Tài liệu SURVEY ON HOW COMMERCIAL BANKS DETERMINE LENDING INTEREST RATES IN ZAMBIA docx

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BANK Of ZAMBIA








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September 2010
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1.0
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1.1 As Government has indicated its intention to shift monetary policy away from
monetary targeting towards interest rate targeting, the Bank of Zambia (BoZ) has embarked
on conducting preliminary research to assess the feasibility of an interest rate targeting
framework in Zambia. Gaining a thorough understanding of the interest rate decision-making
process undertaken by commercial banks in Zambia would not only assist in the
determination of an appropriate policy rate, but would also enable the Bank of Zambia to
ascertain the transmission channel through which the policy rate would be most effective.

1.2 Evidence from numerous interest rate targeting central banks indicates that the policy
rate should be aimed at influencing developments in the interbank rate, which is then

expected to affect borrowing costs along the yield curve. The interbank market is therefore
expected to play a crucial role in the implementation of the interest rate targeting framework.

1.3 Investigating why the lending rates are high was also an area of great policy interest.

1.4 The main objective of the survey was therefore to identify the factors, both
quantitative and qualitative, that commercial banks consider in making decisions regarding
their base lending rates. The specific objectives were twofold:

(a) Assess to what extent the interbank market influenced the cost of funds in the
interest rate determination process; and,

(b) Ascertain which factors have significantly contributed to the high level of
lending interest rates currently prevailing in the market.

1.5 The key question posed to commercial banks was: What factors do you take into
consideration when determining the base lending rate for Kwacha/Foreign currency loans?
A formal model of the calculation method for determining the base rate was also requested,
as well as the minutes from Assets and Liabilities Committee (ALCO) meetings in which the
interest rate decisions were discussed. All of the 18 registered commercial banks in Zambia
were surveyed over the period 1
st
– 12
th
March, 2010.

1.6 Overall, it was observed that the most common factors considered in the rate setting
process were, as expected, the regulatory cash reserve requirements – namely, the statutory
reserve ratio (8%), core liquid asset ratio (9%) and the BoZ supervisory fee (0.2% of
deposits). Other factors which were considered significant in the determination of base

lending rates included: Treasury bill and GRZ bond yield rates; operating costs; cost of funds,
i.e. weighted average deposit rates; return on shareholder’s equity and the cost of non-
performing loans. The qualitative factors highlighted included, credit risk premiums, the
demand and supply for credit and the industry trend in base lending rates.

1.7 The survey results indicated that only half of the banks surveyed considered inflation
explicitly in their determination of base lending rates; although some banks indicated that
inflation was taken into account when calculating real returns. It was also found that almost
all the banks do not consider the interbank rate, or the BoZ overnight facility rate in their
calculation of base lending rates.

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1.8 Furthermore, several of the banks stated that qualitative or “judgemental” factors
contributed significantly in the determination of their base lending rates. In particular, they
noted that large information asymmetries within the domestic market, as well as the high
default culture experienced in Zambia, resulted in large risk premiums being attached to key
macroeconomic factors, such as inflation and Treasury bill yield rates.

1.9 These findings have two key implications: the first being for implementation of an
interest rate targeting framework in Zambia, and the second being the prevalence of high
lending rates. Firstly, as the interbank market is expected to be the transmission channel for
the framework, a policy rate that is linked to the interbank rate or overnight rate may not have
the desired effects on interest rates in the economy, as it will have no bearing on the banks’
cost of funds. In particular, further analysis indicated that there is a weak correlation between
the weighted lending base rates and the interbank rate (0.50) while there is a stronger
correlation between the weighted lending base rates and the OMO rates (0.72). This suggests
that, as an alternative, a policy rate linked to the OMO rate may be more effective.

1.10 Secondly, with regards to high lending rates, qualitative factors used widely in the
rate determination process may dampen the intended effect of a policy decision. For example,
a policy rate adjustment intended to lower interest rates in the economy may not be effective
if large information asymmetries and high credit default rates remain.

