What Drives Interest Rate Spreads of Commercial Banks in Pakistan? Empirical Evidence based on Panel Data

Abstract

This study analyses the determinants of interest rate spreads of commercial banks operating in Pakistan by using a balanced panel of 28 banks from 1997 to 2009. A one step linear regression with fixed effect across banks is estimated to take into account the impact of bank-specific, industry-specific, and macroeconomic factors on banking spreads. The results indicate that spreads of commercial banks are primarily driven by the banks' low cost of funding; operating expenses; and opportunities to earn income from non-core business activities. Specifically, the share of non-remunerative deposits in total deposits and administration expense in total expense are positively correlated with banking spreads, while the share of non-interest income in total income negatively affects banking spreads. Further, market concentration and macroeconomic variables, such as real GDP and interest rates also have a positive influence on commercial bank spreads in Pakistan. We also analyze the impact of the recent imposition of a regulatory floor on savings deposit returns on banking spreads. Using a difference-in-difference approach we find that in the absence of subsequent tightening in monetary policy, banking spreads would have been lower as a result of the policy measure.

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