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Boyd, J. and Gertler, M.; “Are Banks Dead? Or Are the Reports Greatly Exaggerated?”; Federal Reserve Bank of Minneapolis Quarterly Review; Summer 1994; pp 2-23
IMF Monetary and Exchange Affairs Department; Eastern Caribbean Central Bank: Government Securities Markets and Monetary Operations; April 1996.
Nelson, Augustine; “Failed, Restructured and Problem Banks: The Performance of Government-Sponsored Indigenous Commercial Banks with Special Reference to Trinidad and Tobago”.
Revell, Jack; Costs and Margins in Banking: An International Survey;Organization for Economic Co-operation and Development, Paris; 1980.
I would like to thank, without implicating, the following staff members for their invaluable comments on various drafts of the paper: Brian Stuart, Lorenzo Perez, Sandy Mackenzie, Frits van Beek, Olav Gronlie, Sam Itam, Lawrence DeMilner, Alain Ize, Hugo Juan-Ramόn, Sukhdev Shah, Rogerio Zandamela, David Dunn, Henry Ma, Mario Mesquita, Charles Mordi, Obert Nyawata, Sebastian Paris-Horvitz, Marcio Ronci, and Mayra Zermeño. I am also grateful to John Venner and Gale Archibald of the ECCB for providing the requested data.
There are eight countries in the region that share a common central bank, namely the Eastern Caribbean Central Bank (ECCB), six of which are independent states and are members of the International Monetary Fund (IMF). The six countries are, in alphabetical order: Antigua and Barbuda, Dominica, Grenada, St. Kitts and Nevis, St. Lucia, and St. Vincent and the Grenadines. These six countries are henceforth collectively referred to as the ECCB area. The two non-independent states are Montserrat and Anguilla.
The review period from 1991-96 was selected on the basis of the availability of the required data for each member country. However, it is also noteworthy that this time frame corresponds with a new banking regime under the Uniform Banking Act, approved by member governments in 1991, which expanded the ECCB’s banking, regulatory, and supervisory powers and procedures. In so doing, the new regulations tightened the capital requirements for banks, established a limit on unsecured loans of 15 percent of banks’ total loan portfolio, and mandated the publication of financial performance information.
The theory of interest rate parity states that in a competitive market, interest rates movements will shift so that a domestic investor will become indifferent between investment in the domestic currency securities and foreign currency securities with foreign rates, as capital flows seek the highest rate of return. To the extent then that commercial bank deposits are potential substitutes for financial securities, then by a logical theoretical extension, in the absence of capital controls, domestic interest rates can be expected to equal foreign interest rates plus the expected change in the exchange rate and an adjustment for market risk.
The representative rates are as shown in the IFS. The ECCB area regional average interest rate spread (for the period 1991-96) based on representative rates in the IFS exceeded the average spread in the U.S. and the U.K. by 3.2 and 4.0 percentage points, respectively.
The subsequent discussion explains that the ECCB is in the process of rectifying this problem, through the establishment of a regional government securities market.
For example in Dominica and St. Kitts and Nevis, where some private businesses reportedly have started to accept deposits and provide credit to the private sector. In addition, there were reports of banks rejecting savings deposits following the enactment of this regulation.
It is worth noting that although a narrowing of the spread would be expected, in practice, interest rate spreads might never fully converge to international levels for any number of reasons. For instance, if fixed costs are high—say, owing to a certain amount of excess capacity stemming from over-banking—and the banking system serves primarily small depositors, then there might be a certain inelasticity in the demand for local bank services (driven principally by a transactions, as opposed to speculative, motive) despite the lower remuneration rates available on local deposits.
There is also a ceiling of 16 percent on lending rates in Grenada, although it is believed to be non-binding and is not found elsewhere in the ECCB area.
Data on nonperforming loans were not provided.
The new regulations stipulated specific provisions based on loan risk characteristics. For example, a 100 percent provision is required for unrecoverable loans, a 50 percent provision for doubtful loans, and a 10 percent provision for substandard loans. Also included was a minimum general provision of 1 percent. In addition, the maximum time permissible for writing off bad debts and suspending interest income was tightened to three months. The ECCB also required banks to hold a minimum capital (including equity capital and disclosed reserves) equivalent to 8 percent of a bank’s risk weighted assets. Risks for on-balance sheet assets are zero for currency and government securities, 20 percent for claims on domestic and foreign financial institutions, 50 percent for loans fully secured by mortgages on residential properties, and 100 percent for other claims on the private sector and for real estate and equity investments. The new bank reporting requirements call for detailed information on the type, currency, country of issue, interest rate, and maturity date of a bank’s investments. Banks are also required to file separate reports on investments that they administer as fund (continued…)
During the review period, these restrictions applied in the case of Grenada, Dominica, St. Kitts and Nevis, St. Lucia and St. Vincent and the Grenadines (Exchange Arrangements and Exchange Restrictions, Annual Report 1996.)