1.11 Overall, it was clear from the survey that there are several issues that need to be
addressed before a significant reduction in lending rates in the market is observed; and more
importantly, before an effective interest rate targeting framework can be implemented in
Zambia.

1.12 The rest of the report is organized as follows. Section 2 outlines the methodology
employed. This is followed by a discussion of the survey results. Section 4 concludes,
focusing on the way forward.




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2.1 The survey was undertaken using a structured questionnaire over the period 1
st
March
to 12
th
March, 2010. The questionnaire was supplemented with interviews between BoZ staff
and representatives from all the 18 registered commercial banks. The questions posed in the
questionnaire are listed below:

(i) What factors do you take into consideration when determining the base lending
rate for Kwacha loans?

(ii) What factors do you take into consideration when determining the base lending
rate for foreign currency loans?

(iii) Kindly rank the importance of these factors, separately for the Kwacha and
Foreign Currency lending rates.

(iv) Does the importance of these factors change? If yes, under what circumstances?

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(v) Kindly provide a computer spreadsheet which shows the formula used in
computing the base lending rates from 2005 to 2009. It is expected that the
spreadsheet contains all the factors mentioned which are used in computing the
base lending rates. A soft copy will be preferred.

(vi) Kindly provide Assets and Liabilities Committee (ALCO)
1
Minutes and Packs for
December 2005, 2006, 2007, 2008 and 2009.

(vii) Please assist us with any other relevant information.

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3.1 This section presents the findings of the survey, based on the information provided by
each of the commercial banks. These are discussed in turn below.
Determination of Base Lending Rates
3.2 Taking all the commercial banks’ responses into account, we summarised the key
factors considered in the base lending rate decision-making process in terms of cost of funds,
economic conditions, market conditions and political risks. As can be noted from Table 1, the
most common factors considered in the rate setting process are cost of funds: cash reserve
requirements – namely, the statutory reserve ratio, core liquid asset ratio and the BoZ
supervisory fee; operational costs; and yield rates on Government securities. This is followed
by market conditions: credit risk, industry trend, interbank rate, overnight facility and
demand and supply of credit.

3.3 The survey results indicated that only half of the banks consider economic conditions,
in this case, inflation, explicitly in their determination of base lending rates. Furthermore,
while it is understood that the interbank rate represents the cost of short-term liquidity, it is
evident from Table 1, that all banks, with the exception of one bank, do not take the interbank
rate into account while four banks indicated that they consider the BoZ overnight facility rate
in their determination of the base lending rate.

3.4 It was also found that the ranking of factors depended primarily on the bank’s profit
motive. For example, while the Treasury bill yield rates are considered by all banks, and by
implication one is likely to rank them highly and thus give them a relatively larger weighting
in the calculation method, a fall in the yield rates should result in a fall in the base lending

rate. However, this is hardly the case. This, therefore, suggests that achieving the required
return on equity and covering operational costs are, among other factors, more important
factors in the determination of base lending rates.

3.5 From the foregoing, one is bound to ask the following two questions:

(i) What are the implications of these findings for the interest rate targeting
framework in Zambia?


1
Assets and Liabilities Committee (ALCO) is a senior management committee in a bank or thrift institution, responsible for
coordinating the institution's borrowing and lending strategy, and funds acquisition to meet profitability objectives as interest
rates change.
5


(ii) What are the implications of these findings for the prevailing high lending rates in
the economy?




6



2
Operating costs in this case include the following: management fees, staff costs, transaction costs and communication costs, costs of provisioning, internal cash reserves,
projected profit and cost of capital (return on equity).

