The Banking Industry and Interest Rates

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Table of Contents

Introduction
Significance of the Study
Literature review
Conclusion and Recommendations
References

Introduction

The government and the central rates have been the major bodies used to determine the interest rates. In the United States the Federal Reserve’s is responsible for setting the interest rates. However, the markets are also used to determine the interest rates in an economy. In the current world, the interest rates are constantly increasing due the crises that hit the world. Crises such as recession and the European debt crisis have led to the rise in interest rates in the world. Banks have adopted various strategies to survive the dynamism of the interest rates. Banks in Europe are forming mergers to cushion the effect of costs of lending (Laurin and Majnoni, 2003). The banking industry is highly concentrated. This concentration may have led to the collusion and high interest rates margins. The mergers seen in the European market are attributed to the market expansion.

With the extension of the Euro zone, entry into the banking market has become easier. The number of banks has increased and the competition is at its highest (Santos and Winton, 2008). Due to the high competition in the industry, the more efficient banks are taking over the less efficient banks. The efficient banks find it possible to offer more competitive interest rates than the less efficient banks. However, in the market, competition and interest rates are also determined by other factors such as technology and consumer preference. Technology has led to an increase in the levels of competition. This is because competition increases efficiency and cuts the cost of lending. With lower costs of lending, banks can afford to offer lower rates than the ones prescribed by the market (Business Insight, 2009).

The banking industry mergers are usually for the purpose of reducing the effects of the high interest rates. However, the mergers do not necessarily affect the efficiency of the banks relative to others. Another reason behind the bank mergers is to gain market power in the face of high interest rates (Amemiya, 1981). Market power can be used to control the rate of lending. The more powerful a bank is the easier for it to offer lower interest rates. In some countries there is clear differences in the loan pricing between banks. This difference in loan prices has been attributed to the power exhibited by merging of banks. Mergers are better placed to compete in the market than the single banks.

The rates of interest charged by banks can determine the type of competition facing the bank. Banks operating in a monopolistic market have no competition and can charge higher interest rates than banks in a highly competitive market. These because, without competition in the market banks can easily charge higher rates and not lose customers. On the hand, banks in a competitive market have to charge interest rates that would attract customers. These rates must also be within the range of rates set by the foreign reserves or the central bank (Bacchetta and Ballabriga, 2000). Therefore, banks in this industry will usually charge the market interest rates or a rate that is a bit lower than the market rate depending on their market power.

Efficiency in the banking sector is enhanced by various factors. In this article, the discussion focuses on efficiency brought about due to technological advances and the recruiting of qualified personnel. Usually efficiency of a bank can be used to determine the rates of interest charged. Moreover, the efficiency of a bank will also determine the competitive index. The more efficient a bank is, the more competitive it will be in the market. Efficiency enhances competitive ability of a bank and may lead to fall in the costs of offering loans.

Significance of the Study

The importance of this study is to provide scholars and academics knowledge on how the interest rates affect the level of competition in the banking industry. Moreover, it provides students on knowledge how the banks use the market interest rates, set by the government, Federal Reserve or the central bank, to determine the price of offering a loan at a competitive rate. In addition to this, the paper will provide knowledge on why the banks prefer mergers when the interest rates in the economy increases.

Purpose and Objective of the Study

The main purpose of this study is to determine how the interest rates affect the Competition in the banking industry. The paper also tries to find out how the Competition affects the cost of lending in the banking industry. The specific objectives of this paper are:

Determine the models that banks use in loan pricing
To determine the specific of increasing interest rates on the banking industry
Find out the reason the relation between merging and interest rates.
To determine the relation between bank efficiency and interest rates

Methods to be employed

In order to gain more knowledge on these objectives the research will conducted from different sources. Data on determining the models used by banks will be obtained from international journals and books. Data on determination of how the interest rates increase affects the banking sector will be obtained from newspapers and financial articles. Furthermore, relevant books, research and theses will form part of the material used to determine the reason why banks prefer the use of mergers when the interest rates are high.

Literature review

Competition

Many economists have analyzed the competition in the banking sector. Moreover, economists have tried to find method of measuring Competition exhibited by the various banks in the market. The economists measure the aggregate characteristic exhibited by a bank in the market and estimating the conjectural variation (Bikker and Bos, 2005). The strength of the conjectural variation determines the bank’s competitive power in the market. In a perfectly competitive market, the conjectural variation figure is usually zero. This indicates that no bank has an advantage over its competitors. In the case where the bank is a monopoly, the conjectural variation figure is usually equal to zero. This figure shows that the bank has an absolute advantage over its competitors.

