Reducing Interest Rate Spreads: Observations to be Considered (Business Brief No.2406)

To stimulate the sagging economy, Thai policymakers want to see narrower interest rate spreads at the Thai commercial banks. Looking closely however, the spreads between loan and deposit rates are currently not so wide as many think. The effective interest rate spreads – gauged by net interest margin (NIM) – which is derived from dividing the net interest income by earning assets in 9M08 stood at only 3.71. If deducting annual contributions to the Deposit Protection Agency and NPL management costs (credit cost) by 0.4 percent and some 0.8 percent, respectively, the NIM would equal only 2.5 percent. If operating costs are factored in, i.e., if banking performance is taken into account, the interest rate spreads at commercial banks will be even lower.

In 2009, commercial banks may encounter further declines in NIM due to several negative factors, i.e., the economic slowdown that will continue to squeeze lending growth, lower returns on liquidity in line with the falling policy rate and higher costs of funding as a result of gradual hikes in fixed interest rates in the first half of 2008.

The government's latest guidelines to have interest rate spreads at commercial banks narrowed may have a negative implication toward Thai banking performance and the overall capital base. KASIKORN RESEARCH CENTER (KResearch) estimates that if loan rates are cut until the gross spreads (lending rates minus savings rates) drop to only 2 percent from currently around 6 percent, the NIM will fall to some 1.7 percent. This will cost Thai commercial banks around THB130 billion in loss of income and the capital adequacy ratio (CAR) may drop by 2.2 percent (if other factors are unchanged). Thus, Thai banking stability could be put into jeopardy, especially with the CAR at some commercial banks marginally close to the minimum regulatory requirement.

Narrower interest rate spreads may, at first glance, be positive to businesses and households that are depending on bank lending. However, the calculation of interest rate spreads by deducting deposit rates from lending rates may not truly reflect the actual business of Thai commercial banks. Even worse, a sole reduction in lending rates or a larger size of reduction in lending rates than their deposit counterparts may adversely affect commercial banks' capital bases and their stability.