Bank
I
H
G
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A
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P
Q
R

Cost of Funds
√
√
√
√
√
√
√
√
√
√
√
√
√
√
√
√
√
√
√
√
√

√
√
√
√
√
√
√
√
√
√
√
√
√

√
√
Statutory reserve
requirement
√
√
√
√
√
√
√
√
√
√
√
√

√
√
√
√
√
√
√
√
√
√
√
√
√
√
√
√
√
√
√
√
√
√

√
√
Core liquid asset
requirement
√
√
√

√
√
√

√
√
√
√
√
√
√
√
√
√
√
√

√
√
√
√
√
√

√
√
√
√

√

√
BoZ supervisory fee


√
√

√
√




√
√



√
√

√
√


√
√
Taxation

√

√
√
√

√
√
√
√
√
√




√
√
√
√


√
√
√
√

√
√
Weighted average
deposit rate

√
√
√
√

√
√
√
√
√
√

√
√

√
√
√
√
√
√
√
√
√
√
√
√
√
√

√
√
Operating costs
2

√
√
√
√

√
√
√
√
√
√
√
√
√
√
√
√

√
√

√
√

√

√


√
√
Economic
Conditions



√
√

√
√

√
√
√
√
√
√


√
√
√
√

√

√
√
√

T-bill/GRZ bond rates
√
√

√
√
√
√
√
√
√
√
√
√


√
√
√
√
√
√
√
√
√
√

√
√

√
√
Inflation


√
√
√
√
√
√
√
√

√
√

√
√




√
√

√
√
√
√

Exchange rate
√
√
√
√



√
√








√
√
√
√

√
√

Market Conditions

√
√
√
√
√
√
√
√


√
√
√
√
√
√

√
√
√
√

√
√

Credit risk premium







√
√

√
√




√
√



Liquidity premium

√
√

Interbank rate

√
√

Overnight facility rate



√
√




√
√







√
√


√

√

Demand and supply





√
√


√
√




√
√




Market expectations




√

√
√
√



√
√
√
√

√
√
√
√

√
√


Industry trend

√
√

Political Conditions


















Political risk/Country

risk premium









√
√




√
√



Table 1: Aggregate results of the factors considered in the determination of Kwacha base lending rates
7


Interbank Rate and Policy Rate

3.6 Since we have observed that the interbank rate is not a significant input in the
calculation of banks base lending rates, the introduction of a policy rate which is expected to
influence the interbank rate will not have the desired effects on commercial bank interest

rates, and ultimately inflation, in the economy.

3.7 Thus, as an alternative, it may be necessary to consider the possibility of using a
policy rate that is linked to the Open Market Operations (OMO) rate rather than the interbank
or overnight facility rate. This is because other studies conducted in the Bank have shown
that there is a strong correlation between the OMO rates and base lending rates in Zambia –
with a correlation coefficient of 0.72, compared to a correlation coefficient of 0.50 between
the interbank rate and base lending rates. In addition, and as is the case in South Africa,
interest rates in the money market are influenced through the use of a repurchase (repo) rate
and OMO. This refinancing mechanism has allowed the South African Reserve Bank to
effectively administer its inflation targeting regime.

Inflation and Lending Rates

3.8 Despite the survey results showing that only half of the banks used inflation in
determining the base lending rates, our analysis suggests that inflation is taken into account.
This assertion is supported by Graph 1, which depicts a positive relationship between the
weighted lending base rate (WLBR) and inflation, over a 10 year period from 2000 to 2009,
with a correlation coefficient of 0.75.

3.9 Although Graph 1 shows that overall, the WLBR and inflation moved in the same
direction, inflation declined from 16% in 2008 to 9.9% in 2009, but the WLBR rose from
20.8% to 22.6%. This could be due to the fact that changes in the WLBR lag those in
inflation, or that there are other factors, such as risk aversion in the recessionary climate and
large information asymmetries, that result in the WLBR remaining significantly higher than
inflation.

Graph 1: Weighted Lending Base Rate (WLBR) and Inflation, 2000 to 2009.

0
10
20
30
40
50
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
Weighted Lending Base Rate
INFLATION
Percent
8


Government Securities yield rates and Lending Rates

3.10 The relationship between the WLBR and Treasury bill yield rates, over the same 10
year period, is shown in Graph 2. As is evident from the graph, there is also a positive
relationship between the WLBR and Treasury bill yield rates, with a correlation coefficient of
0.89. This suggests that, as indicated by the banks, Treasury bill yield rates should play a
significant role in the determination of the base lending rates.