Banks competitive advantage can also be measured by observing the bank’s power in the market. The power of the bank is determined by the market share of the bank. The number of customers that a bank has will determine how powerful they are (Choi and Elyasiani, 1997). Herfindahl-Hirschman Index is used to measure the market concentration (Berger et al, 2005). The users of this index assume that the market structure affects the performance of the bank. The performance of the banks determines the market share and in the long run determines how competitive they are in the market.

Banks can also determine their competitiveness in the market using the H-statistic approach. In this approach, the banks measure the elasticity values obtained after solving econometric equations on revenues (Bikker and Bos, 2005). H values that are less than zero indicate that the bank is operating in a monopoly (Bikker and Bos, 2005). Values between zero and one show that the bank is operating under an oligopolistic market whereas a value of one show that the bank is operating under perfect competition in the market.

The method above can be used to measure the competitiveness of banks in the market. By using the aforementioned methods, a bank can determine their position in the market and choose the interest rates they can offer to their customers. Banks that are highly competitive have the luxury of offering interest rates at a lower rate than their competitors. However, the concept of competition cannot be discussed without incorporating the concept of efficiency. Factors such as technology and professionalism determine efficiency in the banking industry.

Efficiency

Various factors contribute to efficiency of a business entity. This report discusses how technology and recruiting skilled and qualified staff contribute to effectiveness and efficiency. Advances in technology have led to automation of some tasks in the banking sector. Tasks that were once performed with human beings are now delegated to the machines. For example, the introduction of automated teller machines has made the need for many cashiers in the bank to be obsolete. Therefore, banks have become more effective and efficient due to technological advances. These banks can save costs and use the saving to provide loans cheaply.

Another way that banks have increased their efficiency is by hiring highly specialized and professional staff members. Availability of skilled staff can be a source of efficiency in the organization. They can save time and money for the organization thus making it possible for the organization to compete highly in the market. Skilled personnel perform their duties at their maximum potential they are highly effective than unskilled employees. Moreover, they enhance professionalism in a business setting. These characteristics may attract customers and increase the organizational profits. Profits may be ploughed back into the business to ensure that they remain highly competitive in the market.

Economists use various methods to measure efficiency. The Boone’s indicator model has been used by some economists as a measure of efficiency. This model assumes that more efficient banks with lower marginal cost will have a high probability of gaining a large market share (Boone, 2001). Moreover, the theory suggests that banks with more market power gain more profits and can easily provide stronger competition in the market. It should be noted that the Boone’s model simplifies real market conditions. According to the models, the banks can decide to convert the profits into either greater profits or lower price of lending. A general assumption by many economists is that business entities pass some of their efficiency gains to their customers (Kieso, 2001). This efficiency gains may be passed in forms of rewards, bonuses or lower interest rates. Banks with the aim of gaining market power use the lower interest rates to attract borrowers (Robert and David, 2000). Established monopolistic firms use the profits gained to generate more profits.

Competition can be measured concurrently with efficiency. The Herfindahl-Hirschman Index that is used to measure the market concentration can be used together with efficiency hypothesis (Bikker and Bos, 2005). The efficiency hypothesis tests incorporate the concept of profits from the markets and the measure of efficiency. The general assumption in this test is that the market variables cannot contribute to profits. Instead, efficiency of the organization is the ultimate source of profits (Bikker and Bos, 2005). The idea of testing efficiency together with competition is used to show the relation of bank’s competitiveness relative to its effectiveness levels (Bikker and Bos, 2005). However, according to Bikker and Bos (2005) the concept of efficiency hypothesis suffers from the problem of variables being highly correlated. Therefore, the coefficient estimates of the efficiency hypothesis are highly volatile to small changes in the variables. Nevertheless, the multicollinearity nature of efficiency hypothesis does not affect or reduce its predictive power.

The banking industry is operating under extremely competitive situation (Mehdi, 2005). Most of the banks have the responsibility of being more efficient in order to compete at an equal rate with others. Moreover, the credit crisis has highlighted the importance of efficiency in the bank lending habits (Duncan et al, 2006). To discuss efficiency comprehensively two aspects in the banking industry should be examined. Managers need to examine the manner in which the economic situation affects the banking efficiency first. This can be accomplished by investigating the banks procedures and habits with the changing economic situation. Secondly observing the bank’s lending channel can also be used to determine if the bank is efficient or not. If the monetary decision of a bank remains sound over an extended period o time while the economic conditions remain dynamic, the bank can be said to be highly efficient.

