Determinants of Banks Lending Interest Rates in Tanzania: An Investigation Using Banks Balance Sheet Data

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The study seeks to examine the determinants of bank lending interest rates in Tanzania, largely focusing on identifying the key determinants and their relative importance. Techniques employed comprise interest rates decomposition and econometric estimation using banks’ annual balance sheet data. Results on interest rates decomposition suggest that, the main drivers of lending rates are operating costs, non-performing loans; and costs of funds (banks deposits interest rate). The three factors accounted for 70.4 percent of small banks’ average lending rates in 2014-17; while for medium and large banks, they constituted about 69.5 percent and 67.4 percent of the lending rates, respectively. SMR ratio appears to play an important role in all banks' lending rates, but its share has been declining overtime consistent with the expansionary monetary policy measures pursued since 2014. With respect to econometric estimations, the findings confirm the role of operating costs, non-performing loans, and costs of funds in explaining banks’ lending rates dynamics. Operating costs, cost of funds, and inflation have a statistically significant positive effect on banks’ lending rates, while bank size and level of liquidity have a negative influence. SMR ratio is statistically significant but bears a negative sign except for locally owned banks. In relative importance, the main determinants of banks’ lending rates could be ranked as follows: inflation with an average positive impact of 0.432 on lending rates for a unit change in inflation, trailed by operating costs (0.261), and cost of funds (0.255). Bank size has the largest negative effect of 0.288 for every unit increase in the variable. These factors are also significant but with some variation across bank categories. The main factors behind high deposits rates include banks' high competition for deposits partly following tight liquidity conditions experienced by banks especially from 2016, largely due to cumulative impact of substantial decline in net foreign budgetary inflows, transfer of public institutions’ deposits from commercial banks to the Bank of Tanzania and heightened expenditure management. Factors affecting non-performing loans comprise global financial crises; credit screening weaknesses; a decrease in supply of loans partly contributed by factors such as liquidity tightness, and decline of effective demand for loans ascribed to domestic fiscal consolidation and disciple enhancement measures; capital enhancement measures including adoption of capital charge for operational risk, introduction of capital buffer and anticipation of increased provision due to adoption of IFRS 9. At the same time, operating costs are largely driven by costs related to employees’ salaries and benefits which account for an average of 43.7 percent of the banking industry’s operating costs and have been increasing overtime. Other notable costs components in this are rental expenses on premises and equipment, depreciation of premises and equipment, and utilities expenses. Employees’ salaries and benefits costs are much higher for small banks at 44.4 percent of operating costs compared to 42.5 percent and 43.9 percent for medium size and large banks, respectively. The implications of these findings are that effort should be directed at improving operational efficiency aiming at reducing banks operating costs. The key areas of attention are with respect to employees’ salaries iiiBank of Tanzania WP No. 17: 2019 and benefits, as well as rental and depreciation expenses related to premises and equipment. In this, banks may consider to take advantage of ICT advancement in the country in services provision so as to cut on costs of “mortal and brick” as well as employees. Priority could be put on utilizing the growing agent banking framework, and digital banking technology. Prudent consolidation of small banks could as well help cut on operating costs, improving efficiency, and enhancing liquidity levels. Also, measures need to be taken to reduce non-performing loans including through enhancing borrowers screening mechanisms enabled by credit risk management frameworks at bank level and mandatory use of credit reference system to reduce credit risk. Strengthening of the regulatory and supervisory role is important mostly targeting to ensure adequate liquidity in the banking system for daily needs. Since SMR is a tax on banks deposits, it is recommended to reduce it further from the current 7 percent (at end-August 2019) so as to enhance banks’ lending capacity. Nevertheless, such a move should be mindful of the absorption capacity of the economy in order to reduce the possibility for building inflationary pressures. The EAC statutory reserve requirement convergence target is 5 percent by 2021, the target is already attained by Burundi with a rate of 3 percent, Rwanda (5.0 percent), and Kenya (5.25 percent). Another area of attention is related to macroeconomic stability. That can be achieved through measures targeting higher and sustainable economic growth and low and stable inflation. The duo macroeconomic fronts are important in boosting demand for credit as well as improving loan repayment capabilities, hence reducing credit risks.