Graph 2: Weighted Lending Base Rate (WLBR) and T-bill yield rate, 2000 to 2009

3.11 Why then have the lending rates not declined in line with the recent fall in Treasury
bill yield rates?

From our analysis, we can infer that the commercial banks’ base lending
rates seem to be sticky downwards in response to declining Treasury bill yield rates. This is
especially evident in Graph 2.




3.12 It should also be noted that although inflation and yield rates tend to be relatively
unstable, the banks’ base lending rates tend to generally remain stable for long periods of
time, suggesting that there could be other factors that dominate the banks determination of
base lending rates. However, over a long period of time, a sustained downward adjustment in
macroeconomic fundamentals, such as inflation, should eventually result in lower lending
rates in the economy.




Base Lending Rate used as a Reference
3.13 Although banks set the base lending rates and announce these rates in the market, it is
generally expected that the actual lending rates given on loans and advances differ
considerably from the base rates. In addition, it appears that the market is divided between
prime borrowers, who are able to borrow at the base rate minus some margin, and individual
clients, considered more risky, who borrow at the base rate plus some margin.
0
10
20
30

40
50
60
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
Weighted Lending Base Rate
91 day Treasury Bill yeild rate
Percent
9


3.14 In addition, it was found that most of the banks set their base lending rates
qualitatively during the Assets and Liabilities Committee (ALCO) meetings, which primarily
assess the borrowing and lending strategy of the bank, among other things, with the view to
attaining the profitability objectives of the bank. This suggests that interest rate adjustments
seem to be dominated by the banks profit motives rather than the developments in economic
fundamentals.
Large Information Asymmetries
3.15 The margins charged on loans and advances are, in some cases, excessively high. We
observed that this was partly due to the lack of accurate information on borrowers and the
“default culture” inherent in the Zambian market. The introduction of the CRB is therefore
expected to help in eliminating the information asymmetries, and thus reduce the credit or
default risk premium that is included by all banks in the determination of base lending rates.
3.16 Nonetheless, while the CRB was noted as a welcome development by most banks, the
survey results indicated that currently the CRB falls short of expectations. Banks were of the
view that the CRB’s scope of coverage was too narrow as it was restricted to information
provided to it by commercial banks alone. In this regard, it was suggested that the scope of
coverage be widened beyond commercial banks, in that information regarding the credit
history of clients and employees of other credit-providing institutions be provided to the CRB
as a statutory requirement.
Excess Liquidity in the Inter-Bank Market

3.17 During the period of the survey, it was found that the excess liquidity in the inter-bank
market had resulted in little activity within the market, as well as limited use of the overnight
lending facility introduced by the BoZ. The interest rate on the overnight lending facility was
found to be punitive (at a 6% margin to the interbank rate), thus giving the impression that a
bank accessing the facility is in distress. In this regard, most banks noted that the margin
currently applicable on the overnight lending facility should be adjusted downwards and that
the interest rate on the facility should not be linked to the inter-bank market. Rather, the
interest rate on the central bank’s facility should be independently determined, with the
policy rate as a reference.
3.18 Furthermore, it was observed that several smaller banks were unable to access funds
within the interbank market, despite the apparent excess liquidity in the market. The
reduction of the overnight lending facility rate would therefore make the facility a more
viable option for banks that cannot access funds within the interbank market.
Operational Costs in the Banking Sector are high
3.19 From the survey, it was found that the operational costs, especially staff costs, for
most commercial banks are high and this has a bearing on the determination of base lending
rates. In particular, staff loans had, on one occasion, been explicitly included in the
calculation of the base lending rate. This, it can be inferred that these loan costs were being
passed directly onto clients. The high staff costs may be due to the fact that new banks
entering the market have to “poach’’ staff from existing banks, therefore resulting in higher
salaries which become sticky downwards.
3.20 In addition, the high operational costs in the banking sector could be an indication of
inefficiencies in the banks’ operations, which are then passed on to their clients through high
10


lending rates. In view of the high operational costs, it would be difficult to achieve a
significant and sustainable reduction in lending rates regardless of the positive developments
in macroeconomic fundamentals, unless competition and innovation are enhanced.
3.21 Further analysis into the nature of the operating costs in the banking sector