The relation between competition and interest rates

Interest rates set by the government, the central bank or the Federal Reserve can affect the market pricing power on loans and deposits (Deshmukh et al., 1983). The interest rates of investments with inelastic demand are less competitive. Therefore, the rate of interest changes in the market is dependent on the competition to a certain degree. Banks with a large market share are more powerful in the market than their counterparts. Powerful banks experience less competitive pressure in the market when compared to their counterparts (Boone, 2001). More powerful banks can use their own funds to finance the cost of lending and this explains the reason behind the difference in lending rates among banks. Banks usually use different strategies to earn more. The lending interest rates are usually higher than deposit interest rates (Li and Mao, 2003). Banks are forming mergers to increase their competitive edge. The banking industry mergers are usually for the purpose of reducing the effects of the high interest rates. However, the mergers do not necessarily affect the efficiency of the banks relative to others. Merger usually increase the competition and the market share of the banks this in turns enables the banks to create interest margins.

Models used by banks in pricing the loan

The central banks and governments use short-term interest rates as an instrument of implementing monetary policies. It is therefore a useful to understand the effect of monetary policy on the economy. Substantial research on interest rate rule has been done in the past. From the research done, the rate of interests is usually dependent on the models used to determine the rate of interest. Most books use the Keynesian model because it has fewer limits, and can accommodate application of any interest rate policy (Brevinge, 2009).

The central bank and the government apply the IS-LM model to determine the interest rates. This model aims to determine the levels of interest rates and the level of income where both the money markets and commodity market will be equal. The IS curve is the locus of all points showing all the level of income and interest rates that are consistent with equilibrium of the real output (Brevinge, 2009). The LM curve is a graphical path traced by all points showing the relation between cost of borrowing and income levels consistent with equilibrium of the financial market (Mudida, 2003). This model is however criticized by economists who deem it as a classroom model. This model is said to miss important points expressed in the Keynesian theory and thus its use is in determining interest rates is limited.

In the theoretical world of perfect competition where the information is totals and all economic agents have the knowledge of the prevailing conditions, the prices are usually equal to the marginal costs. The derivates of the marginal costs and the prices is usually equal to one. When this idea is applied in the banking industry, the equation of marginal cost pricing model equation is given below (Rousseas, 1985).

I = Y_o + Y1 mr

I in this equation represent prices set by the retail banks for acquiring a loan (Rousseas, 1985). Therefore, it represents the interest rates of the retail banks. Y_orepresents the constant mark up in the banking retail business. The coefficient mr represents the marginal costs of the retail banks approximated by comparing the interest rates in a similar market (Rousseas, 1985). The general idea behind this equation is that the market rates of interest provide the most desired marginal cost prices (Rousseas, 1985). This is because they reflect the marginal cost of funding faced by the retail banks. The coefficient of the equation Y₁ is dependent on the demand elasticity of deposits (Rousseas, 1985). In addition to this, it is dependent on the demand elasticity of the loans with respect to the retail interest rates offered by the banks. In case the investors demand for deposits and loans is inelastic the figure Y₁is represented by a numerical value of less than one (Sawyer and Sprinkle, 2009).

If the demand for deposits and loans has unitary elasticity Y₁is represented by the numerical value of one and if the deposit rates are elastic then, Y₁is represented by a numerical value that is greater than one (Sawyer and Sprinkle, 2009). Economists expect the deposit demand to be relatively elastic when compared to the banks’ deposit rates. This condition is only so in situations where there are close substitutes for deposits. For example if business activities can yield as much as the bank deposit rates then, the business may act as the close substitute to the rates of deposit. The loan demand is dependent on various factors (Ruthenberg and Landskroner, 2008). Included in these factors is the ability of investors to obtain their finances from other sources in the market. In cases where the businessmen can obtain loans from other sources at a cheaper rate then the interest rates offered by the retail banks should reflect this situation (Ruthenberg and Landskroner, 2008). This means that the interest rates of the commercial rates ought to be lower in order for them to compete with these financiers.

The coefficient Y₁may also be less one when a bank commands a substantive degree of market power. This means that the bank is highly competitive in the market and the demand for loans or deposits is highly inelastic. Based on the knowledge above the banks which are more powerful in the market will have more customers. Therefore, the probability of losing a big margin in demand for loans and deposits is relatively very low. Therefore, with knowledge in mind we can ascertain that the retail interest rates in monopoly markets are not based on competition. In the oligopolistic market, the retail rates will generally be less competitive since there are fewer banks.

