexplainalargeproportionofbankingspreads.Were&Wambua,
(2012)investigatethedeterminants of interest rate spread in Kenya’s banking sector based on
panel data analysis their result revealed that return on average asset positively influences interest
rate spread, it implies the higher banks return will encourage them to reduce interest rate spread.
Munjeri and Younus,(2009) who found out that bank with high return on average assets have
high spreads as their assets are expected to be charging higher rates in order to have high returns.
Similarly Afzal &Mirta, (2010); Gesang et al, (2014); Hyeon et al, Konar and Kimaondo, (2014)
also indicates same directional relation. However, Aregu, (2014) using eight commercial banks
in Ethiopia, with multiple regression models revealed that return on asset has negative and
significant relation with interest rate spread. This study is also similar to the result stated
byAhokpossi,(2013);Aquirreand Hainz(2014).

Net interest income as a ratio of total income

 Banks that traditionally rely on interest income from loans and advances relative to non-
interest income assets are likely to be associated with higher spreads. Since, they may not be
willing to forego interest income traditionally generated from higher spreads Were & Wambua,
(2013). However, it might also be the case that higher interest income is associated with lower
interest rate spreads due to higher probability of loan repayment. Siddiqui, (2012) estimates
interest rate spread in Pakistan based on individual bank specific actors using net interest income
as a percent of total income the spread is found in significant relation with net interest incomes to
total income ratio.

Administrative expense
Administration expense is at the heart of banking spread, as it is considered to be the cost
of financial intermediation. Administrative expense related to financial intermediation includes
costs for screening loan applicants, costs to assess the risk profile and monitor the projects for
which loans and advances (Were & Wambua, 2014). Siddiqui, (2012) estimates the interest rate
spread in Pakistan based on individual bank specific factors using annual panel data,
administrative expenses as a percentage of total expense. The spread is found to be significantly
affected by the given variable. Aboagyeet al., (2008) finds that an increase administrative
expense increases the net interest margin of banks. Unstable and high net interest margins have
generally been attributed to high administrative expense (Central bank of Swaziland). High
spread associated with less developed market characterized by high administrative
expense(Ghoshetal,2001);Horvath,(2009);Khawaja&Din,(2007)andAfanasieff,
(2002).Additionally,Khan&Khan,(2010)determine interest rate spreads of commercial banks
operating in Pakistan by using a balanced panel of 28 banks. A one step linear regression the
results indicate administration expense is positively correlated with banking spreads and stated
that the higher administrative expenses, banks would increase interest rate spread to cover
suchcosts.However,Fungacova&Poghosyan,
(2009)investigateadministrativeexpensehavenegativerelation with interest rate spread.

National bank directive

est margin because of higher staff efficiency diminishes the dependant variable
(Chortareaset al, 2012).
Regulation in the financial sector is aimed at reducing imprudent actions of banks with
regards to maintaining appropriate level of interest rate spread, insider lending and reducing loan
defaults. The central banks have achieved this through interest rate ceilings and other monetary
policies, procedures and directives. Demirguc-Kuntand Huizinga(1997) found that better contract
enforcement, efficiency of the legal system and lack of corruption are associated with lower
realized interest margins and loan non-performance. While subsidized rates can help increase
loan accessibility, it tends to favor the wealthy and politically connected and borrowers who
might not take the loans seriously enough (Muraki, et al., 1997: 36). Borrowers may take loans
less seriously since the rate is lower than the market rate and money may not be used for the best
investment available in the market. However, lower interest rates may be helpful for small
borrowers who may not know many high return investment opportunities.

According to a World Bank report,(1994) in Uganda, owing to lack of proper regulations

the country’s banking industry was described as extremely weak, with huge non-performing
loans and some banks teetering on the verge of collapse. Interest rate spread is a measure of
profitability between the cost of short term borrowing and the return on long term lending. These
costs are normally transferred to borrowers who might, with time, be in a position of not
repaying the loan. World Bank policy research working paper on Non-performing Loans in Sub-
Saharan Africa revealed that bad loans are caused by adverse economic shocks coupled with
high cost of capital and low interest margins (Fofack, 2005).