highlighted specific concerns with regards to efficiency and returns on equity. Table 2 depicts
selected operating ratios for each of the commercial banks surveyed, from 2006 to 2009.
Efficiency refers to the ability of a bank to generate enough income to cover its non-interest
expenses.
3.22 Table 2 also shows that salaries and employment benefits continue to make up a
significant portion of operating costs. Although the average salaries to operating costs ratio
was between 30% and 50% from 2006 to 2009, salaries for several of the banks reached
approximately 60% of operating costs over the last 4 years.
3.23 Given improvements in technology and the relative increase in competition due to the
entry of more banks in the market, it is expected that the efficiency in the banking sector
should improve over time. Efficiency ratio of 60% or less is considered to be favourable.
3.24 The efficiency ratios presented in Table 2 indicate that operational efficiency within
the domestic banking sector has been unfavourable over the period. While it is understood
that the global financial crisis had a significant negative impact on the income-generating
ability of many banks in 2008 and 2009, several of the banks have had unfavourable
efficiency ratios for a number of years. For example, the operational efficiency ratio for Bank
H has been above 80% over the past four years, reaching 236% in 2009; and the efficiency
ratio for bank L rose from 85% in 2006 to 140% in both 2007 and 2008.
3.25 Further analysis of the relationship between the banking industry efficiency ratio and
the lending base rates, as indicated in Graph 3, shows that increased inefficiency partially led
to high interest rates. In 2006, based on the efficiency threshold of 60%, the industry was
inefficient and correspondingly the base rates were high. However, in 2007 the lending base
rate declined despite the efficiency ratio increasing. This can be attributed to the favourable
macroeconomic conditions experienced in 2007. In 2008, the lending base rate and industry
inefficiency increased and worsened in 2009, as a result of the global financial crisis.
11


Graph 3: Average Industry Efficiency Ratio and Base Rates, 2006-2009

3.26 From Table 2 for example, we can see that bank G can be considered as the most
efficient because its efficiency ratio was consistently below the 60% threshold for the period
under review. Graph 4 indicates that with increasing efficiency from 2006 to 2007, the
lending base rate remained the same and an increase in efficiency in 2008 resulted in a further
reduction in the lending rate.
Graph 4: Bank G Efficiency Ratio and Base Rates, 2006-2009


3.27 With regard to bank K, whose efficiency ratio was above 60% over the period, it can
be seen from Graph 5 that the lending rates declined with an improvement in efficiency from
2006 to 2007. However, in 2008 the lending rates increased despite an improvement in
efficiency. In 2009, there was an increase in efficiency, and to cover the increasing expenses
the lending rates also increased.
60
70
80
90
100
18
19
20
21
22
23
2006 2007 2008 2009
Industry Efficiency
Weighted Lending Base Rate
Efficiency (%)
Lending Rate (%)

25
30
35
40
45
50
17
18
19
20
21
2006 2007 2008 2009
G Efficiency G lending rate
Effiiciency (%)
Lending Rate (%)
12


Graph 5: Bank K Efficiency Ratio and Base Rates, 2006-2009


3.28 From Graph 6, it can be seen that the efficiency ratio for bank H was above 80%
from 2006 to 2009 and that the lending rate generally increased with increases in inefficiency
especially during the period 2007 to 2009.

Graph 6: Bank H Efficiency Ratio and Base Rates, 2006-2009


3.29 From the foregoing, it can be inferred that an increase in the efficiency ratio indicates
that a bank is using a larger percentage of its income to cover its expenses and the

corresponding increase in lending rates implies that this cost is being passed on to the
borrowers.
60
62
64
66
68
70
72
18
20
22
24
26
2006 2007 2008 2009
K Efficiency K lending rate
Efficiency (%)
Lending Rates (%)
80
120
160
200
240
18
20
22
24
26
28
2006 2007 2008 2009

H Efficiency H Lending rate
Efficiency (%)
Lending Rate (%)
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3
Operating costs are also referred to as non-interest expenses.
4
Efficiency ratio = non-interest expenses/net interest and other income. Efficiency ratios below 60% indicate good operational efficiency, while those above may suggest that
the operations of the institution are inefficient.
5
In this case, a simple average is used.