The fact that the oligopolistic market faces a kinked demand will explain the lack of competitive interest rates in these markets (Temin and Voth, 2008). In an oligopolistic market, the banks are the price makers since they are few and can easily form cartels. In these markets, the competition that mostly occurs is the non-price competition. Therefore, the banks in such a market will aim at differentiating their products rather than get involved in an interest rate war (Mudida, 2003). The fact that the banks in an oligopoly market have two demand curves, one for price increase on obtaining a loan and another for price decrease for obtaining a loan, makes the banks vulnerable to interest rate wars (Mudida, 2003). Therefore, the interest rates in this case are usually maintained within the kink to avoid losses.

In a competitive environment the banking interest rates are extremely competitive. In the theoretical model of a perfectly competitive market, the value of the parameter Y₁is equal to one. This case is however not true in the real market situation. This is because existence of a perfectly competitive market in the real world is not possible. Therefore, in a highly competitive market of the real world the parameter Y₁is given by a numerical value closer to one. This means that the interest rates set in an extremely competitive market will respond in a quicker manner to the changes than in the monopoly markets and oligopoly.

The pass through rates of interest is usually determined by the levels of competition of the banks (Boone, 2001). Competition is determined by the market power and the market share of a bank. Various other factors determine the competitiveness of a bank. For example, the regulatory policies that restrict entry into the banking industry provide the existing banks with a chance of monopolizing the market. This has therefore created a precondition that allows certain banks to be more powerful than others. Banks that are generally more powerful and better established than others tend to pass a lower rate of interest to the consumers (Boone, 2001). This is because they can minimize the costs they pass through to their consumers. The less competitive firms find it hard to cut the costs of providing interest and sometimes pass additional costs to their customers. Therefore, the pricing of the interests of less powerful competitors are even higher than the prescribed rates.

Cases on different countries have acted to provide evidence of the slow pass through rate from markets into the retail bank rates in highly competitive markets (Rehman, 2000). A good example of a current situation is the Kenyan market where the retail interest rates do not reflect the market rates. After the rates were adjusted to a higher level in Kenya in order to reduce the rates of inflation, the banking industry is still lagging behind in implementing the new market rates. The highly competitive banks in Kenya finance part of the cost of obtaining loans in order to acquire more customers. These banks are highly powerful in the market. Therefore, they can afford to provide part of the cost of a loan and increase their market share.

However, the power of a bank does not necessarily mean that the interest rates will always be lower (Boone, 2001). This situation is only applicable in an extremely competitive market. In the cases of monopolies where the bank serves the majority of the consumer base it is a difficult to find them lowering the interest rates below the prescribed rates. This is because the bank knows that the elasticity of demand in such a case will very little. Investors will demand loan whether the cost of lending is high or not in a monopolistic market. In oligopolistic markets, the interest rates tend to be sticky. This has been attributed to the low elasticity of demand in these markets.

Relation between bank mergers and interest rates

The current trends of merging and consolidation in the banking sector has raised concerns that investors and small business entities may find it difficult to obtain finances at affordable rates. This has been attributed to the increasing complexity of the financial institution. There has been a noticeable increase in the level of bank consolidation in the last two decades (Hughes and Mester, 2008). This has encouraged studies into the banking industry to determine the causes of the mergers. Most of the analysis has been focused on the aggregate effects of banks. This is because little data on individual small firms is available for study (Hughes and Mester, 2008). This paper however, analyses the effect the mergers have had on the interest rates of an economy (Hughes and Mester, 2008).

Between 1996 and 2005, European banks spent a great deal of money to enhance the process of bank consolidation. A total of 816 deals, costing over 600 Euros, to consolidate the banks were completed during this period (Hughes and Mester, 2008). This case of consolidation and mergers is not limited to the European countries only. There is evidence suggesting that the consolidation of banks is occurring everywhere in the world. Banks are getting bigger by merging and acquisition (Hughes and Mester, 2008). A good example of such cases can be seen in the United States.

The big retailer banks in the United States control over 49% of the market share. These banks have gained more market power by gaining over 20% increase in the market share in a period of ten years (Hughes and Mester, 2008). The idea of market concentration brought about by mergers and has raised a lot o concerns among the economists and the policy makers. Small businesses are finding it more challenging to obtain finances from the large and complicated retail financial institutions. This report discusses the potential merits and demerits of bank consolidation to investors and other business entities. The question raised on whether the bank mergers harm or benefits borrowers is extensively discussed in this paper. The importance of banks on investors vary with the bank policy and the investors requirements

