Financial Stability Report No1 20 December 2010 - Banka Qendrore ...

Financial Stability ReportNumber 19. Decomposition of Financial Intermediation Costs: A ComparativeAnalysisValentin Toçi, Arben Mustafa and Astrit Panxha9.1. IntroductionThe interest rate spread in the Kosovo’s banking sector hasshowed some declining trend. .High interest rate spread mainly reflects high lending and low deposit rates. This can haveimplications in discouraging investments and savings thus harming economic growth.Lending rates are determined by many factors, such as bank size, market power, liquidity,economies of scale and operating Also, funding costs, regulatory costs (e.g., taxation andreserve requirements), rule of law, overall institutional setting, and macroeconomicenvironment represent important determinants of lending rates. In addition, a veryimportant component of interest rates consists of risk perceived by banks, which can derive,among others, from institutional failures in general and the legal ones in particular i.e.,difficulties in repossessing collateral.This study draws on and is an updated version of earlier paper by Morina and Toçi (2007).The main focus is to explain the trend in interest rate spread in Kosovo. It also comparesthe structure of income statement and earning margins of Kosovo’s banking sector withfour countries in the region. Then the study focuses on the cost structure of the bankingsector in Kosovo related to lending to the domestic economy only by decomposing funding,operational, risk and regulatory costs. The results indicate that one of the most importantcomponents contributing to the high level of lending rates and the spread are operationalcosts and risk costs expressed by the level of provisioning.9.2. Interest rate spread and earning marginsOne of the commonly used measures of the banking sector efficiency is interest rate spread,i.e., the difference between the interest rate that banks charge for loans and interest ratepaid to savers. Lower spreads can be interpreted as an indication of the intermediationefficiency of the banking sector, although this may not necessarily always be the case. Forinstance, low ex post spread may reflect excessive risk-taking and high loan defaults. Onthe other hand, high spreads could imply excessive transfer to banks, inefficiency inintermediation in the local market, lack of competition, excessive risk by borrowers,institutional failures, etc. According to Valvarde et al. (2004), high spreads will decreasesavings and investment. Barjas et al. (1999) found evidence that commercial banks withgreater market power and high reserve requirement set by the regulatory body willincrease interest rate spreads. Also, weak institutions will increase interest rate spreads(Demirguc- Kunt et al., 2003). Regarding macroeconomic variables, there is an extensiveliterature that found evidence that high inflation, large fiscal deficit and increase in broadmoney () can increase interest spreads (Crowley, 2007; Demirguc-Kunt and Huizinga,1998).Higher efficiency, as broadly recognized in the literature of banking, comes at cost forstability (a so-called efficiency-stability trade-off). Higher spreads may contribute to thestability of the sector by ensuring profitability, increasing the franchise value of the sector| 75