2006
2007
2008
2009
Bank
Operating
Cost
3
/Total
Costs
Salaries/
Operating
Costs
Efficiency
Ratio

4

(%)
Return
on
Equity
(%)
Operating
Cost/Total
Costs
Salaries/
Operating
Costs
Efficiency
Ratio
(%)
Return
on
Equity
(%)
Operating
Cost/Total
Costs
Salaries/
Operating
Costs
Efficiency
Ratio
(%)
Return

on
Equity
(%)
Operating
Cost/Tota
l Costs
Salaries/
Operating
Costs
Efficiency
Ratio
(%)
Return
on
Equity
(%)
I
-
-
-
-
-
-
-
-
0.95
0.41
1,492.0
-175.4
0.82

0.41
160.0
-118.6
H
0.66
0.24
84.3
7.7
0.65
0.40
99.2
0.4
0.58
0.48
126.6
-12.3
0.53
0.48
235.7
-124.7
G
0.83
0.57
47.3
59.6
0.73
0.61
34.4
52.5
0.76

0.55
27.2
29.5
0.67
0.65
32.1
31.8
F
0.79
0.43
91.3
12.7
0.77
0.55
75.1
57.4
0.72
0.57
80.6
14.3
0.73
0.50
144.1
-82.3
E
0.92
0.47
86.4
17.2
0.91

0.49
91.3
10.1
0.84
0.51
80.8
20.8
0.84
0.51
105.3
-10.9
D
0.63
0.24
31.7
54.7
0.58
0.33
45.3
21.0
0.63
0.33
33.0
27.6
0.65
0.37
36.5
31.9
C
-

-
-
-
-
-
-
-
-
-
-
-
0.97
0.50
-1,123.6
-58.3
B
0.82
0.35
54.1
57.8
0.79
0.43
53.1
42.4
0.78
0.42
49.7
43.5
0.72
0.43

54.7
53.8
A
0.69
0.36
30.3
35.9
0.64
0.57
31.4
23.8
0.67
0.57
29.2
24.4
0.66
0.58
36.9
29.9
J
-
-
-
-
-
-
-
-
-
-

-
-
0.98
0.32
519.2
-99.9
K
0.84
0.52
70.0
23.9
0.86
0.68
65.7
17.3
0.80
0.64
60.4
14.6
0.82
0.63
67.0
22.2
L
0.65
0.34
84.9
23.4
0.61
0.50

140.0
-66.6
0.70
0.45
142.8
-79.5
0.71
0.36
204.7
-85.2
M
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
N
0.61
0.31

65.0
52.3
0.63
0.54
64.7
39.1
0.67
0.53
68.0
34.8
0.66
0.48
74.0
35.1
O
0.86
0.38
51.7
75.9
0.83
0.56
47.3
78.0
0.86
0.44
83.8
14.3
0.86
0.45
81.1

31.0
P
0.83
0.46
53.3
68.3
0.83
0.54
56.6
42.4
0.84
0.55
81.7
13.7
0.81
0.46
66.4
52.4
Q
-
-

-
-
-
-
-
-
-
-

-
-
-
-
-
R
0.94
0.57
89.3
17.4
0.94
0.62
94.3
9.7
0.93
0.62
80.1
28.3
0.88
0.56
42.1
42.1
AVERAGE
5

0.77
0.37
64.6
39.0
0.75

0.52
69.1
25.0
0.77
0.51
174.0
-0.07
0.77
0.48
46.0
-15.6
Table 2: Operating Ratios, 2006 to 2009.
14


