Challenges in the Era of Globalization - iaabd

Proceedings of the 12th Annual Conference © 2011 IAABD
2010); the inefficient banking operating system (Claeys and Vander Vennent 2008); the bank regulation,
concentration and inflation (Demirguc-Kunt et al 2004) and the monetary policy and macroeconomic
shocks (Maudos and Fernandez de Guevara 2004). Employing micro-bank-specific and macro-countrylevel
data from 24 SSA countries, this paper contributes to the literature by examining the determinants of
bank interest spread in African banks focusing on the stance of monetary policy and the degree of market
power in the following ways: first, as there is no consensus in the literature regarding how best to assess
the degree of bank market power (Carbo et al,. 2009), three different specifications of the Lerner index
are constructed: conventional Lerner, efficiency-adjusted Lerner, and funding-adjusted Lerner to
investigate competitive environment of African banks. To the best of my knowledge there is no study that
has employed various specifications of the Lerner index in examining the causes of spread in SSA. The
second innovation of this paper lies in identifying the channel through which policies affect bank spread
and resource allocations.
The results suggest that on average conventional Lerner index is lower than that of funding and
efficiency-adjusted Lerner indices. These results imply that the former has been underestimating the
degree of market power in SSA. The results also suggest that the high net-interest margin in SSA is
attributed to high credit risk, risk aversion, excessive implicit payments and the increasingly high cost of
labor. Furthermore, the results reveal that spreads among banks with market power is significantly more
sensitive to the monetary policy stance.
The paper has four remaining sections. Section 2 reviews related literature on banks spread. Section 3
provides the methodology including the measurements of the key variables. Empirical results are
presented in section 4 and section 5 concludes.
Literature review
The theoretical principles explaining spread of banks can be described either in terms of ‘monopoly’,
‘dealership’ or ‘behavioral model’. The monopoly model developed by the seminal work of Klein (1971)
considers the banking firm’s main activity as the production of deposit and loans in the intermediation
services that is represented by a cost function of the C ( D , L ) type. Where D is the volume of deposits
while L is the volume of the loans produced by the bank. The rule in line with the cost function is that a
banking firm pursues its activities in an environment characterized by the presence of imperfect
competition in both deposit and credit markets. That is, the bank has the monopolistic power to set
interest rates in at least one of the markets where it conducts its operations. Klein (1971) contends that the
monopoly power of a bank can then be used to explain the scale of operations, its asset and liability
structure as well as its decision to affect the rate of return on liability (deposits) and asset (loan)
components. Thus, with this approach, banking firm spread reflects primarily its ability to charge a price
higher than the marginal cost for providing the services in both loan and deposit markets. The second
model in explaining bank spread is dealership. The dealership model introduced by Ho and Saunders
(1981) views the bank as a dynamic dealer, setting interest rates on loans and deposits to balance the
asymmetric arrival of loan demand and deposit supplies. The Non-synchronous arrival of loan and deposit
generates a cost for the bank given that it will have to hold either a long or short position in the money
market. The monopoly model and the dealership model of net interest margins have two main limitations.
According to Hanweck and Ryu (2005), monopoly and dealership models are single-horizon, static
models in which bank assets and liabilities are considered homogenous and accordingly priced at
prevailing loan and deposit rates and on the basis of the reference rate. The second limitation of these
models is that the banking sector is treated as either being homogenous or as having heterogeneous traits
that is based only on the assets’ size of banks. Conversely, banks with different products usually differ in
terms of their business models, pricing power and more importantly the funding structure and exogenous
shock. Hanweck and Ryu (2005) model of bank behavior in relation to net interest margins assume that at
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