The growing awareness of this problem has reportedly prompted eleven of the larger local banks to seek to implement a joint initiative that would possibly: establish a jointly-owned lending subsidiary that could diversify across countries and fund loans too large for individual banks; expand the existing joint credit card facility to link ATMs and to support debit cards; create an investment banking subsidiary; and facilitate the acquisition of problem institutions both inside and outside the OECS. (The OECS Financial Sector Review, op.cit.)
A comparison of the cost structure of the commercial banks in the ECCB area and that of banks in the United States was not shown owing to the absence of a comparable scaling factor for operating costs in the United States, reflecting the growing significance of off-balance sheet items in the operations of the United States banks. Off-balance sheet operations give rise to operational costs and income, but have no balance sheet asset counterpart. Thus, the understatement of commercial bank assets would bias the ratio of operating cost to total assets (or similarly the ratio of operating cost to average deposits) upwards. In addition, it is possible that such a comparison could also be subject to biases stemming from differences in accounting practices.
Wealth is omitted as an explanatory variable for purposes of simplification, given the difficulties inherent in the measurement of this variable in developing countries.
The monopoly assumption is made for simplification purposes. Since the market is probably best characterized as oligopolistic, the optimal level of deposits is likely to lie between the perfectly competitive and monopolistic outcome. Therefore, when possible, the solution under perfect competition is also presented (see graphical analysis below).
Loan loss provisions are grouped together with production costs since they represent a small proportion of total commercial bank costs in the ECCB area, notwithstanding the regulatory changes that went into effect in July 1995. A deposit tax of 1 percent, applicable solely to private banks, is known to exist only in St. Vincent and the Grenadines, and was unchanged over the review period—consequently, the influence of taxes will not be modeled explicitly.
Reserves are unremunerated in the ECCB area, so rR, which is only shown here for completeness is zero, and will be subsequently dropped from the analysis.
The present analysis will not permit an assessment as to whether or not the observed scale economies are of a long run or short run nature, owing to data constraints which limit our ability to observe how costs vary over time and with changes in banks’ scale. With the requisite information on individual firms, it would be interesting to investigate further the issue of scale diseconomies in banking in the ECCB area, with a possible partitioning of the data between private and government-owned banks.
For the purposes of simplification, the presentation in Charts 3 and 4 assumes that marginal production costs (including taxes) and reserve requirements are zero, so the only costs are interest cost—hence the marginal interest cost curve is drawn.
The industry supply curve is the horizontal summation of those portions of the individual firms’s marginal cost curves above their respective minimum average variable cost points.
The influence of market rates cannot be estimated separately owing to the fact that both the Treasury Bill rate and the yield on government securities were practically invariant in each country during the review period and were therefore indistinguishable from the constant. The effect of market rates is therefore believed to be captured by the constant.
Market characteristics such as the degree of competition and market size are all expected to be important determinants of the variation in the interest rate spread. However, the direct effect of competition on the interest rate spread could not be assessed owing to the lack of time series information on the number of commercial banks by country. Ideally with data on both operational cost and the volume of operations per bank, the analysis could include the calculation of concentration ratios, and more thoroughly analyze the issue of scale diseconomies in the region’s banking industry.
This conclusion is consistent with that reached by Robert A. Lucas, Jr., in “Money Demand in the U.S.: A Quantitative Review” in Carnegie-Rochester Conference Series on Public Policy, 29(1988), pp. 137-168.
It would be useful, with additional data, to conduct an analysis of scale diseconomies which separates the government-owned banks from other banks in the region.
It is not presently possible to conclude this with any certainty, however, as the current analysis is based on pooled data for commercial banks of varying operational size, owing to data constraints.
It is reported that the market share of nonbank financial institutions has been growing rapidly. However, it is not yet possible to document this empirically, as the ECCB has only just implemented a reporting requirement for these institutions.
The market share variable (MKSH)—defined as country-specific average total assets as a percentage of regional average total assets—was found to be highly positively correlated with operating cost and strongly negatively correlated with the share of loans going to the public sector (GOVT) and the share of savings deposits (SVSH). The inclusion of MKSH in the equation rendered OPCT (operating expenses as a percentage of average total assets) and GOVT insignificant, while the variable itself was significant only at the 5 percent level and the coefficient of determination remained unchanged. The influence of this variable could therefore not be separately distinguished and was consequently omitted.
The numbers in parentheses are t-ratios, and “*” connotes significance at the 5 percent level and “**” connotes significance at the 1 percent level.
This hypothesis is difficult to substantiate, however, in the absence of bank-specific information and is somewhat difficult to reconcile with the finding of scale diseconomies.
This gave rise to the recommendation that further analysis be conducted—contingent on the availability of disaggregated data by bank and branch and over time—examine separately determinants of interest rate spreads in the case of private and government-owned banks.