3.30 In addition, from Table 2, it is evident that the returns on equity for several of the
banks have been considerably high, although most collapsed in 2008 and 2009, as a result of
the global financial crisis. In particular, the average return on equity in 2006 was 39%, with
some banks exhibiting returns greater than 50%. However, in 2009, several banks
experienced significant negative returns of 80% and above, with Bank H experiencing a -
124% return on shareholder’s equity. It can be inferred, therefore, that even with the recent
decline in inflation and Treasury bill yield rates, the lending base rates in the domestic
economy may not come down as rapidly, as banks may be under pressure to cover prior
losses and achieve their target returns on shareholders’ capital.
3.31 Furthermore, a comparison of the returns on equity in the domestic banking sector
with others in the sub-Saharan region reveals that while the Zambian banking sector does not
exhibit the highest return on equity, it has consistently had the highest lending rate in the
region from 2006 to 2009. Graph 7, Graph 8, Graph 9 and Graph 10 illustrate the return on
equity and actual average lending rates for selected countries in the region in 2006, 2007,
2008 and 2009, respectively.

Graph 7: Return on Equity and Actual Average Lending Rates – 2006

Source: IMF IFS and Global Financial Stability Report, 2010







10
20
30
40
50
60
70
Namibia
Zambia
Kenya
Mozambique
South Africa
Uganda
Return on Equity Lending Rate
Return on Equity and Lending Rates
Percent (%)
15

Graph 8: Return on Equity and Actual Average Lending Rates – 2007

Source: IMF IFS and Global Financial Stability Report, 2010

Graph 9: Return on Equity and Actual Average Lending Rates – 2008

Source: IMF IFS and Global Financial Stability Report, 2010





10
20
30
40
50
60
Namibia
Zambia
Kenya
Mozambique
South Africa
Uganda
Return on Equity Lending Rate
Return on Equity and Lending Rates
Percent (%)
10
20
30

40
50
60
Namibia
Zambia
Kenya
Mozambique
South Africa
Uganda
Return on Equity Lending Rate
Return on Equity and Lending Rates
Percent (%)
16


Graph 10: Return on Equity and Actual Average Lending Rates – 2009

Source: IMF IFS and Global Financial Stability Report, 2010

3.32 As can be seen from the graphs, the returns on equity earned in the Zambian banking
sector have been very similar to those in Uganda and Kenya from 2006 to 2009; yet the
lending rates have been significantly higher than both countries over the period. For example,
in 2007, the average return on equity earned by banks in Zambia was 31.2%, similar to 31.4%
earned in Uganda, yet the lending rate in Zambia was 24.4%, compared to 19% in Uganda.
3.33 Furthermore, the graphs highlight that it is possible to earn significant returns on
equity without charging high lending rates. This is particularly evident in Namibia and
Mozambique, where returns on equity in 2008 were 52% and 45%, respectively, while
lending rates were 14% and 18%, respectively. Thus, holding other things equal, it can be
argued that that the profitability in the Zambian banking sector may be generated primarily
through high lending rates charged in the domestic economy, rather than through cost

efficiencies.

Macroeconomic Fundamentals
3.34 The history of consistently high inflation in Zambia has resulted in economic agents
rarely adjusting their inflation expectations downwards. In addition, the absence of clear
communication, by the BoZ to the public, on its monetary policy strategy makes it difficult
for the BoZ to anchor inflation expectations.
3.35 Therefore, it is essential for the BoZ to improve its policy transparency and credibility
in order to guide the inflation expectations of market participants.


5
10
15
20
25
30
35
40
Namibia
Zambia
Kenya
Mozambique
South Africa
Uganda
Return on Equity Lending Rate
Return on Equity and Lending Rates
Percent (%)
17

Money Market
3.36 In order to fully assess the interest rate channel of the monetary policy transmission
mechanism, it is necessary to look at the interaction between commercial banks and the
central bank, developments within the inter-bank market, and developments in the deposit
side of the market (i.e. savers and the savings rate) to get a holistic view of the money market
and to assess how effective the interest rate targeting framework would be in the long-run.
Maturity of Financial Markets and Development of a Secondary Market
3.37 The survey also highlighted the fact that an interest rate targeting framework requires
well-developed financial markets to provide an effective transmission mechanism of
monetary policy. This would have to be supported by a well functioning secondary market,
which would result in the creation of a short-term yield curve that would allow banks to
appropriately price their loans and advances. The secondary market would also facilitate the
trading of Government securities of smaller size amongst commercial banks and other market
participants, and thus aid in the liquidity management of financial institutions.

