University of Ruhuna: IRS Determinants in Sri Lanka's Commercial Banks

This dissertation, submitted to the University of Ruhuna in February 2014, investigates the impact of macroeconomic determinants on interest rate spread (IRS) in Sri Lanka's commercial banking sector. The study, conducted by S.M. Gunawardana, analyzes annual data from 1983 to 2012, focusing on the relationships between IRS and macroeconomic variables including inflation rate, Bank Rate, banking sector development, exchange rate, and Treasury bill rate. Using regression analysis, the research aims to identify the significant determinants of IRS, contributing to a better understanding of the financial system's efficiency. The study's methodology includes descriptive statistics, variance inflation factor analysis, and regression analysis to analyze the collected data from the Central Bank of Sri Lanka. The findings highlight the significant influence of inflation rate, Bank Rate, banking sector development, and exchange rate on IRS, offering valuable insights for improving the efficiency of the financial system in Sri Lanka. The dissertation includes an introduction to the banking sector structure, the concept of IRS, the research problem, questions, objectives, methodology, and significance of the study, followed by a literature review, methodology, data presentation, analysis, and conclusion with recommendations and suggestions for future research.

IMPACT OF MACROECONOMIC
DETERMINANTS ON INTEREST RATE SPREAD
IN SRI LANKA
(Special Reference to Commercial Bank Sector)
By
S.M.Gunawardana
MF/2009/2356
Department of Accounting and Finance
February 2014
Dissertation Presented to the Faculty of Management and Finance
of University of Ruhuna
in Partial Fulfillment of the Requirements for the Degree of
Bachelor of Business Administration

i
Acknowledgement
Firstly, I would like to convey my sincere gratitude to my research supervisor
Ms.T.A.N.R Jayarathne, Lecturer of the Department of Accounting and Finance,
University of Ruhuna. The guidance, enthusiasm and all support provided throughout
this endeavor is highly appreciated.
I would like to make my heartfelt gratitude to Dr.Manjula K.Wanniarachchige, Head,
Department of Accounting and Finance, University of Ruhuna, for his supervision,
educational support and good advice. He provides me with helpful comments which
results in developing a better and vital understand of the subject.
Finally, I express my heartfelt gratitude to my friends, parents and family members
who are behind me throughout my life as well for helping me for the successful
completion of everything of this study.

ii
Dedication
This Dissertation is dedication to my family members for their kindness, devotion and
endless support which gave me much more courage.

iii
Table of content
Acknowledgement ...................................................................................................................... i
Dedication .................................................................................................................................. ii
Table of content ........................................................................................................................ iii
List of Tables .............................................................................................................................. v
List of Figures ............................................................................................................................ vi
List of Acronyms ....................................................................................................................... vii
Declaration .............................................................................................................................. viii
Certification .............................................................................................................................. ix
Abstract ...................................................................................................................................... x
1 CHAPTER 01 ....................................................................................................................... 1
INTRODUCTION .......................................................................................................................... 1
1.1 Background of The Study ........................................................................................... 1
1.2 Banking Sector Structure in Sri Lanka ........................................................................ 1
1.3 Interest Rate Spread .................................................................................................. 2
1.4 Research Problem ...................................................................................................... 3
1.5 Research Question and Objectives ............................................................................ 4
1.6 Methodology .............................................................................................................. 4
1.7 Significance of The Study ........................................................................................... 5
1.8 Limitations of the study ............................................................................................. 6
1.9 Summary and Chapter Organization .......................................................................... 6
CHAPTER 02 ............................................................................................................................... 7
LITERATURE REVIEW .................................................................................................................. 7
2.1 Introduction ............................................................................................................... 7
2.2 What is Interest Rate Spread ..................................................................................... 7
2.3 Determinants of Macroeconomics ............................................................................ 8
2.4 Summary .................................................................................................................. 13
CHAPTER 03 ..................................................................................................................... 14
METHODOLOGY ....................................................................................................................... 14
2.5 Introduction ............................................................................................................. 14
2.6 3.2 Conceptual Framework .................................................................................. 14
2.7 Rationalization of the variables ............................................................................... 15
2.7.1 Dependent Variable ......................................................................................... 15