However, literatures states that central banks should apply stringent regulation and
rigorous policies on interest rate to regulate interest rate spread of commercial banks
(Gatune,2015). In the mean time, National bank of Ethiopia (NBE) enacts interest rate directive
number BE/11/2010. This directive is approved in 2010 but put in to effect on Dec, 2010. This
researcher wants to see the role of this directive indetermination of interest rate spread.
Bank size
Ideally, one would expect bigger banks to be associated with lower interest rate spreads,
arguably because of large economies of scale and ability to investing technology that would
enhance efficiency. Big banks are associated with relatively higher spreads with more market
power they also enjoy good reputation and trust and hence can easily mobilize deposits even at
lower rates and attract higher loan demand even at higher rates(Horvath, 2009). Bigger bankscan
have lower cost per unit of income and therefore higher net interest margin (Dumicic &Ridzak,
2012). Large banks may be able to exert market power through stronger brand image
orimplicitregulatoryprotections.Thelargerthesizehardertomanagethebusinessduetobureaucratic
and other reasons (Iloska, 2014). Economic of scale suggests that banks provide more loans
should benefit from their size and have lower margins (Kalluci,2009).

For big banks the demand for loans or deposit mobilization is more or less inelastic with
respect to the respective interest rate charged (Were & Wambua, 2014).Smaller banks had higher
spread than large banks (Ho & Saundres, 1981).Bigger banks tend to have narrower spread due
to economic of scale (Samaliya & Knakunga, nd). Beck and Hesse, (2006) state banksize
explains a large proportion across banks, across-time variation in spreads. Afanasieff et al.,
(2002) found that the spread is higher the larger a bank. Increase in bank size increases the net
interest margin of banks Aboagye, et al, (2008); Kharawish et al, (2008); Gesang et al,
(2014);Illoska, (2014); Islam & Nishiyama, (2015); Were and Wambua, (2014); Horvath, (2009)
and Afzal & Mirza, (2010). On the other hand, Gambacorta, (2004) finding revealed that Bank
size was found to be irrelevant in influencing interest rate spread.
CHAPTER Five RESEARCH METHODOLOGY
1. 5 Researchapproachandparadigm

The researcher will use empirical analysis of determinants of interest rate spread of
commercial bankingsector in Ethiopia is an explanatory research approach which seeks
explanations of observed problem, determine the accuracy of the theory and test atheory's
predictions. Mostly, explanatory research conducted to gain new insights, discover new ideas
and/or increase knowledge of a phenomenon (Burns & Grove, 1998). It also employed a
quantitative method will be used to test the pre specified concepts, constructs and hypotheses
that built a theory.
Researchdesign
The objective of this research will be to investigate the determinants of interest rate
spread in commercial banks of Ethiopia. To do so, the study will adopt a causal research design
a sit focuses on establishing the causal relationships between the dependent variable (interest
rate spreads) and the various independent variables namely the firm (bank) specific determinants.

SamplingDesign
The researcher will use purposive sampling techniques. The main reason for using this sampling
technique is to include branch managers and those individuals who haveenough knowledge about
the banks interest rate spread activity. sample size

Dependent Variables
Interestratespread
Empiricalmeasuresofbankspreads attempt tocapturethecostoffinancialintermediation
that is, the difference between what banks charge borrowers and what they pay todepositors. A
number of studies approachspreads by calculating the so-called net interest margins. Demirguç-
Kunt& Huizinga, (1999)states the measure of net interest margin (efficiency of bank
intermediation) as ex-ante and ex-post spreads.Theex-antespread is thedifferencebetween
thecontractual rateschargedonloans and ratespaid on deposits.