Limitations of the Survey
3.38 While the lessons learnt from the survey provided valuable information that will be
used in assessing the way forward, it should be noted that there were a number of limitations
in gathering information from the commercial banks, notably that:
(i) Not all banks provided complete and comprehensive information to the questions
asked;

(ii) Some of the banks did not have a formal calculation method or formula for the
determination of the base rate;

(iii) Some of the factors mentioned as key to base rate determination process were not
actually reflected in the formulas provided; and,

(iv) Some factors were not disaggregated into various components, especially with

respect to operating costs.


4
4
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0




C
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4.1 The undertaking of this survey was broadly aimed at identifying the factors that
commercial banks consider in making decisions regarding their base lending rates. The
specific objectives were twofold:

(i) To assess to what extent the interbank market influences the cost of funds and
thereby the lending interest rates; and

(ii) To ascertain which factors have significantly contributed to the high level of
lending interest rates in Zambia.

18


4.2 From the foregoing, it is clear that there are common factors which all the commercial
banks take into account in the determination of base lending rates. These include cost of
funds, economic conditions, market conditions and political risks. The cost of funds include:
cash reserve requirements – namely, the statutory reserve ratio, core liquid asset ratio and the
BoZ supervisory fee; operational costs; returns on economic capital/equity and yield rates on
Government securities. This is followed by market conditions: credit risk, industry trend,
competitors’ base rates or the average base rate in the market, inter-bank rate, overnight
facility and demand and supply of credit. However, economic conditions and in this case
inflation was found to be directly taken into account in the determination of base lending
rates by only half of the surveyed banks. The exchange rate is included in the economic
conditions.

4.3 The factors vary among the banks according to their impact on the cost of funds and
the bottom line. Further, we can conclude from the survey results that the decisions made in
setting and adjusting base lending rates are largely decided qualitatively, though some few
banks base their decisions on quantitative computations using specified formulas.

4.4 The survey results indicated that the interbank rate, which is expected to influence the
policy rate, is not a significant input in the determination of the lending base rates. Our
analysis indicated a correlation coefficient of 0.50 between the weighted lending base rate
and the interbank rate, versus a correlation coefficient of 0.72 between the weighted lending
base rate and the OMO rate. In light of these findings, it may be necessary to consider linking
the policy rate to an alternative market interest rate, such as the OMO rate.

4.5 Furthermore, the survey highlighted that there are other qualitative factors such as high
default risk and large information asymmetries that contribute to high lending rates, despite
the current positive macroeconomic conditions. In addition, we found that operational
inefficiencies and the need for high returns on the shareholders equity may also have
contributed to the high lending rates in the domestic economy.

4.6 Going forward, it is vital that conditions that will be conducive to an effective interest
rate targeting framework are put in place. These will include:

(i) An active interbank market, which will improve access to liquidity in the
market particularly for smaller banks;

(ii) A well functioning secondary market, which will make it easier to develop a
short-term yield curve;

(iii) An efficient CRB, which will enable banks to more easily assess credit risk of
potential clients; and,

(iv) Improved communication of BoZ monetary policy strategy to help anchor
inflation expectations.






19


4.7 On the issue of the high interest rates, it is recommended that:

(i) There is need for banks to improve efficiency by lowering the operational costs.

(ii) Banks should be consistent in the use of macroeconomic factors, i.e., inflation,
exchange rates and Treasury bills, in determining lending rates. That is, other
things equal, it is expected that when inflation or Treasury bill rates are low,
lending rates should also be adjusted downwards.

(iii) While qualitative factors are important in the determination of lending rates, in a
liberalized economic system like Zambia, macroeconomic factors should be
dominant to the determination of rates. In this regard, commercial banks are
urged to develop formal frameworks for the interest rate decision making
process.

(iv) On the part of the BOZ, we will continue to foster competition by encouraging
the entry of new banks for the purpose of improving the provision of banking
services.