iv
2.8 Development of Hypotheses ................................................................................... 18
2.9 Methodology ............................................................................................................ 18
2.10 Data Analysis ............................................................................................................ 18
2.11 Summary .................................................................................................................. 19
CHAPTER 04 ..................................................................................................................... 20
DATA PRESENTATION AND ANALYSIS ...................................................................................... 20
3.1 Introduction ............................................................................................................. 20
3.2 Data Presentation .................................................................................................... 20
3.3 Data Analysis ............................................................................................................ 21
3.3.1 Descriptive Statistics ........................................................................................ 21
3.3.2 Variance Inflation Factor (VIF) ......................................................................... 23
3.3.3 Regression Analysis .......................................................................................... 24
3.4 Summary .................................................................................................................. 27
CHAPTER FIVE .................................................................................................................. 28
CONCLUSION AND RECOMMENDATIONS................................................................................ 28
4.1 Introduction ............................................................................................................. 28
4.2 Conclusion ................................................................................................................ 28
4.3 Recommendations ................................................................................................... 30
4.4 Suggestion for Future Researches ........................................................................... 31
REFERENCES ..................................................................................................................... 32
Annexure .......................................................................................................................... 34

v
List of Tables
Table 4.1 Descriptive Statistics……………………………………………22
Table 4.2 Collinearity Diagnostics…………………………………………23
Table 4.3 Results of the Equation I………………………………………..24
Table 5.1 Conclusion of Regression Result……………………………….29

vi
List of Figures
Figure 1.1 Conceptual Frame Work…………………………………………5
Figure 3.1 Conceptual Framework………………………………………….14
Figure 4.1 Interest Rate in Recent Past – Sri Lanka………………………...20

vii
List of Acronyms
BR Bank Rate
CPI Consumer Price Index
EXR Exchange Rate
GDP Gross Domestic Production
GDPpc Per Capita Gross Domestic Production
INF Inflation Rate
IRS Interest Rate spread
LCB Licensed Commercial Bank
LSD Licensed Specialized Bank
NSD National Saving Directorate
SCALE Banking Sector Development
SRR Statutory Reserve Requirement
SSA Sub Saharan African
TBR Treasury Bill Rate
US United State

viii
Declaration
I hereby declare that this dissertation is my own work and effort and that, to the best
of my knowledge and belief, it contains no material previously published or written
by another person nor material which has been accepted for the award of any other
degree or diploma of the university or other institute of higher learning, except where
due acknowledgment has been made in the text.
Signature of the student : _______________________________
Name of the student : S.M.Gunawardana________________
Registration number of the student: MF/2009/2356___________________
Date : 10th February 2014________________

ix
Certification
This is to certify that this dissertation submitted by S.M.Gunawardana
(MF/2009/2356) in partial fulfillment of the requirement for the Degree of Bachelor
of Business Administration in Accounting at the Faculty of Management and Finance
of the University of Ruhuna is a record of the own work carried out by the student
under my supervision. This dissertation has been submitted with my approval.
____________________________
Supervisor
Ms.T.A.N.R. Jayarathne
Department of Accounting and Finance
Faculty of management and Finance
University of Ruhuna
____________________________
Head
Dr.Manjula K. Wanniarachchige
Department of Accounting and Finance
Faculty of management and Finance
University of Ruhuna

x
Abstract
This study gives emphasis on the macroeconomic determinants of Interest Rate
Spread in Sri Lanka commercial bank sector. Based on the literature, focus of this
study has been placed on five macroeconomic determinants of interest rate spreads in
the commercial banking sector. Accordingly the variables are inflation rate, Bank
Rate, Banking Sector Development, Exchange rate and Treasury bill rate. Study used
in the Central Bank of Sri Lanka annual data from 1983 to 2012 are analyzed by using
Regression model. Result of the study concluded that inflation rate, Bank Rate,
Banking Sector Development, and Exchange rate have significant relationship with
Interest Rate spread in Sri Lanka.
Key Words;CommercialBanking Sector, Interest Rate Spread, Macroeconomic
Determinants

1
1 CHAPTER 01
INTRODUCTION
1.1 Background of The Study
Economic development of a country essentially depends on patterns and levels of
resource mobilization and allocation. Resources are mobilized through savings,
which, at the macroeconomic level, way for the allocation of resources for
consumption and investment. The banking system and the financial system more
generally, is a key pillar in any economy to reallocate funds from agents with a
surplus to those with a deficit.
Similarly, investment depends on banking credit and the primary lending
system, which enables investors to borrow for the purpose of investing in real capital
to enhance existing businesses or establishing new businesses. In this way, banking
credit contributes to the generation of economic activity and eventually leads to
higher national income and growth.
Therefore, all economic players, including households, businesses, and the
public sector, are sensitive to the efficient flow of resources from surplus to deficit
units. Analysis of resource transfer through the operations of the banking system,
therefore, has to contend with the price structure prevailing in the credit market. The
strong correlation of banking system stability with the economic growth and
development of a country has only recently been noted. Supervisory authorities
around the world are driven to ensure the safety and soundness of their respective
financial systems so that they can play an active role in the economic development of
their country.
1.2 Banking Sector Structure in Sri Lanka
According to Central bank of Sri Lanka the banking sector accounted for 56.4% of
financial system assets at end of 2012 and comprises Licensed Commercial Banks