The ex-post spread is the difference between banks’ actual interest revenues and
theiractual interest expenses.The ex-post spread differs from theex-ante spread by the amount of
 loan defaults, it is a more useful measure because it controls for the fact that banks with
highyield, risky credits are likely to face more default. The researcher uses an ex-post approach
incalculatingtheinterestratespread.Tocomputeinterestratespreadoneofthe accounting
equation(model) defined by Khrawish et al, (2000); Chirwa&Mlachila, (2004); Auwalu, (2014)
andBrock & Rojas, (2000) is used due to its simplicity and availability of required dates.
Thisequationis stated as follows;

𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡𝑖𝑛𝑐
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡𝑒𝑥𝑝
𝑜𝑚𝑒 𝑒𝑛𝑠𝑒 𝑥100
𝐿𝑜𝑎𝑛 −
𝐷𝑒𝑝𝑜𝑠𝑖𝑡

Independentvariables
 Credit risk (CR):- Calculated as provision for bad debt to total loans and advance ratio
isusedas an indicator of credit risk orqualityof loans.
𝑝𝑟𝑜𝑣𝑖𝑠𝑖𝑜𝑛𝑠𝑓𝑜𝑟𝑏𝑎𝑑𝑑𝑒𝑏𝑡
𝑇𝑜𝑡𝑎𝑙𝑙𝑜𝑎𝑛𝑠𝑎𝑛𝑑𝑎𝑑𝑣𝑎𝑛𝑐𝑒𝑠 𝑥100
 Return on assets (ROA):- ROA is measured by net income to total asset ratio,
whichexplains the overall profitability of a bank emanating from the asset portfolio
(bothadvancesand investments).
𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒𝑎𝑓𝑡𝑒𝑟𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡𝑎𝑛𝑑𝑡𝑎𝑥𝑒𝑠
𝑇𝑜𝑡𝑎𝑙𝑎𝑠𝑠𝑒𝑡 𝑥100

 Net interest income as a ratio of total income (INTRCOM: - This variable is

measuredas (Interest income minus interest expense as a ratio of total income both
interest andnon-interest).
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡𝑖𝑛𝑐𝑜𝑚𝑒−𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡𝑒𝑥𝑝𝑒 𝑥100
𝑛𝑠𝑒
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡𝑖𝑛𝑐𝑜𝑚𝑒+𝑛𝑜𝑛𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡𝑖
𝑛𝑐𝑜𝑚𝑒

 Administrative expense (ADMEXP):-It is measured by t he ratio of bank’s general and

Administrative Expenses to bank total operating expense.

𝐵𝑎𝑛𝑘𝑠𝐺𝑒𝑛𝑒𝑟𝑎𝑙𝑎𝑛𝑑𝑎𝑑𝑚𝑖𝑛𝑠𝑡𝑟𝑎𝑡𝑖𝑣𝑒𝑒𝑥𝑝𝑒𝑛𝑠𝑒
𝑇𝑜𝑡𝑎𝑙 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔𝑒𝑥𝑝𝑒𝑛𝑠𝑒 𝑥100
 Data source and Collection method
The researcher will use data’s for the study both primary and secondary data. Primary data
will be gather through in-depth interview from finance manager of banks and the Secondary data
will be collect from different documents analysis such as the bank specific variables of the study are
driven from balance sheet and income statement of the banks.
3.5 Method of data analysis and interpretation
The researcher will use both qualitative and quantitative data analysis techniques. The
quantitative data will collect through structured record reviews will be analyzed by using both
descriptive and inferential statistics. Descriptive statistics of the variables will use to analyze the
general trends of the data over the sample period. In addition, Correlation matrix will also use to
examine the relationship between the explanatory and explained variables. the results of the
interview were analyzed using triangulation with the findings of the structured record reviews. As a
result, the response of the interviewees for the interview questions were used for supporting the
result obtained from analysis of structured document reviews or as arguments.

21
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