Bank mergers can either benefit the investors or harm the investors (Robert and Peter, 2003). One of the merits of bank consolidation or mergers is that it enhances efficiency in an organization. This leads to saving of costs, increasing revenue, gaining economies of scale due to the size of the bank, and increasing diversification in the banking industry. Borrowers and investors will benefit from the fact that gains obtained from efficiency will be passed in the form of lower interest rates (Duncan et al, 2006). On the other hand, the increase in mergers in the banking sector has the disadvantage of increasing the market concentration. In this case, borrowers will be harmed because the industry will be moving away from a competitive market to area where the banks may be deemed as monopolies (Edmister and Merriken, 1989). These banks may also be moving towards oligopolistic markets. Such banks are usually very powerful and can exercise their market power by increasing the interest rates. In addition to this, large bank mergers may easily inhibit lending relationships that existed between the lenders and the borrower before the banks merged (Edmister and Merriken, 1989).

In a highly competitive market, the reason for bank mergers is usually to gain market power. The banks that form mergers have the objective of increasing their market share. In addition to this, merging ensures that the banks can compete more efficiently (Hendry and Kamhi, 2009). Such mergers may lead to the decline in interest rates since they will be aiming to earn more market share and gain more power. However, with increase in the number mergers the market moves from high competition to a situation where the competition between firms is very low. This is because the number of total competitors reduces until the market starts to exhibit oligopolistic characteristics (Vickery, 2008).

As mentioned earlier the interest rates charged by the oligopolies are usually sticky since the banks try to avoid a case of price wars that may lead to losses. Therefore, the interest rates set in a market that is dominated by large powerful mergers tend to be more or less equal (Hillebrand and Koray, 2008). These banks can also collude and form cartels in order to exploit the market situation. Such cartels can charge high interest rates to the borrowers in order to gain super-normal profits. In such markets, the interest rates are highly volatile and exhibit abnormal behaviors since they are determined on the basis of the profit a bank wants to make (Hillebrand and Koray, 2008).

Conclusion and Recommendations

The government and the central rates have been the major bodies used to determine the interest rates. In the United States, the Federal Reserve’s is responsible for setting the interest rates. However, the markets are also used to determine the interest rates in an economy. In the current world, the interest rates are constantly increasing due the crises that hit the world. With the extension of the Euro zone, entry into the banking market has become easier. The number of banks has increased and the competition is at its highest. The banking industry mergers are usually for the purpose of reducing the effects of the high interest rates. However, the mergers do not necessarily affect the efficiency of the banks relative to others.

The rates of interest charged by banks can determine the type of competition facing the bank. Banks operating in a monopolistic market have no competition and can charge higher interest rates than banks in a highly competitive market. The power of a bank does not necessarily mean that the interest rates will always be lower. This situation is only applicable in an extremely competitive market. In the cases of monopolies where the bank serves the majority of the consumer base it is a difficult to find them lowering the interest rates below the prescribed rates. This is because the bank knows that the elasticity of demand in such a case will very little.

Efficiency in the banking sector is enhanced by various factors. In this article, the discussion focuses on efficiency brought about due to technological advances and the recruiting of qualified personnel. Many economists have analyzed the competition in the banking sector. Moreover, economists have tried to find method of measuring competition exhibited by the various banks in the market. Interest rates set by the government, the central bank or the Federal Reserve can affect the market pricing power on loans and deposits. The interest rates of investments with inelastic demand are less competitive. Therefore, the rate of interest changes in the market is dependent on the competition to a certain degree.

In the theoretical world of perfect competition where the information is total and all economic agents have the knowledge of the prevailing conditions, the prices are usually equal to the marginal costs. The current trends of merging or consolidation in the banking sector has raised concerns that investors and small business entities may find it difficult to obtain finances at affordable rates. This has been attributed to the increasing complexity of the financial institution. The importance of this study is to provide scholars and academics knowledge on how the interest rates affect the level of competition in the banking industry. Moreover, it provides students on knowledge how the banks use the market interest rates, set by the government, Federal Reserve or the central bank, to determine the price of offering a loan at a competitive rate.

From the report above several recommendations can be suggested to various parties. However, this report only provides recommendation to the lenders and the borrowers. On the part of the lenders, it is recommendable to enhance efficiency in an organization setting. This is because efficiency has been found to facilitate healthy competition among banks and thus ensuring they can maximize their profits. The concept of competition efficiency and interest rates is highly intertwined in the banking industry bankers need to take these three elements and ensure they can strike a balance in these issues.

In the case of the borrowers, choosing a bank to obtain funding should be researched properly. Banks in a competitive market offer competitive interest rates in order to attract consumers. However, banks in less competitive markets tend to be exploitative and charge higher interest rates. Therefore, borrowers should find markets that are highly competitive in order to obtain finances cheaply.

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